On March 8, Silicon Valley Bank, Signature Bank -22.87%decrease, red down pointing triang, were both, according public disclosures, “well capitalized,” which is the optimal level for health as per federal regulatory standards.
Days later, both failed.
Jerome Powell, Federal Reserve Chair, stated Wednesday that “the question we all asked ourselves over the first week was: “How did this happen?”
Interviews with bankers, examiners, and former regulators reveal that there was a combination of rapid economic shifts and regulators who were slow to adapt to these changes. Even though supervisors saw problems, they failed to act quickly and decisively enough in order to prevent them from spiraling into crisis.
After years of quiescence, interest rates rose. Regulators didn’t anticipate how much the banks would take to their bondholdings. As late as mid-2021, the Fed expected that the era with ultralow rates would continue. SVB was not warned by regulators until late 2022 when rates had already risen significantly, because its modeling of interest rate risk was insufficient.
The second was the failure to recognize the dangers of bank dependence on deposits exceeding the $250,000 federal insurance limit. These deposits had become more important to banks. Regulators admit that they didn’t stress this concern as the large deposits were from Signature’s core customers who, it was believed, would stay around.
Deposits fled much faster than ever before due to social media-fueled fear as well as technology that enabled people to move large sums of money with just a few taps on their smartphones.
Aaron Klein, a Brookings Institution senior fellow, said that SVB displayed “classic red flags” for bank examination 101. “Founding problems late and moving slowly are two of the most dangerous ways to fail in supervisory supervision. This looks very much like what happened.
A third factor was that the nature of supervision itself had changed, becoming more bureaucratic and process-oriented–just when banking was moving faster. Although they raised concerns about SVB, examiners didn’t escalate them to formal enforcement actions until a run started.
“The supervisory process is not designed for quick decision-making. Eric Rosengren, ex-president of the Federal Reserve Bank of Boston, said that it is focused on consistency rather than speed. “In a fast-moving environment, the system isn’t as well-designed to allow for rapid change.”
The investigation by banking regulators could take months or even years. For now, the Fed, FDIC, and Treasury have limited contagion by guaranteeing all Signature and SVB deposits and providing additional support for all banks. Powell announced that an internal Fed review will be conducted to determine what went wrong and report back by May. Hearings will be held by the lawmakers starting next week.
Representatives of SVB and its former chief executive did not comment. A spokesperson for New York Community Bancorp declined to comment on Signature’s assets.
SVB was a smaller bank which grew quickly in recent years with its tech clients. The Fed in Washington, San Francisco’s Federal Reserve Bank of San Francisco and California’s Department of Financial Protection and Innovation were its principal regulators.
In the past, SVB had been identified by inspectors. The Fed alerted the bank’s management of problems in its risk control systems in 2019, they said. According to sources familiar with the matter, the Fed raised concerns about weaknesses in liquidity, risk management, and governance last summer. One source said that SVB was eventually placed under a “4M” restriction which prevented it from making acquisitions.
Alerts were sent in the form “matters that require attention” or “matters that require immediate attention”. These alerts were supervisory memos which urged but did not force action.
Inflation was the main issue facing both banks and the economy by 2022. It jumped to 5% from 2% over decades. The Fed, which had indicated that it would keep rates close to zero for many years until mid-2021, has raised them at their fastest pace since the 1980s.
Rising rates cause bond prices fall, particularly bonds that don’t mature for long periods of time, which many banks including SVB had preferred for their higher yield. These banks were left with large unrealized losses by the end of 2022. This was something that the FDIC warned about in the second half.
The value of banks’ bonds could fall, which would in theory decrease their capital, which is the buffer between assets and liabilities that absorbs loss. Congress directed regulators in 1991 to develop a formula to measure the impact of interest rates on capital.
However, the Fed, FDIC, and Office of the Comptroller of the Currency stated in 1996 that the “burdens and costs and potential incentives of implementing an explicit capital treatment and standardized measure currently outweigh the potential advantages.” They would instead “work with the sector to encourage efforts towards improving risk measurement techniques.” Bank examiners must also consider the effect of changes to interest rates.
In recent regulatory actions, the Fed did not prioritize interest rate risk. Large financial institutions are subject to stress tests that don’t consider high inflation or high interest rates. This has been true for many years.
The Fed asked banks this year to demonstrate how they would react to an increase in inflation in its stress tests. However, this scenario was published after inflation had reached its highest point and would not have any practical impact on banks operations.
According to an ex-Federal Examiner, SVB had grown large enough by 2022 to warrant its own Fed supervisory group. According to sources familiar with the matter, staff at banks scrambled for increased regulatory scrutiny as the bank approached $250 Billion in assets. According to a former employee in risk management, the Fed examiners were more intense.
According to sources familiar with the matter, some bank employees were aware that higher interest rates could put SVB’s bond portfolio in danger and tried to convince executives to change.
However, company management bet that interest rates will fall. In a presentation of its second quarter results, the bank stated to investors that it was “shifting to managing downrate sensibility.” Employees have been asking why management hasn’t acted immediately despite the Fed’s oversight.
According to people familiar with the matter, the San Francisco Fed met last fall with senior bank leaders and raised concerns about the bank’s handling of interest rate risk in a rising rate environment.
According to people familiar, SVB did model interest rate risk. However, it assumed that higher interest rates would increase profits. One person said that the Fed also issued a “matter requiring notice” alert about the bank’s interest rate modeling.
Powell stated Wednesday at a press conference that the supervisory team appeared to be very engaged with the bank and was “repeatingly escalating”
Over the years, bank supervision has shifted to a focus on fairness, consistency, and transparency over speed. In the 1990s, interstate banking became easier to access, so federal regulators tried to establish rules that could be applied across states, which allowed Washington to make more decisions.
After the 2007-2009 financial crisis, passage of the Dodd-Frank financial regulation bill, and subsequent financial crises, supervision became more centralized and bureaucratic, according to Mr. Rosengren. He was the president of the Boston Fed between 2007 and 2021, and previously headed bank supervision.
Bank examiners are often alerted to urgent matters by banks. However, they can force them to change their course with a cease and desist order or formal enforcement action.
“The goal is to not surprise anyone.” It is to make changes over time,” stated Mr. Rosengren, who is now a scholar at MIT Golub Center for Finance and Policy.
FDIC officials stated that problems rarely escalate to cease-and-desist orders, unless there is a long-term pattern or noncompliance. He stated that, except for an emergency (which was not apparent with SVB until too late), it can be difficult for supervisors and managers to push back against management if the banks are in compliance with all its capital requirements and liquidity requirements.
The politics also started to intervene. With the financial crisis behind them, banks including SVB began lobbying for a lighter treatment. They found a sympathetic ear from both Republicans and some Democrats. The threshold for Fed’s most rigorous oversight was raised to $250 billion in assets by Congress that year from $50 billion.
To ease the burden on smaller firms, the Fed also modified its regulations. Under Randal Quarles as Vice Chair of Supervision, the Fed issued “guidance of guidance” in March 2021. It stated that supervisory guidance, which is a common way federal regulators explain to banks and examiners the expectations they must meet, didn’t have the force or law.
According to an ex-big-bank examiner at the San Francisco Fed who stated that the move “created 10,000 additional steps,” it became harder to get banks to change their minds.
Mr. Quarles denied that the 2018 law or 2021 guidance were involved in SVB’s problems. He stated that the purpose of the guidance was to strengthen supervision by ensuring examiners’ actions are grounded in law and more able to resist a court challenge.
Supervisors are reluctant to take formal action if there is no clear evidence that a bank is in serious danger. SVB maintained all of its capital ratios.
If a bank’s bonds are “trading” or available for sale, they must be held at market value. In 2022, SVB reclassified some of its bonds as “held until maturity,” meaning they weren’t required to be kept at market price.
SVB also took advantage of an option offered by the Fed in 2013, to ensure that losses on securities “available for purchase” do not flow through to its regulatory capital.
If the reported capital of SVB was less than its actual capital, it did not matter if the bank had sold bonds to pay deposit redemptions.
Banks have been steadily seeking more funding from individual and corporate deposits since the financial crisis. This was in contrast to tapping funds from financial market, which are seen as less stable and less reliable. Uninsured bank deposits accounted for a growing percentage of total bank deposits. Uninsured deposits pose a growing risk to regulators, who have at times considered asking banks for longer-term debt. However, the issue was not high up on the list of concerns about the financial system.
The Fed’s November financial stability report showed that uninsured deposits have steadily increased as a percentage of financial system funding, with the potential for them to leave very quickly. This was not cited in the report as a threat. The report did note with approval that large banks had reduced their dependence on volatile financial markets for short term funds.
Not only were 90% of SVB’s deposits not insured, but they were also unusually concentrated in venture capital and technology-related companies. Some deposits were worth hundreds of millions of dollar or were held in the bank under an agreement between a VC company and SVB.
If bank examiners point out problems, it is possible for the bank’s management to agree and voluntarily comply. Former San Francisco Fed examiners said that banks could involve their lawyers if they disagree with the findings of the examiners. They would treat the matter as a court case and not as a routine oversight matter.
Another examiner stated that bank examiners should not assume the bank is ready for rapid growth, high interest rates, and sudden loss of deposits. This was what happened later to SVB. This former examiner stated that the bank could argue that such an event has never occurred before, and that preparing for it would harm shareholder returns.
Signature Bank did not have SVB’s bond exposure but was dependent on uninsured deposit. Former Rep. Barney Frank (co-sponsor) of the Dodd-Frank law said that it was not raised by its regulators.
On February 15, regulators from the Federal Deposit Insurance Corp., New York State Department of Financial Services, met with Signature Bank’s board and “didn’t say anything about ‘We’re worried that your non-insured depositors will fly,’” Mr. Frank, who was a Director. “There was no alarm or warning at that meeting that you guys were in trouble or that this is a problem.” Regulators took over the bank after a run on Signature’s deposit accounts.
FDIC stated that its “examiners raised grave concerns in written or verbal communications to Signature’s management team, including less-than satisfactory ratings for liquidity management at least five years prior to it experiencing a liquidity crisis.” “Candid discussions with its Board regarding deficiencies in liquidity and deposit volatility and corporate governance took place as recently as February 15,” the NYDFS said.
The speed at which depositors can flee was something that neither regulators nor bankers could have predicted. This is a new reality in this age of smartphones and social media.
The speed at which tellers could cash out cash, or refill ATMs, affected deposit outflows in the past. Customers who needed to close their accounts, or transfer large amounts of money had to visit the branch. This allowed regulators and executives to plan a strategy to calm anxious customers. This grace period was eliminated by the new ability to transfer money using a smartphone.
FDIC officials are currently discussing ways to manage public confidence in the face of social media’s expansion of people’s ability “electronically panicking,” according to a source familiar with the discussions.
Wednesday’s statement by Mr. Powell stated that the speed of the run is very different to what we have seen in the past. It does suggest there may be a need to make regulatory and supervisory changes. This is because regulation and supervision need to keep pace with the world’s changing events.