United States: Bank Failures Lead to a Changing Industry – What to Expect
The twin failures of Silicon Valley Bank (“SVB”) and Signature Bank (“Signature”) are now causing a regulatory revaluation of the existing bank supervisory framework. Nowhere is this re-examination happening with more emphasis than at the Federal Reserve Board (the “Federal Reserve”). Friday’s 118-page Federal Reserve report (the ”Report”)1 on the causes and “learnings” from the bank failures is replete with agenda items that will mean more cost and burden on the system, without addressing whether the system or the regulators are ready for it. Left unsaid is that these efforts will come with dramatically more oversight, especially for mid-size banks and banks willing to consider novel product developments. The macroeconomic consequences of these changes are murky.
AOCI and Incentive Compensation
Two noteworthy items coming out of the Report relate to AOCI and incentive compensation. The Federal Reserve is now going to require smaller institutions (threshold not yet set) to take into account unrealized gains or losses on available for sale securities. Such risk will no doubt reduce available lending. One needs to only look at the decline in lending at the banks already subject to such rules. It will grow the shadow economy further.
We can also expect the proposed rules on the long delayed proposed rules on incentive compensation to be adopted. The Report notes that “oversight of incentives for bank managers should also be improved.”2 The compensation plan at SVB, the Report concluded, did not incentive risk-management, and so management did not manage risk effectively. But, there are already existing guidelines on incentive compensation.3 The Report correctly notes that the Federal Reserve should “ensure banks comply with the standards we already have.”4
Supervision and the False Allure of Derisking
A number of the steps proposed in light of the existing framework are sensible. For example, the self-assessment is a useful tool. However, we cannot help but note that the Report is focused on the banking sector and does not ask broader questions such as what the impact on the overall economy will be of the recommendations in the Report, where will the risk in the system move, and can examiners even do the job that they are assigned or will they criticize everything with the hope that something that they are noting hits the mark.
The Report noted that SVB’s “rapid growth but slow transition to heightened standards contributed to the slow identification of risk and slow pace of supervisory action.”5 The Federal Reserve plans to evaluate how to make sure supervision intensifies as a firm grows in size or complexity.6 The Regulators already associate growth with undue risk. The Report’s take on SVB will certainly contribute to hostility to growth. The Federal Reserve will also push to shorten the time periods between when an asset threshold is reached and implementing heightened standards. We can expect such a threshold to trickle down. It may not reestablish the 10-billion-dollar level, but stress testing expectations will be much more robust at smaller levels.
The post-mortem also goes on to indicate that the Federal Reserve has begun to build a dedicated “novel activity supervisory group to focus on the risks of novel activities.”7 The two activities listed are Fintech and Crypto. This dedicated team will be a complement to existing supervisory teams. Nowhere, however, is the question raised in the report whether regulators have the ability to actually supervise traditional activities. The Federal Reserve noted that its own supervisors did not appreciate the extent of SVB’s “vulnerabilities”. When they did actually identify a vulnerability, they did not take sufficient steps to make sure that those problems were addressed quickly enough. After all, the Federal Reserve’s wanted stress testing did not consider the possibility of rising interest rates. Clearly, they drank their own Kool-Aid.
The Report specifically raises the question whether the Federal Reserve should be requiring additional capital and liquidity beyond regulatory norms when a bank has either inadequate capital planning, liquidity risk management, governance or controls. The Federal Reserve believes higher capital levels can be an important safeguard until risks controls improve. Growing organizations will now be expected to maintain higher liquidity and capital levels. It will be difficult for examiners to relax such levels or conclude that risk controls have sufficiently improved because there will be no incentive for doing so. The likely result is that institutions will be pushed to stop growing or not grow nearly as fast.
The Federal Reserve plans to specifically change the way in which it supervises for interest rate risk. Among the liquidity risks called out is the “risk of uninsured deposits.” The Federal Reserve believes both stability of uninsured deposits and treatment of how maturity securities should be addressed differently in liquidities stress testing. The Federal Reserve again plans to consider applying standardized liquidity requirements to a broader set of firms. On this action, however, the Federal Reserve plans to first go through the notice and comment process.
A fundamental re-examining of the nature of supervision is appropriate. Instead, however, the Report makes clear we are getting dramatically more of the same approach to supervision, just applied to many more institutions. It might be better to consider changing incentives and tools. As the regulators have pushed banks out of servicing, consumer lending, mortgage originations, and now crypto, venture capital and technology banking and potentially Fintech, the shadow banking environment has grown dramatically. While this derisking may be beneficial in some sense for the banking system (although even that is up for debate), it is decidedly not beneficial for the economy as a whole.
1 Review of the Federal Reserve’s Supervision and Regulation of Silicon Valley Bank.
2 Report, page 4.
3 See e.g., 12 C.F.R. Part 208, Appendix D-1, Section III.
4 Report, page 4.
5 Report, page 2.
6 The Report also blames the Economic Growth, Regulatory Relief, and Consumer Protection Act (“EGRRCPA”) as reducing standards, increasing complexity and promoting a less assertive supervisory approach.
7 Report, page 2.
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