Federal Reserve, California Department of Financial Protection and Innovation Reports on Failure of Silicon Valley Bank Promise Increased Regulation and Supervision

On April 28, the Board of Governors of the Federal Reserve System (the Federal Reserve or Fed) issued a report¹ (the Fed Report) summarizing its review of the conditions that led to the failure of Silicon Valley Bank (SVB), including the Fed’s own supervision and regulation of the bank. The full report included a cover letter by Michael S. Barr, the Vice Chair of Supervision for the Federal Reserve, which outlined a number of changes that the Fed “needs to,” “has begun,” or “should” implement to improve its supervisory and regulatory processes. Following the Fed Report, on May 8, 2023, the California Department of Financial Protection and Innovation (DFPI) issued its own report² (the DFPI Report) summarizing its review of the conditions that contributed to the failure of SVB, echoing many of the conclusions made in the Fed Report.

Overview

Fed Report

The Fed Report highlights several proposed changes to the Federal Reserve’s supervision and regulation of its regulated banking organizations viewed by the Federal Reserve staff as essential, including the need to revisit bank capital and liquidity requirements and the interagency Tailoring Rules³ for the applicability of enhanced prudential standards for banking organizations with US$100 billion or more in total consolidated assets. For an extended period of time, the OCC, the Fed, and the FDIC have been developing a proposal to amend the interagency bank capital and liquidity rules as part of the implementation of the “Basel III-end game” standards; however, in light of SVB failure, the Fed is considering further changes to strengthen capital and liquidity requirements for large regional banks, as well as potential changes to the Tailoring Rules. Other expected changes include more speed in the supervisory process; increased supervisory scrutiny on rapid growth, incentive compensation, and uninsured deposits; and regulatory revisions of treatment of available for-sale and held-to-maturity securities.

Some of the proposed changes would require joint action among the federal banking agencies to amend interagency regulations and guidance or uniform policies and procedures adopted by the agencies. Some changes, such as those relating to supervisory staffing and examinations by the agencies, can be implemented at the discretion of the agencies, but such changes would require consensus of the FDIC and OCC and a formal rulemaking subject to the Administrative Procedure Act (APA). We expect that certain proposed changes will be focused on large banking organizations (i.e., those with US$100 billion or more in total consolidated assets); however, certain changes that are being contemplated (e.g., changes to the accounting treatment of available for-sale securities under bank capital and liquidity rules), could impact banking organizations of all sizes. In light of SVB failure and increasing congressional and public scrutiny of the federal government’s response, all large and midsize banks should brace for increased regulation and supervisory scrutiny.⁴

DFPI Report

The DFPI Report, like the Fed Report, summarized the DFPI’s own findings regarding contributing factors that led to the failure of SVB, as well as next steps that the DFPI will undertake to address supervisory and regulatory gaps. The DFPI Report highlighted several changes that are already in progress to enhance the DFPI’s supervision and regulation of its regulated banking organizations, including increasing coordination with federal regulators, such as the Federal Reserve, to develop stronger and more timely supervisory processes,⁵ allocating more regulatory staff to oversee banks with assets over US$50 billion,⁶ and requiring banks to take into account emerging risks related to digital technology, such as real-time deposit withdrawals and reputational and public relations risks related to social media.⁷ Other expected changes include more speed in the supervisory process; additional levels of supervisory review for exam reports prior to issuance; changes to the Early Warning System Module to more quickly identify critical red flags; and increased supervisory scrutiny on rapidly growing banks and those with large amounts of uninsured deposits.⁸

Further, the DFPI Report announced that the DFPI has begun to take certain steps to enhance monitoring of DFPI-chartered banks and credit unions in order to identify institutions that could face liquidity failures or other severe risks.⁹ The DFPI has already identified institutions requiring increased monitoring and has implemented more frequent monitoring for these more vulnerable financial institutions.¹⁰

High-Level Causes of SVB Failure

The Fed Report identified the following key managerial, supervisory, and regulatory factors that the Federal Reserve alleges contributed to the failure at SVB — many of which were also addressed in the DFPI report:

• SVB failed to manage risks. Managerial weaknesses, a highly concentrated business model, and a reliance on uninsured deposits left banks exposed to rising interest rates and other risk factors.¹¹ Despite these growing risks, SVB’s bank directors did not receive adequate information about potential vulnerabilities and did not hold management accountable for failing to manage the bank’s risks.¹²
• Supervisors did not fully appreciate the extent of the risks as SVB grew in size and complexity. Even after risks had begun to materialize, supervisors did not appreciate the severity of deficiencies in governance, liquidity, and interest rate risk management at vulnerable institutions.¹³ These judgments resulted in SVB’s management being rated as “satisfactory” by regulators from 2017-2021, even as conditions deteriorated and threats to the safety and soundness of the bank became apparent.¹⁴
• When supervisors did identify vulnerabilities, they did not ensure that SVB fixed those problems in a timely manner. Supervisors took too long to address vulnerabilities and permitted SVB to delay taking remedial steps that would have mitigated risks.¹⁵ Transition provisions under the Tailoring Rules provided SVB with significant leeway before it was required to meet heightened regulatory standards under the enhanced prudential standards. As SVB continued to experience rapid growth, the regulatory requirements imposed on it lagged behind those ordinarily required for a banking organization of its size and complexity. The extended runway provided to SVB meant continued vulnerabilities went unnoticed or unaddressed by federal supervisors despite increasing risk to both SVB and to the banking system more generally.¹⁶
• The use of tailoring impeded effective supervision. Consistent with congressional intent under the Economic Growth Act, in 2019 the Federal Reserve, along with the FDIC and OCC, adopted the Tailoring Rules to tailor the applicability of enhanced prudential standards for banking organizations with US$100 billion in total consolidated assets.¹⁷ For SVB, this appeared to result in lower supervisory and regulatory requirements, including lower capital and liquidity requirements. The Federal Reserve concluded that the higher supervisory and regulatory requirements that would have applied prior to the Tailoring Rules may not have prevented the failure of SVB but would likely have bolstered its resilience.¹⁸
• The DFPI Report also drew attention to the role that digital banking technology and social media played in the speed of the run on SVB, noting that in the future, the DFPI will require banks to take into account how best to manage the risks posed by social media and real-time deposit withdrawals.¹⁹

Changes to Federal Reserve Regulation and Supervision

Significantly, the Fed Report highlighted several changes (described by Vice Chairman Barr as changes that the Federal Reserve “will,” “is going to,” “needs to,” or “has begun to” implement) of which industry participants should take note as summarized below. While some of the changes relate solely to the operations of the Federal Reserve, changes that would require the adoption or amendment of interagency regulations would require consensus and joint action of the FDIC and the OCC. Furthermore, the proposed changes to examination and supervision could be implemented at the discretion of the Federal Reserve and could be implemented relatively quickly, but changes to rules, regulations, and binding supervisory guidance will require a formal rulemaking, subject to public notice and comment requirements under the APA.

• The Federal Reserve “will revisit” the existing tailoring framework.²⁰ The Fed Report states that the Federal Reserve will revisit the current tailoring framework, including re-evaluating a range of rules for banks with US$100 billion or more in assets.²¹ Under the current Tailoring Rules, banking organizations with at least US$100 billion in total consolidated assets but less than US$250 billion in total consolidated assets and less than US$75 billion in other risk-based factors (i.e., nonbank assets, off balance sheet exposure, weighted short-term wholesale funding, and cross-jurisdictional activities) are subject to the least stringent requirements. As a result of the changes under the Economic Growth Act, as implemented by the Tailoring Rules, banking organizations that would have been subject to enhanced prudential standards at US$50 billion (based on a trailing four quarter average) now are able to grow up to US$250 billion (based on a trailing four quarter average) along with an additional transitional period before having to comply with the full set of enhanced prudential standards, including additional capital and liquidity requirements. For many large banks, this resulted in lower supervisory and regulatory requirements, including lower capital and liquidity requirements. The Fed Report concluded that, while the higher supervisory and regulatory requirements that existed prior to implementation of the Tailoring Rules may not have prevented the SVB failure, they would likely have bolstered resilience.²²
• The Federal Reserve “needs to” provide less runway to rapidly growing banks.²³ The Fed Report acknowledges that the transition provisions under the Tailoring Rules provide banking organizations with significant leeway before they are required to meet heightened regulatory standards under the enhanced prudential standards and that the Federal Reserve needs to provide less runway.²⁴ For a bank that is experiencing rapid growth, its risk management program may lag behind that necessary for a banking organization of its size and complexity, especially if there are not specific regulatory or supervisory mandates requiring such. The Fed Report focused on internal delays in escalating supervisory intensity over SVB as it moved from a supervisory portfolio for smaller firms, with less intense supervision, to a supervisory portfolio for larger firms, and harder supervisory expectations. The Fed Report suggested that more regulatory continuity should be introduced so that, as a bank grows in size and changes its supervisory portfolio (i.e., from less than US$100 billion to a US$100 billion in total consolidated assets or from a Category IV banking organization to a Category III banking organization under the Tailoring Rules), the bank will be ready to comply with heightened regulatory and supervisory standards more quickly.²⁵
• The Federal Reserve “has begun” to build a novel activity supervisory group.²⁶ The Federal Reserve has a group that focuses on the supervision of large noncomplex banking organizations (those with US$100 billion in total consolidated assets that are not G-SIBs). The Fed Report stated that the Federal Reserve has begun to build a new supervisory group that will focus on the risks of novel activities (such as fintech or cryptocurrency activities) as a complement to existing supervisory teams.²⁷ This team will also identify whether there are other risk factors — such as high growth or concentration — that warrant additional supervisory attention.²⁸ Additional risk factors identified by this supervisory group could be incorporated into the analysis under the Tailoring Rules for determining the applicability of enhanced prudential standards for banking organizations with US$100 billion or more in assets.
• The Federal Reserve “needs to” require additional capital and liquidity requirements for some vulnerable banks.²⁹ Although the Federal Reserve generally does not impose additional capital or liquidity requirements on banks solely because they have inadequate capital planning, liquidity risk management, or governance and controls,³⁰ the Fed Report stated that this needs to change and that additional capital and liquidity requirements need to be imposed in certain cases to address these kinds of vulnerabilities. Vice Chairman Barr stated that higher capital or liquidity requirements, including limits on capital distributions or incentive compensation, can focus management’s attention on the most critical vulnerabilities and can serve as an important safeguard until risk controls improve.³¹ Generally, bank capital and liquidity requirements are implemented under interagency regulations of the Federal Reserve, FDIC, and OCC. Therefore, to the extent that a proposal would result in changes to the codified bank capital and liquidity rules, such changes would require a formal rulemaking subject to the APA. The agencies are working on a rulemaking to implement Basel III-end game standards, which has not yet been released, meaning it is possible that additional requirements could be included in that rulemaking. However, under the tailoring rules and existing supervisory authority, the Federal reserve can impose tighter capital and liquidity requirements on an institution-by-institution basis, which would seem to be the most likely next steps for institutions that the Federal Reserve perceives to be at risk.
• The Federal Reserve “needs to” empower supervisors to act with less information.³² The Fed Report stated that supervisors need to be able to act to address threats to safety and soundness even before every fact is gathered and every conclusion made airtight.³³ Agency staff delayed action to gather more evidence even as weaknesses at SVB were clear and growing.³⁴ This meant that supervisors did not force SVB to fix its problems, even as those problems worsened.
• The Federal Reserve “needs to” reevaluate supervision and regulation of interest rate risk management.³⁵ Banks are expected to manage interest rate risk in a manner that is appropriate to the size of the institution and the complexity of the assets and liabilities, including as part of internal stress testing processes, and provide periodic reporting to directors and senior management.³⁶ However, Vice Chairman Barr acknowledged that steps need to be taken to better prepare vulnerable banks to manage rising interest rates.³⁷ The Federal Reserve has published guidance and advisories on interest rate risk management over the years.³⁸ The Fed may consider updating its current guidance and/or adopting binding guidance under the APA.
• The Federal Reserve “is going to” reevaluate the supervision and regulation of liquidity risk management.³⁹ The Fed Report noted that liquidity requirements and models used by both banks and supervisors should better capture the liquidity risk of a firm’s uninsured deposit base.⁴⁰ The Fed Report states that the Federal Reserve should reevaluate the stability of uninsured deposits and the treatment of held-to-maturity securities in their standardized liquidity rules and in a bank’s internal liquidity stress tests.⁴¹ The Fed Report also stated that the Federal Reserve should consider applying standardized liquidity requirements to a broader set of banks.⁴² These changes would require amendments to the interagency liquidity rules, and therefore, would require consensus of the FDIC and OCC and a formal rulemaking subject to the APA.
• The Federal Reserve “is going to” evaluate how to improve capital requirements including the treatment of unrealized gains or losses on available-for-sale securities.⁴³ In particular, the Fed Report stated that the Federal Reserve should require a broader set of banks to take into account unrealized gains or losses on available-for-sale securities.⁴⁴

Takeaways

Potential changes (as identified in the Fed Report) that will require rulemakings

• Changes or modifications to the Tailoring Rules to raise the baseline for resilience. Potential changes could include additional risk-based factors or modification of current risk-based factors that trigger a banking organization moving from one category to the next and shortening of transition periods, timing of applicability of certain enhanced prudential standards for banking organizations, and changes to stress testing requirements.
• Changes to bank capital and liquidity requirements for banking organizations to enhance interest rate risk management, liquidity risk management and funding plans, and to require additional capital and liquidity for banking organizations based on weaknesses identified as part of the supervisory process
• Changes to any supervisory or examination processes that are codified in a regulation, guidance, or policy statement that was previously subject to the APA rulemaking process
• Any changes to the resolution planning requirements implemented under the joint regulations of the Federal Reserve and FDIC

Potential changes that can be implemented at the discretion of the Federal Reserve

• Changes to policies and procedures for supervisory staff in evaluating institutions and escalating supervisory concerns, and developing a culture that empowers supervisors to act even “in the face of uncertainty”
• Greater focus and attention on risks associated with rapid growth, concentrated business models, or other special factors of all banking organizations, regardless of asset size
• More scrutiny of all the deficiencies identified in the Fed Report (e.g., interest rate management, liquidity and funding plans, and incentive compensation)
• Supervisors will be encouraged to evaluate banking organizations in a manner that guards against complacency and to not be too accepting, but rather to evaluate risks with rigor and consider a range of potential shocks and vulnerabilities.
• Supervisors and examiners have the authority to impose higher capital and liquidity requirements on an institution-by-institution basis through the examination and enforcement process. We expect this authority to be utilized for those institutions found to have greater liquidity risk.

Criticism of the Fed Report

Although the Fed provided a critical assessment of its own regulatory and supervisory missteps that contributed to the failure of SVB, the report did not address how monetary policy pursued by the Fed may have also played a role. William C. Dudley, former president of the Federal Reserve Bank of New York and former vice-chairman of the Federal Open Markets Committee argued that the Fed’s report should have explained why financial stability monitoring did not identify the danger imposed on the banking sector by recent increases in interest rates by the Fed. Dudley criticized the Fed for failing to identify these risks and for not raising rates in a slower, more preemptive manner that Dudley argues would have been less likely to shock funding costs for banks and the value of their longer-term investments.

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