Recent bank failures followed by stresses on other regional banks have resulted in a variety of theories of causes and predictable finger-pointing among various constituencies, followed by proposals for new legislative and regulatory restrictions. Before all facts are known and final rules adopted, however, banks of all sizes will be subject to more rigorous and vigorous regulatory scrutiny. Bank management should begin preparing now for this increased scrutiny with proactive preparation.
Who is to blame for the recent stress on banks? Critics have pointed to the following parties with varied levels of fairness and analysis.
- U.S. Congress and Trump—The Economic Growth, Regulatory Relief, and Consumer Protection Act passed in 2018 increased the threshold bank size requiring the strictest federal scrutiny from $50 billion to $250 billion, which exempted dozens of banks from the strictest federal oversight. Critics claim that as a result, large, complicated, systemically important regional banks were regulated as if they were small community banks. The recently failed banks and others requiring supplemental liquidity actions were within this group.
- Bank Regulators—Congressional critics and certain senior executives of regulatory agencies openly question the effectiveness and rigor of the regional staff of federal regulators and state supervisors to correct risk management problems “hiding in plain sight.”
- Executive Mismanagement—Current and former regulators have argued that the primary responsibility for these failures resides with senior management, who built a business model overly reliant on large, unhedged positions in low-interest-rate securities, financed by large amounts of uninsured, short-term deposits from a concentrated industry sector or depositor profile whose financial decisions are influenced by a network of advisors.
- Deposit Influencers—Some observers of at least one failure claim that but for the panic of some “VC Bros” who advised their portfolio companies to pull their deposits out of the bank, the resulting “run on the bank” would not have occurred.
- Federal Reserve Board Monetary Policy—Some criticize the lack of coordination between the monetary and the bank supervision and regulation functions of the Federal Reserve Board (FRB), to allow regional regulators and banks to plan for the effect of rapid interest rate increases on bank securities portfolios, deposit migration away from banks to money market funds and resulting liquidity strains. Why the FRB did not anticipate the negative effect on banks of the fastest increase in interest rates in 40 years and make available the supplemental liquidity it threw out over the post-failure weekend should also be questioned.
Regardless of the relative merits of these allegations, undoubtedly there will be legal changes and strong agency reactions to these criticisms that will ripple throughout the banking system.
At least three bills have been introduced to provide legislative remedies to alleged causes of the failures.
- The Secure Viable Banking (SVB) Actwas introduced by Senator Elizabeth Warren (D-MA) and Representative Katie Porter (D-CA) to return enhanced prudential regulation to banks with over $50 billion in assets as originally set forth in Dodd-Frank rather than the $250 billion threshold set forth in the 2018 amendments to that legislation. The premise of this bill is that had the failed banks been subject to the enhanced federal scrutiny set forth in Dodd-Frank, they would not have failed. President Biden recently has indicated his support for enhanced regulatory scrutiny focusing on banks with between $100 billion and $250 billion in assets.1
- The second bill, introduced by Senators Warren, Josh Hawley (R-MO), Catherine Cortez Masto (D-NV) and Mike Braun (R-IN), the Failed Bank Executives Clawback Act, would require the Federal Deposit Insurance Corporation (FDIC) to claw back all or part of the compensation received by institution-affiliated parties during the preceding five years from a bank for which the FDIC is appointed receiver. President Biden has indicated his support of legislation of this type as well.2 This legislation may formalize joint agency guidance on limits to executive compensation arrangements3 that has been dormant for over a decade.
- Senators Warren and Rick Scott (R-FL) introduced a Senate bill to assign presidentially appointed and Senate-confirmed inspector generals to the FRB and Consumer Financial Protection Bureau.4
Each of the FRB, FDIC and California Department of Financial Protection and Innovation has announced that it is conducting a review of the oversight and regulation of the failed banks, with reports due in early May 2023.
It is impossible to predict whether or when any new legislation or regulations will be adopted, or their contours. Bank legislation is usually heavily lobbied, especially by community banks with broad access in the House of Representatives. Given the size (over $100 billion in assets), unique business models (venture-capital-backed startups and cryptocurrency sectors) and locations (California and New York) of the failed banks, the incentive for community banks to lobby may not be as strong as it would be normally. However, the bipartisan support from Senators Warren and Hawley of the legislation, together with the publicity surrounding this latest financial predicament, may provide some momentum for more rapid legislative change.
Despite the uncertainty and timing of new legislation, we expect that under their existing authority the bank regulatory agencies will be more rigorous in their scrutiny of banks of all sizes especially banks in the $100 billion to $250 billion in assets category) in the areas identified as contributing to the recent failures—risk management, asset/liability management, liquidity, capital and reliance on uninsured deposits. If there is a consensus within Congress and the Administration to “make banking boring again,” based on past experience this most likely will result in:
- A return of more restrictive regulations, especially for banks in the $100 billion–$250 billion in assets size
- More rigorous examinations
- Higher expectations of responsive, timely remediation of identified deficiencies within shorter time frames
- Faster escalation of unresolved matters and issuance of enforcement orders that carry the risk of civil money penalties
- Higher risks for senior management and board members
While more detailed information will be revealed over the next several months, the 2023 bank failures identified certain deficiencies that all banks should be prepared to address on an expedited basis even before the status of new legislation or regulations is known.
More Rigorous Scrutiny of Banks
Based on the recent significant criticisms of the regulatory agencies, we anticipate that banks of all sizes will be subject to higher standards, whether formal or informal, more rigorous scrutiny of banks’ performance under such standards, and less tolerance for unresolved matters requiring attention and resolution. An additional factor supporting this expectation during 2023 is the growing consensus that the economy will enter a recession, which will increase pressure on credit quality, earnings and capital.
To avoid future allegations of lax supervision, banks should expect strict adherence to Matters Requiring Attention (MRAs) and Matters Requiring Immediate Attention (MIRAs) target dates and faster issuance of enforcement orders. Banks whose Boards of Directors and senior management are not actively and demonstrably engaged in implementing effective remedial actions will run a higher risk of ratings downgrades and enforcement orders.
The principal focus of the enhanced regulatory regime following the Great Recession of 2008 has been credit risk and capital. The 2023 bank failures highlighted another component of risk management—loss of depositor confidence, resulting in withdrawals in volumes and with unprecedented speed, made possible by technology that destroyed two prominent banks overnight regardless of the quality of their loans or securities portfolios. This deposit withdrawal phenomenon occurred at Silicon Valley Bank, Signature Bank, Silvergate Bank and several other regional banks that depositors believed had similar asset and liability profiles.
With the renewed emphasis on the identified deficiencies that led to the recent crisis, banks of all sizes, especially community and regional banks, should be prepared to demonstrate their focus on their risk management infrastructure in the following ways:
- Conduct a clear-eyed assessment of the bank’s risk profile, including engagement of independent third-party consultants to supplement or fill a capacity gap.
- Review risk management policies and procedures for the principal risks to the bank
- Assess the adequacy and breadth of bank personnel who monitor risk, as well as the adequacy and security of the bank’s technology platform.
- If one is not already present, designate a committee of the Board of Directors with risk assessment experience to supervise the bank’s risk management policies and procedures.
- Ensure the risk management policies and procedures are effective confirmed by internal audits and third-party assessments.
An important component of risk management is asset/liability management—in particular, liquidity risk management. Given the prominence of this issue in the recent failures, it is likely that this will be a regulatory focus—especially a bank’s deposit profile and stable liquidity funding sources.
Since the introduction of FDIC deposit insurance in 1933, it has been assumed that depositors have no need to withdraw their insured deposits from banks. Following the recent bank failures, it was revealed that many banks of all sizes have over 50% of their deposits in large (greater than $250,000) uninsured deposits, which are believed to be more volatile. An additional source of volatility is the large percentage of deposits concentrated in one industry segment. The recent bank failures have also demonstrated that deposit influencers can escalate depositor fears with deposit withdrawal instructions to portfolio companies or by their own behavior.
So, what will be the regulatory response?
The regulatory response will depend on the size, business model complexity or novelty of a bank. If the enhanced prudential regulation regime is rolled back to at least the level of $100 billion to $250 billion in assets, these banks are likely to experience the greatest impact. However, it is possible that the regulators will be provided with Dodd-Frank-level discretionary authority, that was reduced in 2018, to impose next-level standards based on a perceived need. Community banks will experience ripple effects of enhanced prudential regulation at a lesser level. Banks should anticipate the following areas for enhanced regulatory review:
Liquidity risk management, including:
- Liquidity stress testing
- Liquidity ratios and adequacy of high-quality liquid assets (HQLAs)
- Contingency funding under various scenarios
- Policies to set or revise limits on individual or industry sector deposit concentrations and uninsured deposits
- Updated assumptions regarding duration of deposit base
- Understanding of relationships among depositors to identify potential network effects and any deposit influencers (e.g., venture capital funds vis-à-vis their portfolio companies) in the bank’s deposit portfolio
- Confirmed eligibility for Federal Home Loan Bank and FRB borrowing
- For smaller banks, strategies to reduce deposit volatility, including use of term deposits, IntraFi Network Deposits and bank term debt to reduce risk of overnight withdrawals of uninsured deposits
- Reviewed and revised limits on unhedged loss exposure in the securities portfolio caused by interest rate increases, and controls of sales of interest rate swaps that increase unhedged loss exposure.
Changes to Treatment of Held to Maturity Securities and Capital Adequacy
The 2023 bank failures highlighted for the public the accounting differences between securities characterized as Available for Sale (AFS) and those characterized as Held to Maturity (HTM). Unrealized gains or losses for AFS securities are reflected in the capital account, while those related to HTM securities are not shown in the financial statements5 or in calculating capital ratios. It is unlikely that this accounting convention will be changed soon, if at all. It is possible, however, that the regulators will require banks to take the amount of unrealized losses into consideration in their capital planning and expect some capital raising in a form qualifying as capital for regulatory purposes if needed to fill a significant “mark-to-market” hole in the securities portfolio. Such forms can include redeemable preferred stock or subordinated debt than can be redeemed at the option of the issuer once the capital hole has diminished.
The recent bank failures have shocked the banking industry and the public for a variety of reasons. There is no one single cause or party responsible for the failures, but the composite of contributing factors formed to date has identified certain potential weaknesses in the system that we believe will be addressed in some combination of future legislation and regulations, and more rigorous examinations of areas previously thought not to be problems.
In the FRB’s self-examination, it will be interesting to see whether it will find that there was a lack of sufficient coordination of the FRB’s rapid increases in interest rates and its role as a prudent regulator of our nation’s banks. A related question is whether the FRB could have taken proactive action to prepare for the predictable negative effects of its rate increases, such as establishing the Bank Term Funding Program sooner in the rate increase cycle.
In the final analysis, however, we anticipate that the internal regulatory reviews currently underway will find that the primary responsibility for these failures will fall on the shoulders of management and the board of directors, if for no other reason than to divert responsibility away from the agencies.6 In anticipation of this reality, banks should begin planning for the enhanced regulatory and investor scrutiny that is likely to follow these failures, even if they believe they do not have the risk profiles of the failed banks.
3 https://www.fdic.gov/news/financial-institution-letters/2016/fil16034.html; we believe the recent bank failures will further legislative and regulatory momentum toward meaningful clawback of incentive compensation if certain adverse material events occur, including bank failures.
5 With some digging in a bank’s financial statements, unrealized losses in HTM securities can be found in the footnotes to the financial statements.
6 In his statement to the Senate Committee on Banking, Housing and Urban Affairs dated March 28, 2023, Michael Barr, Vice Chair for Supervision of the FRB, stated, “[O]ur first step is to establish the facts—to take an unflinching look at the supervision and regulation of SVB before its failure.” He then proceeded to jump to the conclusion by presenting a long list of “management failures” deflecting other factors contributing to the failures.