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California’s financial regulator and the San Francisco Fed told SVB that its interest-rate-risk simulations were not reliable and require improvements. Image Credit: AP

Washington: The Federal Reserve’s bank-supervision chief called for an extensive reevaluation of how the institution oversees US financial firms following the failure of Silicon Valley Bank, which he blamed on the company’s weak risk management and supervisory foot-dragging by the Fed.

The central bank will revisit the range of rules that apply to firms with more than $100 billion in assets, including stress testing and liquidity requirements, Michael Barr, the Fed’s vice chair for supervision, said in a letter accompanying a lengthy report released in Washington on Friday. SVB’s failure demonstrated the need for stronger standards applied to a broader set of firms, Barr said.

He also suggested the regulator could require additional capital or liquidity, or limit share buybacks, dividend payments or executive compensation, at firms with inadequate capital planning and risk management.

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“Following SVB’s failure, we must strengthen the Federal Reserve’s supervision and regulation based on what we have learned,” Barr said. “This report represents the first step in that process.”

Here’s the Fed’s plan for tighter bank oversight after SVB

The 102-page report provides the clearest picture yet of how rapidly the situation at SVB deteriorated and the various factors behind its quick collapse. It also shows regulators were aware of most of the bank’s lurking issues, but by the time they took steps toward decisive action, it was too late.

At the same time, the report blames the approach under Barr’s predecessor Randal Quarles, who served as Fed vice chair for supervision from 2017 to 2021 and led the Fed’s effort to “tailor” regulations for mid-size and regional lenders, following 2018 legislation that eased rules for those firms.

Quarles did not respond to requests for comment on Friday, but earlier this week he defended the regulatory changes, and denied that supervision was weakened during his tenure.

Secret process

The document represents one of the most detailed looks to date at how the Fed supervised an individual bank, a process that is often shrouded in secrecy and confidentiality. The Fed’s Board “has determined that releasing this information is in the best interest of the public,” the report said.

Barr said the Fed would reevaluate how it supervises and regulates a bank’s management of interest-rate liquidity risks, and said it should consider applying standardized liquidity rules to a broader set of firms. He also said the Fed should require a broader set of firms to take into account unrealized gains or losses on available-for-sale securities, “so that a firm’s capital requirements are better aligned with its financial positions and risk.”

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The Fed will seek comment on such proposals soon, Barr said, though he noted that any such rules would not take effect for several years. Other possible steps will follow later.

Barr also called for changes to improve “the speed, force and agility of supervision,” including more continuity in how the Fed oversees banks of different sizes, so firms will be ready to quickly comply with heightened supervisory standards as they grow, and stronger penalties for banks that fall short of supervisory standards.

For example, he suggested that the Fed could more quickly require banks to raise capital if deficiencies are found.

“Higher capital or liquidity requirements can serve as an important safeguard until risk controls improve, and they can focus management’s attention on the most critical issues,” he said. “As a further example, limits on capital distributions or incentive compensation could be appropriate and effective in some cases.”

In a briefing with reporters, a senior Fed official said many of the changes would not require legislative approval.

Stemming run

The failure of SVB and Signature Bank caused regulators to invoke a measure that allowed them to insure all depositors, both big and small, to prevent what they said might have been a wide-scale run on the banking system. In addition, the Fed launched an emergency term lending facility for banks.

The report indicated SVB management expected to lose over $100 billion in deposits on March 10, the day the bank was shuttered, on top of the over $40 billion that flooded out of the bank on March 9.

In a November 2022 letter detailing key financial ratings provided by regulators, California’s financial regulator and the San Francisco Fed told SVB that its interest-rate-risk simulations were “not reliable and require improvements.” The bank’s revenue forecasts and its internal interest-rate-risk modeling were inconsistent, “calling into question the reliability of IRR modeling and the effectiveness of risk management practices,” the regulators wrote.

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The warning from regulators ultimately proved prescient, with the mismatch between the duration of the bank’s assets and its liabilities playing a key role in its demise.

The FDIC, the primary regulator for Signature, acknowledged it was too slow to respond to problems at the lender before its spectacular collapse last month.

In a separate review released Friday, the FDIC said that “resource challenges” in its New York office kept it from adequately staffing an examination team dedicated to Signature Bank. Regulators also could have downgraded a key risk metric on the bank’s management, according to the report.

Culture shift

The report, which was undertaken by Board staff soon after the bank’s failure by order of Powell and Barr, took direct aim at Quarles, though it didn’t name him directly.

“Under the direction of the vice chair for supervision, supervisory practices shifted,” the report said. “Staff repeatedly mentioned changes in expectations and practices, including pressure to reduce burden on firms, meet a higher burden of proof for a supervisory conclusion, and demonstrate due process when considering supervisory actions.”

The report also cited “a shift in culture and expectations from internal discussions and observed behavior that changed how supervision was executed,” which led to slower action or none at all in some cases, as well as an apparent erosion of supervisory resources.

From 2016 to 2022, the report said, banking sector assets grew 37 per cent, while Fed supervision headcount declined by 3 per cent. Supervisory coverage of SVB declined when it was still in the regional bank portfolio and under the San Francisco Fed, the report said.

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After runs at the two lenders worsened, the FDIC took over SVB and Signature Bank. The crisis cost the FDIC’s deposit insurance fund about $23 billion.

Former President Donald Trump nominated Quarles to be the Fed’s top bank oversight official in 2017; Barr took over the role last year after President Joe Biden tapped him for the job.

“Barr is leaning on the faults of his predecessor who is on the other side of the political aisle,” said Kaleb Nygaard, a research fellow at the Wharton Initiative on Financial Policy and Regulation. “The Congress decided that they wanted a politically-appointed vice chair of supervision; therefore, supervision itself is going to be more political” along with any review with what went wrong.