Since 2011, the Government Accountability Office (GAO) has been sounding the alarm over the federal financial regulators’ reluctance to elevate supervisory actions when it is necessary to stymie irresponsible bank behavior. This is relatively concrete evidence that the recent bank failures were not, as the self-evaluation from the Federal Reserve (Fed) recently asserted, a result of bipartisan legislation enacted in 2018 that tailored bank regulation. Rather, the bank failures are a result of the regulators’ continued failure to enforce regulations that are already on the books.
In the past, Congress has passed legislation that has further subjected the banking sector to a dizzying array of federal regulations. Fortunately, in 2018, Congress passed the bipartisan Economic Growth, Regulatory Relief, and Consumer Protection Act (EGRRCPA) to support regional and midsize banks so that they were not subjected to the same stringent rules as the largest banks in the U.S.
In the wake of the Federal Deposit Insurance Corporation’s (FDIC) takeover of Silicon Valley Bank (SVB) and Signature Bank (Signature), Democrats immediately blamed EGRRCPA and the prior Administration’s alleged disempowerment of supervisors for the failures. However, SVB was already well regulated. For example:
- SVB was already subject to various enhanced prudential standards under the Fed’s Regulation YY, including a requirement to perform internal liquidity stress tests and maintain a contingency funding plan to address potential runs by its depositors. The fact is that SVB failed its internal liquidity stress test for a 30-day stress period and Fed examiners failed to follow up adequately.
- SVB was already required to have a risk committee and a chief risk officer to report and resolve any “risk-management deficiencies in a timely manner.” Last year SVB neglected to fill the chief risk officer position for eight months, and by the Fed’s own admission, Fed staff could have issued a violation citing Regulation YY, but they chose not to. Clearly, regulations were not the problem; rather, it was the failure to enforce the rules already on the books that led to SVB’s receivership.
- SVB was not subjected to the liquidity coverage ratio (LCR), but it was required to undergo quarterly internal liquidity stress tests. The Fed was aware of these tests and had access to the results but failed to act appropriately. Even if SVB was subject to the LCR, it would have resulted in SVB holding even more high-quality liquid assets (HQLA), such as Treasury bonds. However, it is difficult to see how holding more HQLA would have saved SVB when it faced a substantial liquidity crisis caused by the losses associated with its inventory of devalued Treasury bonds and agency mortgage-backed securities.
- It is worth noting the market value of SVB’s bond portfolio declined because of the Fed’s rapid interest rate hikes. This exposed SVB to substantial interest rate risk (IRR), which ultimately put SVB in a position where it could not liquidate enough assets to fulfill its customers’ deposit withdrawals. As outlined in SVB’s annual SEC filing, the bank was required to submit annual comprehensive capital analysis and review plans to the Fed and undergo stress testing every other year. FDIC regulations also required SVB to submit a resolution plan. SVB submitted a plan in December 2022.
The real source of SVB’s demise was the Fed’s failure to promptly supervise and enforce rules on SVB. According to the GAO’s preliminary report on SVB and Signature, the GAO warned the FDIC and the Fed about issues with properly escalating “supervisory concerns” as early as 2011. The prompt corrective action framework, “which was designed in 1991 to improve regulators’ ability to identify and promptly address deficiencies at depository institutions and minimize losses to the Deposit Insurance Fund—did not result in consistent actions to elevate concerns.”
In 2011, the Federal Reserve’s Office of the Inspector General (OIG) also released a report highlighting the Fed’s inadequate escalation of supervisory actions. The report examined the failures of state member banks from 2009 to 2011. The OIG determined that “examiners identified key safety and soundness risks, but did not take sufficient supervisory action in a timely manner to compel the Boards of Directors and management to mitigate those risks. In many instances, examiners eventually concluded that a supervisory action was necessary, but that conclusion came too late to reverse the bank’s deteriorating condition.” The OIG also pointed out how the Federal Reserve Bank of Chicago was too slow in escalating its supervisory actions against Irwin Union Bank and Trust (IUBT).
In a 2015 report, GAO critiqued regulators again. The 2015 report found that “regulators could have provided earlier and more forceful supervisory attention to troubled institutions” in the 1980s savings and loan crisis and the 2008 financial crisis.
The Fed was making the same mistakes several years prior to the passage of EGRRCPA. Supervisory failures contributed to SVB’s collapse, not tailoring bank regulation.
Lastly, the Fed did not prioritize supervision of the actual financial risks embedded in SVB’s IRR. The Fed’s report on SVB admits that the Fed deferred an IRR exam “to the third quarter of 2023 in order to prioritize governance and liquidity exams.” The report goes on to say that the Fed “should have conducted comprehensive IRR and investment portfolio reviews, with adequate resources, and communicated findings through [matters requiring immediate attention].”
The Fed dropped the ball—more regulation would not have solved the SVB problem. Moreover, the Biden Administration’s latest proposals to require regional banks to issue long-term debt, or total loss-absorbing capacity, will further leverage banks to where they are more unstable. This is similar to additional tier 1 (AT1) bonds, which were wiped out by Swiss regulators when UBS acquired Credit Suisse. As a result, the market for AT1 bonds is weaker and there is less investor interest for fear of being wiped out during a bank failure. Additionally, it has the potential to open up the door for litigation.
Congress should resist the urge to exploit this crisis by rolling back the provisions of the EGRRCPA or implementing new regulations on regional or midsized banks. These measures would not have prevented the failure of SVB. Instead, Congress should focus on overseeing the Fed and the FDIC. These regulators must be held accountable for ignoring critiques from the GAO and OIG for over a decade.