House Committee on Oversight and Accountability A Failure of Supervision: Bank Failures and The San Francisco Federal Reserve
House Committee on Oversight and Accountability
A Failure of Supervision: Bank Failures and The San Francisco Federal Reserve
Wednesday, May 24, 2023
- Republicans discussed the failure of regulators to address warning signs at SVB.
- Democrats argued that deregulation during the Trump Administration contributed to bank failures.
- Jeremy Newell, Senior Fellow, Bank Policy Institute & Founder and Principal, Newell Law Office, PLLC
- Michael E. Clements, Director, Financial Markets and Community Investment, U.S. Government Accountability Office
- Kathryn Judge, Harvey J. Goldschmid Professor of Law and Vice Dean for Intellectual Life, Columbia Law School
Subcommittee Chairwoman Lisa McClain (R-Mich.)
In her opening statement, McClain said that the speed of Silicon Valley Bank’s (SVB) failure raises concerns not only of poor bank management, but of a failure of oversight as well. She added that while there was incompetence at the bank, the people who are trusted to protect the taxpayer and the financial system had as much to do with SVB’s failure as the bankers themselves. She also said that this was one of the least complicated bank failures in history, and that regulators should have seen this coming from a mile away. Overall, the Chair said that the combination of an unstable deposit base and a plummeting bond portfolio contributed to the evaporation of the $212 billion bank nearly overnight. She concluded by asking a set of questions that the subcommittee seeks to answer, including: Who was overseeing this bank? What were they focused on and why didn’t they intervene? Did regulators flood bank management with process questions instead of focusing on fundamental issues that mattered? Finally, she said that the committee will continue looking into the actions of the Fed and FDIC.
Subcommittee Ranking Member Katie Porter (D-Calif.)
In her opening, Porter stated that Congress has a short-term memory on what works and what does not when it comes to regulating banks. She said that bank stability happens when there are strong, clear rules in place, and there is nothing pro-business about a bank failure. Porter also highlighted two bills that she introduced after the failure of SVB. She explained that one “reverses the most damaging regulatory rollbacks from the last time Congress listened to lobbyists,” and the other claws back compensation from bank executives when their bank fails. Overall, she stated that the problem is Congress repeatedly regulating, then deregulating, then taking too long deciding whether to re-regulate. She noted that the Fed’s report calls out S.2155 as one of the key causes of the SVB failure, as it reduced supervisory standards. Finally, the Ranking Member pointed out that the report also called out the failures of the supervisors, and said it is not her job to defend the Fed.
Michael E. Clements, Director, Financial Markets and Community Investment, U.S. Government Accountability Office
In his opening statement, Clements said that at the time of failure, SVB and Signature were the 16th and 29th largest banks in the country. He noted that their failures could impose a $22 billion cost on the deposit insurance fund. He also discussed the causes of the failures, including risky business strategies and weak liquidity and risk management. Specifically, he said that SVB and Signature both experienced rapid growth that far exceeded a group of peer banks and relied heavily on uninsured deposits. However, when confronted with external pressures – rising interest rates for SVB and weakening digital asset markets for Signature – the risky business strategies and weak management contributed to their failures.
In addition to risky management, Clements said that regulators identified problems at the banks but did not escalate supervisory actions in time to mitigate the risk. He highlighted that the Fed was generally positive in its ratings of SVB from 2018 to June of 2022, but even as it moved from the Fed’s regional banking organization and began to receive downgrades, the Fed did not issue an enforcement action. He also said that the FDIC’s ratings of Signature found its overall rating was satisfactory through 2021, and that the staff was considering escalating supervisory actions in 2022, but in the end only issued enforcement actions the day before the bank failed. He concluded by stating that taking early actions would give regulators and banks more time to address deteriorating conditions.
Jeremy Newell, Senior Fellow, Bank Policy Institute & Founder and Principal, Newell Law Office, PLLC
In his opening statement, Newell stated that it is not the job of supervisors to prevent every bank failure, but good supervision enables the agencies to identify and seek corrections of unsafe and unsound practices. Furthermore, he noted that when supervision is effective, it generally succeeds quietly. While responsibility for SVB’s failure rests first and foremost with management, Newell said that understanding where the Fed supervision may have gone wrong is a rare and important chance to assess the Fed’s supervisory practices and identify potential improvements. He added that the Fed has not released information that provides a full picture, but what it has made public suggests several problems in supervision. Specifically, he said that examiners did not fully appreciate SVB’s weakness and did not take steps to demand that they be fixed. Finally, Newell offered three observations:
- Supervision of SVB was heavily focused on compliance processes and governance, not on material risk to financial integrity.
- Examiners largely relied on a system of issuing Matters Requiring Attention (MRAs) that were not appropriately directed at SVB’s growing risk.
- Supervisors failed to enforce important enhanced prudential standards in the areas of liquidity and risk management that were applicable to SVB.
Kathryn Judge, Harvey J. Goldschmid Professor of Law and Vice Dean for Intellectual Life, Columbia Law School
In her opening statement, Judge noted that there are many examples of Congress usefully using its oversight authority to hold banks, bank executives, and bank supervisors accountable. She said that in revealing troubling practices by large financial firms and showing how often other people suffer, these reports helped spur legislative and regulatory change. Furthermore, Congress has an illustrious history of using its oversight authority to expose troubling behavior and being about needed reforms, which has been in part enabled by asking the right questions and learning the right lessons. As it relates to recent bank failures, Judge said that shortcomings in bank supervision at four different supervisory bodies played a meaningful role, and that these events should spur examination of how to encourage supervisors to ask hard questions, spot troubles in a timely way, and follow through with diligence and rigor. Finally, she argued that strengthening the regulations governing large regional banks is the most important step that Congress and regulators can take to make the supervisory task manageable.
Question & Answer
Regulatory Failures and Reforms
McClain asked if there was more the Fed could have done to prevent this. Newell replied that the Fed has not provided enough information for a complete picture, but what is public shows a focus on process and risk controls. He noted that 31 supervisory directives were outstanding when SVB failed: six had to do with liquidity, one had to do with interest rate risk, and the rest were in other areas. None went to the core question of whether they had enough liquidity. McClain also asked about how to keep this from happening again. Clements recommended a trigger mechanism to require more forceful actions when problems arise.
Rep. Virginia Foxx (R-Va.) asked what can be done to get regulators to stop focusing on process and look at deficiencies. Newell said there needs to be structural change in the way banking agencies approach supervision. Foxx asked if Congress should have the Federal Reserve write instructions to hold examiners accountable, and submit a report on it. Newell said that would be a constructive step. Finally, she asked if MRAs or MRIAs include teeth to enforce compliance. Newell said that they tend to be formal, but they are not enforcement actions.
Rep. Paul Gosar (R-Az.) asked if the Fed acted recklessly by raising its policy rate by 450 basis points between January 2022 and March 2023, and if that created a national banking crisis. Judge said that the Fed was pursuing price stability, which is an important mandate, and she added that banks have the obligation to handle changes in the interest rate environment, as most have. Gosar said that the Fed’s unprecedented tightening in response to inflation caused by COVID spending has caused a stock, bond, and overall banking crisis.
Rep. Becca Balint (D-Vt.) asked what the SF Fed should have done to address the red flags at SVB. Judge said that they did a decent job identifying some of the issues, but failed to appreciate the magnitude of the issues and were not creative in appreciating the fragility that existed. She added that there should have been an escalation framework in place in advance so that they were ready if issues were not addressed. Balint also asked about the key takeaways from the incident. Judge said that without appropriate regulation, banks are going to try to game the system that they have. She recommended addressing executive compensation, and making sure they cannot walk away well compensated when a bank fails.
Dodd Frank, S.2155, and Deregulation
Porter said that Congress bowed to political pressure and pursued a deregulatory agenda when it passed Dodd Frank rollbacks in 2018. She stated that the Fed’s report about SVB takes ownership for having weakened capital/liquidity risk requirements, but noted that Fed Chair Jerome Powell told her in a hearing when she first got to Congress that the Fed had not weakened requirements. She continued by stating that under Chair Powell, the Fed removed the liquidity coverage ratio that would have applied to SVB. Additionally, Porter said, in 2019 the Fed made it easier for banks to pass stress tests that assess resiliency. She asked how these moves, as well as the approval of mergers by large banks, impacted stability versus bank profits. Judge said they boosted profits without making the system more stable.
Rep. Summer Lee (D-Penn.) said that Trump era reforms relaxed requirements for banks under a certain size, allowing risk to run rampant at banks like SVB. She asked how these rollbacks created an opportunity for excessive risk taking at SVB. Judge said that prior to that, banks had to pay significant costs in terms of heightened regulatory standards as they grew. SVB grew rapidly, however, and was subject to modestly enhanced standards at a slow rate, so there was inadequate attention to credit and liquidity risks.
McClain asked if the 2018 law actually took any tools away from the Fed. Newell said that the law was a toolkit that granted the Fed wide discretion. McClain asked if there were other tools available to examiners. Newell said that one example is a requirement that banks like SVB conduct internal liquidity stress tests. He noted that the results require a sufficient buffer of liquid assets to survive a 30 day period of stress.
Balint also asked about the risks that SVB was taking. Judge replied that SVB more than doubled in size in a short period of time, did not institute risk management to handle that growth, and instead sought to search for yield by loading up on instruments with little credit risk but lots of interest rate risk. Then, as the Fed signaled higher interest rates, SVB did not hedge appropriately.
Rep. Glenn Grothman (R-Wisc.) asked if the leadership of the San Francisco Fed focused too much on ESG. Newell said that one core problem in the supervision was that they were not focused on material risks to the safety and soundness of SVB. He added that it is hard to say exactly what they were distracted by, and reiterated the need for more information.
Rep. Jasmine Crockett (D-Texas) said that blaming SVB’s collapse on ESG investing or DEI initiatives is nonsense.
Crockett also said that small and community banks provide locally informed investments that enable small businesses and startups to thrive in a challenging economy. She asked how the Fed can work to restore and build consumer confidence in regional and small banks. Judge noted that community banks have come through remarkably well, but for regional banks appropriate regulation is needed to rebuild that trust.
Rep. Eric Burlison (R-Mo.) asked if previous bank failures have resulted in insurance beyond the $250,000 limit. Clements said that in many instances, the FDIC will dissolve an institution and the deposits will simply move to the new institution. Burlison asked if this sends a message to small banks across the country. Clements replied that in the case of SVB and Signature, there was a systemic risk exception, so the FDIC needs to collect those funds through a special assessment.
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