BPInsights: May 6, 2023

Something Missing: Omissions and Surprises in the Federal Reserve’s SVB Report

Policy responses to SVB’s failure would have major implications for banks’ financing of the U.S. economy and long-term economic growth. The appropriate policy response depends on a clear, factual understanding of what caused the failure. 

Gaps: The Fed did not design its SVB report to cover some topics, such as its actions as lender of last resort; actions by the Federal Home Loan Banks; the impact on bank balance sheets of its quantitative easing followed by rapid rate rises; the FDIC’s actions; or the decision to invoke the systemic risk exception. Presumably, others could investigate these areas. However, the report could have included other topics, but omitted them, and exploration of such questions is necessary. For example:

• Tailoring takeaway: The report omits documentary evidence to support its takeaway that the tailoring law impeded effective supervision of SVB.
• Internal communications. While the Fed did include confidential supervisory information in the report, it did not generally include internal emails or memos. The report also does not provide internal materials on the Board’s assessment of the San Francisco Fed or the framework it used to evaluate it. 
• Misplaced focus: The report does not consider the possibility that examiner emphasis on other, less material issues might have stymied proper focus on SVB’s fatal weaknesses. None of the MRAs or MRIAs cited in SVB’s May 2021 examination report relates to financial condition, much less to interest rate or liquidity risk, which were the key problems at SVB. A later supervisory letter does cover liquidity risk problems, but notably, it focuses almost exclusively on process. The volume of MRAs appears to refute the assertion that the former Vice Chair for Supervision fostered an unassertive culture; the materials show examiners quite assertive but about immaterial matters.
• Bureaucratic dysfunction: A key SVB question is why a response was delayed after the San Francisco Fed identified an interest-rate risk problem. The report acknowledges that “[t]he lack of clarity around governance processes and the need for consensus often lead to a lengthy process” and suggests that Board supervisors working alongside Reserve Bank supervisors while also overseeing those Reserve Bank staffers’ work could create tension. But it does not include such internal organizational conflicts in its recommendations.
• Distracted management and board: The report fails to consider how the list of examiner asks – related to documentation, governance and process – could have distracted SVB’s management and board of directors from addressing crucial issues. 
• Comparison: The report does not provide a sense of how the risks that took down SVB were managed (or overseen) at other banks supervised by the Fed, the OCC or state regulators. SVB’s business model appeared to be an extreme outlier both in terms of interest rate risk and depositor concentration – but it’s not clear if that is because other banks managed such risks better or because other regulators supervised such risks better.
• Other unanswered questions: Some topics covered in the report raise other questions that are left unanswered, such examiners’ views on SVB’s plan to remedy its failure to monetize its liquid assets, why SVB decided to sell its available-for-sale portfolio and recognize a loss and whether examiners knew that SVB had removed interest-rate hedges.

Five Key Things

1. Did S.2155 Allow SVB’s Failure?

The Federal Reserve’s recent report on the failure of SVB places blame for its supervisory failures on passage of S. 2155, the so-called tailoring bill. The report suggests that the tailoring of pre-existing capital, liquidity and resolution planning rules allowed SVB to take more risk and avoid more supervision than it otherwise would have. That is a false and misguided narrative. Here’s why tailoring had no meaningful effect on SVB’s liquidity and capital positions or its resolution planning.

• Liquidity: According to the report, liquidity problems centered on SVB’s reliance on uninsured deposits as a source of funding and its inability to rapidly convert its high-quality liquid assets (HQLA) into cash. Had SVB been subject to the pre-S.2155 liquidity framework, neither of these problems would have been changed. To learn more about these liquidity requirements and SVB, click here.
• Capital: The report notes that absent the adoption of the 2019 tailoring rule, SVB would have been an advanced approaches bank and, therefore, required to include unrealized gains and losses on available-for-sale (AFS) securities to be reflected in regulatory capital. Additionally, SVB would have been subject to supervisory stress tests beginning in 2020. However, none of these changes would have materially affected SVB’s stress capital buffer nor forced the firm to raise capital. In addition, and similar to the LCR, SVB could have managed its assets to stay below $10 billion in total consolidated on-balance-sheet foreign exposure to avoid becoming an advanced approaches bank, and therefore could have continued applying the AOCI filter. To learn more about these capital requirements and SVB, click here and here.

Conclusion: Subjecting SVB to enhanced capital requirements and stress testing, including pre-tailoring requirements, would not have forced the firm to raise additional capital or alter its behavior. Ultimately the removal of these requirements did not play a factor in the eventual failure of SVB.

2. Tester: Fed Had Regulation in Place to Handle SVB

At a Senate Banking Committee hearing this week, Sen. Jon Tester (D-MT) noted that the Federal Reserve had the regulatory tools it needed to handle problems with SVB. “The Fed report pointed out that the regulation was there to handle this – that the regulators did not enforce the regulation and hold people accountable,” Tester said. He also expressed concern that regulatory tightening could punish banks that follow the rules. “One of my concerns is that there will be a push to get more regulation. I think that’s going to happen. I don’t think it’ll happen, but there will be a push for it. But my concern is similar to what happened in 2008 – that the regulators will respond in a way where they put the screws to the banks who are following the rules, that the board is paying attention, that the executives are doing a good job.”

3. CFPB Credit Card Late Fee Proposal Deficient on Facts, Risks Higher Costs for All Americans

BPI commented this week on the Consumer Financial Protection Bureau’s misguided proposal to impose strict new limits on the amount banks are allowed to charge for credit card late fees.

Here’s the background: The proposal would cap the “safe harbor,” authorized under the Card Accountability Responsibility and Disclosure (CARD) Act of 2009, at $8 from its current levels of $30 for the first violation and $41 for subsequent violations. The CFPB’s proposal is based on a profoundly flawed analysis and reflects a blatant disregard for the statutory factors that the CFPB must consider under the CARD Act. The CFPB’s decision to move forward with the proposal in its current form risks harming consumers by leading to more frequent late payments and delinquencies, which could negatively affect consumers’ credit scores and lead to higher costs and fewer benefits, including card rewards, for all Americans.

What BPI is saying: Paige Pidano Paridon, BPI senior vice president and senior associate general counsel, issued the following statement: “Credit card late fees are transparent, highly regulated and apply equally to all customers that fail to pay their minimum amount due on time, regardless of income level or credit score. The CFPB bases its proposal on politics rather than sound empirical data and, despite pointing to hypothetical savings, the effort will likely harm consumers. The CFPB itself repeatedly acknowledges in the proposal that lower late fees could make interest payments more expensive for all consumers, reduce lending options for some consumers – particularly low-income borrowers – and increase the frequency of late payments and delinquencies, harming consumers’ credit scores. Consumers are best served when policy is based on data and evidentiary support rather than irresponsible rhetoric.”

To learn more about the proposal’s flaws, click here.

4. Short-Selling Faces Scrutiny Amid Midsize Bank Stock Rout that Defies Reality

Short-selling is drawing scrutiny as short sellers seized on midsize bank stocks in the wake of First Republic’s collapse. The short-selling surge appears to contradict the reality of a healthy, stable sector in which First Republic was an outlier. The White House is monitoring the situation closely, according to the White House press secretary.

• Regulators: Federal and state regulators are scrutinizing whether the short selling activity amounted to market manipulation, according to a recent Reuters article. According to the article, SEC Chairman Gary Gensler said: “[I]n times of increased volatility and uncertainty, the SEC is particularly focused on identifying and prosecuting any form of misconduct that might threaten investors, capital formation, or the markets more broadly.”
• Wachtell: Law firm Wachtell, Lipton, Rosen & Katz, in a letter to clients, called on the SEC to regulate “coordinated short attacks” by imposing a 15-trading-day ban on short sales of financial institutions. That pause would allow regulators to take action and investors to digest information, the firm said. The attacks are not related to the fundamental financials of the banks in question and put the U.S. economy at significant risk, the firm also said, according to Reuters.

5. Powell on M&A, Banking Stress

Federal Reserve Chair Jerome Powell answered questions on a range of topics at this week’s post-FOMC press conference. The FOMC raised the target fed funds rate by 25 basis points. Many questions at the press conference centered on monetary policy and the rate outlook, but several focused on recent bank failures. Here are some key takeaways.

• M&A: “I don’t have an agenda to further consolidate banks,” Powell said in response to a question about acquisitions amid recent bank failures. “I personally have long felt that having small-, medium-, and large-size banks is a great part of our banking system. You know, the community banks serve particular customers very well, regional banks serve very important purposes, and the various kinds of GSIBs do as well. So, I think it’s healthy to have a … range of different kinds of banks doing different things.” His remarks on the necessity of banks of all sizes echo comments from JPMorgan CEO Jamie Dimon in a recent shareholder letter. He deferred to the FDIC as the agency that oversees closing and selling failed banks and noted the statutory exception on the deposit cap (banks controlling 10 percent or more of U.S. deposits are generally prohibited from buying other banks) for failed-bank purchases that enabled the First Republic acquisition. He called that purchase a “good outcome.”
• Interest rate risk: In response to a question about a February presentation to the Fed Board on interest rate risk among banks, Powell noted that there was a page on SVB and its unrealized losses—a key factor in its demise—but said there was nothing in it about the risk of a run. The presentation was meant to be “informational,” not raising alarms, Powell said. “They’re pointing out something that they’re working on and that they’re on the case,” he said.
• In tandem: The Fed’s monetary policy tools and financial stability tools are “working well together” rather than being in conflict, Powell said.

In Case You Missed It

FDIC Weighs Options for Deposit Insurance Overhauls

The FDIC this week released a report outlining various options for deposit insurance coverage. The report comes in the wake of recent bank failures, notably the run of uninsured depositors from SVB, which prompted a rethink of deposit insurance limits. The FDIC this week also gave notice of its upcoming Board meeting, scheduled for May 11, to vote on a special assessment for banks related to SVB’s failure.

• Three options: The report considers three versions of increased deposit insurance coverage – limited insurance coverage, unlimited insurance coverage and targeted coverage for business transaction accounts.
• Legislation: Most of the policy options would require Congress to act, the report acknowledges, although some aspects of the report fall within the FDIC’s rulemaking authority.
• Assessments: One potential change covered in the report is insurance assessment modifications to account for liquidity risk associated with banks’ reliance on uninsured deposits. The FDIC notes that deposit insurance pricing could potentially account for the fair value of banks’ unrealized losses on securities.
• Unlimited: The report does not support unlimited deposit insurance, which it says would “have the most dramatic effects on depositor discipline” and is “the most likely [option] to have broader market implications.” It suggests that any unlimited deposit insurance would need to be paired with factors such as increased capital requirements, expanded long-term debt requirements or interest rate restrictions on deposits. It also says unlimited deposit insurance would necessitate much higher assessments.
• Supervision and regulation: The report suggests several regulatory changes, such as including more unrealized losses in regulatory capital; limits on uninsured depositor funding or other less stable short-term funding; enhanced scrutiny on interest rate risk; expansion of long-term debt requirements and stricter supervision on banks that grow rapidly.
• Bottom line: The report concludes that higher or unlimited deposit insurance thresholds for business transaction accounts would provide the greatest benefit with the least negative consequences.

Cherry-Picked and One-Sided: Flaws in the CFPB’s Late Fee Proposal

The CFPB’s proposal to dramatically reduce the credit card late fee safe harbor fails to take an objective, full look at the available evidence, in violation of the relevant statute and administrative law principles. The Bureau cherry-picks and downplays evidence from published research to justify its proposal, fails to consider all relevant and available studies and overstates the relevance of its own new, flawed analysis. By failing to consider the full range of costs and benefits of its proposal, the CFPB risks harming the consumers it aims to help.

• Deterrence: The Bureau asserts that the substantial reduction in the late fee safe harbor would not materially reduce the deterrence effect of the current safe harbor level, dismissing available evidence by OCC economist Daniel Grodzicki and colleagues that shows that lower late fees may erode deterrence effects and lead to more frequent late payments. Available research provides important evidence as policymakers consider reducing the late fee safe harbor.
• Learning effect: Late fees can be a learning experience for consumers – a consumer who is charged their first late fee may pay closer attention to payment due dates in the future, a study by Chicago Fed economist Sumit Agarwal and colleagues suggests. The Bureau dismisses this study’s findings, but the learning effect of late fees is another important factor to consider in setting late fees.
• Omitting relevant studies: The Bureau’s proposal not only downplays the two relevant studies above, but it also omits two other studies demonstrating deterrence and learning effects of late fees. One study finds that the incidence of late fees drops sharply over time for new accounts. Another study finds that payment reminders for credit card payments are more effective when they include a warning about late fees.

Bottom line: Regulators have an obligation to consider a full picture of costs and benefits and required statutory factors when proposing new rules. The CFPB’s treatment of research evidence on late fees suggests it has failed to fulfill this obligation, a decision that could ultimately result in consumer harm.

The Crypto Ledger

The fallout of the FTX collapse has continued to unfold as the FBI raided the D.C. area home of Ryan Salame, a former top FTX executive. The specific goal of the raid was unclear, but it signals continuing scrutiny of top FTX leaders. Here’s what’s new in crypto.

• Coinbase hit with lawsuit: A Coinbase shareholder sued the crypto exchange this week seeking to recover $1.1 billion for the firm from directors and executives who sold almost $3 billion in shares ahead of a stock price plunge in 2021, following the exchange’s initial direct listing. The investor, Adam Grabski, said that the majority of the board sold ahead of the massive drop in the crypto platform’s stock price in spring 2021, according to Law360.
• NFT conviction: A former employee of NFT trading platform OpenSea was found guilty this week of fraudulently buying NFTs he knew would rise in value, according to the Financial Times. The case appears to be the first NFT insider trading case.

BPI’s Baer on the Likely Future of Regulation, Supervision

BPI CEO Greg Baer laid out predictions for future developments in regulation and supervision post-SVB failure in a PwC webcast on the topic this week.

• Changes ahead? The AOCI filter (accumulated other comprehensive income) may go away, and there could be restrictions on banks’ ability to hold large amounts of securities in the “held to maturity” category, Baer said. Stress testing will likely be a major focus, he said, and the role of interest rate risk in SVB’s failure could hasten a shift to stress tests with multiple rate scenarios. Firms may also see pressure behind the scenes on internal liquidity stress tests, he said.
• Context: Baer observed that the SVB failure occurred during a perfect storm of unusual dynamics that are unlikely to coincide in the future – significant interest rate rises and massive quantitative easing.
• Capital: The implications for capital are “more of a puzzle,” since there is no obvious connection between Basel capital revisions and SVB, Baer said. Basel Finalization is more about market and operational risk, issues that are distinct, he said.
• TLAC: Proposed long-term debt requirements for large regional banks is “a very different type of TLAC,” Baer said. A driving purpose of TLAC for the largest globally active banks is to facilitate a single-point-of-entry resolution so that broker-dealer subsidiaries can stay open – “with regional banks, non-GSIBs, no one’s thinking of that,” he said.
• Liquidity: One central question of the SVB failure is “should banks self-insure for liquidity” and whether they should be able to pledge assets to the Fed and get credit in their liquidity assessments, Baer said. “That’s something that regulators really need to revisit.” Simply requiring banks to hold more high-quality liquid assets (low-risk securities) could drive them to make fewer loans.
• Targeting the right risks? On examiners’ actions covered in the Barr SVB report, Baer suggested that there was no shortage of supervisory activity, but that it focused on less material risks. “I do think it bespeaks a problem with supervisory culture, although not the one stated in the conclusions,” he said of the examination reports in the review. The report also illustrated a “severe dysfunction” between the Fed Board and the Reserve Banks, he said.

JPMorgan Purchases First Republic

JPMorgan Chase acquired First Republic Bank, concluding a competitive FDIC bidding process amid First Republic’s failure. JPMorgan announced on Monday that it had acquired the substantial majority of assets and assumed the deposits and certain other liabilities of First Republic from the FDIC. “In carrying out this transaction, JPMorgan Chase is supporting the U.S. financial system through its significant strength and execution capabilities,” the bank said in a press release. “Our government invited us and others to step up, and we did,” said CEO Jamie Dimon.  “Our financial strength, capabilities and business model allowed us to develop a bid to execute the transaction in a way to minimize costs to the Deposit Insurance Fund.”

TD Bank, First Horizon Terminate Merger Agreement

TD Bank Group and First Horizon Corp. on Thursday announced a mutual agreement to terminate their previously announced merger agreement, according to a press release. The two banks originally announced the deal in February 2022. TD Bank did not have a timetable for obtaining necessary regulatory approvals “for reasons unrelated to First Horizon,” the press release stated. “Because there is uncertainty as to when and if these regulatory approvals can be obtained, the parties mutually agreed to terminate the merger agreement,” the release said.