Fed’s Barr to Congress: How Should Regulators Adapt to New Banking Risks?

Silicon Valley Bank’s sudden demise rattled confidence in healthy banks and threatened the stability of the overall banking system. So the Federal Reserve needs to determine whether it can minimize this type of outcome in the future, and if so, how. That’s the message from Michael Barr, the Fed’s vice chairman of supervision, who lays out a series of questions for Congress to consider in exploring potential legislative action to change how banking is regulated.

The failure of Silicon Valley Bank was “a textbook case of mismanagement,” according to Michael Barr, vice chairman of supervision for the Federal Reserve.

Nonetheless, the failure raises questions about evolving risks in the banking industry and whether regulators can and should do more to intercede, Barr will say to Congress.

Barr is slated to testify before the Senate Banking Committee on Tuesday, March 28, but the Fed released his scripted remarks a day early. He is also scheduled to appear before the House Financial Services Committee on Wednesday.

Barr is in charge of the Fed investigation into how its staff handled Silicon Valley Bank prior to the closure. Its sudden demise rattled confidence in healthy banks and threatened the stability of the overall banking system.

One of the goals for the Fed is to determine whether it can minimize this type of outcome in the future, Barr says in the prepared remarks.

“At the forefront of my mind is the importance of maintaining the strength and diversity of banks of all sizes that serve communities across the country,” he says.

Hours after the Fed published Barr’s testimony on the recent bank runs, the Federal Deposit Insurance Corp. followed suit with the remarks its chairman, Martin Gruenberg, intends to deliver. Gruenberg reveals that the FDIC plans to issue several important reports, one reviewing potential changes to deposit insurance coverage and another with proposed rulemaking for a special assessment on banks.

How Should Banking Regulation Change?

Barr says the Federal Reserve’s final report on Silicon Valley Bank, which is due May 1, will contain confidential examination materials and related data.

He offers a preview, tracing regulatory interaction with the bank — which is typically considered confidential — from late 2021 on. He discloses that the $209 billion-asset bank had deteriorating regulatory ratings, and that the Fed’s actions, before the bank’s closure, escalated to a discussion about its issues in a February 2023 meeting of the Fed Board of Governors.

Michael Barr The full extent of bank's vulnerability was not apparent until the unexpected bank run quote

The testimony includes some early questions for legislators and regulators to ponder regarding risk issues:

  • How effective is the supervisory approach in identifying these risks?
  • Once risks are identified, can supervisors distinguish risks that pose a material threat to a bank’s safety and soundness?
  • Do supervisors have the tools to mitigate threats to safety and soundness?
  • Do the culture, policies and practices of the board and the Federal Reserve Banks support supervisors in effectively using these tools?

“Beyond asking these questions, we need to ask why the bank was unable to fix and address the issues we identified in sufficient time,” Barr plans to testify. “It is not the job of supervisors to fix the issues identified; it is the job of the bank’s senior management and board of directors to fix its problems.”

The framework for supervision focuses on size thresholds, but size is not always a good proxy for risk, particularly when a bank has a nontraditional business model, as Silicon Valley Bank did, the written testimony says.

The Fed recently decided to establish a dedicated “novel activity” supervisory group, with a team of experts focused on risks that might arise from these activities, Barr notes. This move is expected to help improve oversight.

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A History of Red Flags at Silicon Valley Bank

Barr’s testimony describes how the bank had an unusual business model, with a heavy concentration in the technology and venture capital sector. The deposits from these types of firms can be volatile, and when stress at the bank emerged, word spread quickly on social media.

“The bank then suffered a devastating and unexpected run by its uninsured depositors in a period of less than 24 hours,” Barr says in the testimony.

But the problems that contributed to the failure were apparent long before, according to his remarks. The Fed review shows that Silicon Valley Bank had inadequate risk management and internal controls that struggled to keep pace with its rapid growth. Its asset size tripled between 2019 and 2022.

Barr offers an overview of the Fed’s escalating regulatory actions during that period:

  • Near the end of 2021, supervisors found deficiencies in the bank’s liquidity risk management, resulting in six supervisory findings related to the bank’s liquidity stress testing, contingency funding and liquidity risk management.
  • In May 2022, supervisors flagged ineffective board oversight and weaknesses in the internal audit function.
  • In the summer of 2022, supervisors lowered the bank’s management rating to “fair” and rated the bank’s overall governance and controls as deficient. The deficient rating means that the bank was not “well managed” and subjects it to growth restrictions.
  • In October 2022, supervisors met with senior management to express concern with the bank’s interest rate risk profile, and in November 2022, supervisors delivered a supervisory finding on interest rate risk management to the bank.
  • By mid-February 2023, the Fed staff relayed to the board that they were actively engaged with bank management.

“But, as it turned out, the full extent of the bank’s vulnerability was not apparent until the unexpected bank run,” Barr will tell the Senate Banking Committee.

Policy Changes on FDIC Deposit Insurance?

As for the FDIC chairman’s testimony, much of it covers the buildup to the bank runs. Gruenberg goes into considerable detail about the unwinding of Silvergate Bank and the failures of Silicon Valley and Signature banks. But parts of the testimony were forward-looking.

Most importantly, Gruenberg discloses the following actions for the first time:

  • Future of deposit insurance. The FDIC will do a comprehensive review of deposit insurance and issue a report by May 1 with policy options. This will include options related to deposit insurance coverage levels, excess deposit insurance and the implications of both for risk-based insurance pricing and the adequacy of the Deposit Insurance Fund.
  • The special assessment on banks. FDIC will issue a proposed rulemaking dealing with the special assessment that officials have said could be imposed on banks in the wake of the Silicon Valley and Signature bank failures.
  • Signature Bank review. The FDIC’s chief risk officer will conduct a review of the agency’s supervision of Signature Bank, also to be issued by May .

At one point in the testimony, Gruenberg speaks about the liquidity options available to banks, mentioning Federal Home Loan Bank advances along with the Federal Reserve’s discount window and its new Bank Term Funding Program. The point, basically, is that these tools are there to be used.

“It is important that we, as regulators, message to our supervised institutions that these facilities can and should be used to support liquidity needs,” he says. “Sales of investment securities have been a less common source of liquidity as the level of unrealized loss across both available-for-sale and held-to-maturity portfolio remains elevated.”

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Heightened Regulatory Scrutiny Ahead

In discussing lessons learned, Gruenberg calls for heightened regulatory review of banks with more than $100 billion of assets.

He suggests additional attention to capital, liquidity, and interest rate risk. He says this should include the capital treatment associated with unrealized losses in banks’ securities portfolios.

“Given the financial stability risks caused by the two failed banks, the methods for planning and carrying out a resolution of banks with assets of $100 billion or more also merit special attention,” he adds.

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