Bank regulators were asleep at the wheel: Their wake-up call is overdue
While President Biden calls for tougher bank regulation, what the country really needs is competent bank regulators, or at least regulators that are not asleep on the job.
Both Silicon Valley Bank (SVB) and Signature Bank both grew like crazy in the past few years. According to an FDIC discussion of its early warning models, the first sign of a problem bank is often rapid growth funded by a volatile lending source, like uninsured deposits. Other signs include a concentration in bank business or loan categories and growth fueled by a new activity.
The FDIC’s description of a potentially troublesome bank fit both SVB and Signature Bank to a “t” and yet none of the regulators seemed to pay any attention to either bank. It does not appear that either bank made the FDIC’s problem bank list, and neither bank appears to have earned a significant “matters acquiring attention” notice from their regulator.
To add a bit of irony, SVB’s CEO was a director of the Federal Reserve Bank of San Francisco and former Rep. Barney Frank (D-Mass.) — the coauthor of the famed Dodd-Frank Act — was a director of Signature Bank. Apparently knowledge of basic banking skills was not the talent that landed either of them in the board room.
Both institutions failed as a consequence of an old-fashioned bank run. They could not satisfy customer withdrawal demands. They did not have enough liquid assets or enough eligible collateral to borrow from the San Francisco Home Loan Bank or the Federal Reserve Bank of San Francisco.
At least in the case of SVB, maturity mismatch was a major causal factor for the bank run. SVB had a large unrealized mark-to-market loss on its securities holdings and mortgage loans that were not required to be reflected in its regulatory capital calculation. Once you valued SVB’s assets at current market rates the bank was arguably insolvent.
Investors could not analyze banks’ December regulatory reports until they became public information in late February. And even then, investors would have to be financially sophisticated to estimate the market value of a bank’s loans after accounting for the increase in interest rates. When the Dodd-Frank Act eliminated the Office of Thrift Supervision it also eliminated the interest rate risk reports the OTS required of its supervised institutions. Basel-based capital requirements require banks to hold capital against credit risk — they do not account for losses banks could sustain from rising interest rates. Bank examiners are supposed to pay attention to a bank’s interest rate risk profile but apparently they did not sound any alarms in the case of SVB.
Signature Bank grew by cultivating its role in supporting cryptocurrency trading. Given the unfavorable opinion bank regulators have voiced regarding cryptocurrencies and the risks that they pose to the financial system, one would have thought that they would be engaged in close surveillance over Signature Bank. Again, it apparently wasn’t the case.
The resolution treatments of SVB and Signature Bank are unusual. The FDIC typically sells a large failing bank to a healthy bank and the purchasing bank takes possession of all of the failing bank’s deposit accounts — those insured as well as those with balances larger than the $250K insurance limit. Banks — even failing banks — typically have some market value because of their deposit franchise. According to an old banking adage, bank depositors are more likely to get divorced than to move their accounts to a different bank. Since deposits are a bank’s cheapest source of funding, banks value a large diversified depositor base. It could be that neither bank has a depositor base valuable enough to overcome hidden losses on their balance sheets. Or perhaps the outcome simply reflects insufficient lead time for the FDIC to identify a suitable purchaser.
Before it adds a lot of new regulations, perhaps the administration should first make sure that the administration’s bank regulators are awake and on the job enforcing the basic safety and soundness rules already on the books instead of creating climate-change stress tests and assessing a bank’s commitment to the administration’s diversity, equity and inclusion agenda.
Paul Kupiec is a senior fellow at the American Enterprise Institute specializing in financial services issues.
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