In the wake of Silicon Valley Bank’s collapse, which set off panic in the financial sector and concern across the global economy, a crucial question has been whether regulators could have intervened sooner. Recent reporting has indicated that, more than a year ago, the San Francisco Fed did notice problems—including how the bank managed its exposure to changes in interest rates and whether it would have enough cash in a crisis—and warned S.V.B. about them. (Between 2017 and the time of those warnings, the bank’s assets had quadrupled to more than two hundred billion dollars.) After the financial crisis of 2008, Congress passed the Dodd-Frank Act, which imposed stricter regulations on the banking sector; in 2018, Congress scaled back Dodd-Frank, raising the threshold for increased scrutiny of banks from fifty billion in assets to two hundred and fifty billion.
I recently spoke by phone with Peter Conti-Brown, an associate professor of financial regulation at the Wharton School and an expert on the Federal Reserve. During our conversation, which has been edited for length and clarity, we discussed whether the Trump Administration’s push to weaken Dodd-Frank helped cause the current crisis, whether the Federal Reserve should be in the business of regulating banks, and how much autonomy and power regulators really possess.
Late last week, Bloomberg reported that regulators had warned Silicon Valley Bank repeatedly about its risk-management practices, sending it warning letters that would precede more severe action. Can you talk about those letters, and how binding they are?
The supervisory processes include a number of different elements. Sometimes they include checking to make sure that specific procedures have been followed. Sometimes they are second-guessing risk-management practices. When something goes wrong, examiners and bankers will talk with each other to make sure that the questions are well understood. When they are, an examination report comes out, and that gets a response from the bank.
When an examination report highlights a failure to follow adequate procedure, or when the risk has been increased without adequate explanation, then the examiner—in this case, an employee of a Federal Reserve Bank—will work with a team to escalate the issue. That escalation goes through a process that culminates in a Matter Requiring Attention (M.R.A.), and the M.R.A. goes to the board of the examined entity. It’s not uncommon for just about every supervised bank to have M.R.A.s.
To escalate from an M.R.A. to a Matter Requiring Immediate Attention (M.R.I.A.) typically requires the approval of a supervisor of supervisors, sometimes called a chief examiner. That chief examiner covers a number of different banks and isn’t going to act unilaterally. Typically—again, this isn’t spelled out in any kind of public document—the chief examiner, in consultation with others at the Federal Reserve Bank and the Board of Governors in Washington, D.C., will reach the determination. Of the many M.R.A.s, there are a few that are especially significant and need to be resolved “immediately.”
But an M.R.I.A. is not a file that just gets parked on a desk—it is the basis for additional enforcement action. When there’s a failure to resolve M.R.A.s or M.R.I.A.s, that can easily turn into more aggressive action, such as a mandate that a bank not take on any more clients, or sell assets, or even shut down.
Regarding Silicon Valley Bank, how much could regulators have known about its problems?
Every single M.R.A. and M.R.I.A. was available to regulators. These are written by supervisors, and, while we don’t know the content, we can be almost certain that they referred to the deterioration of risk management on the asset side and the explosion of flighty deposits on the liability side. Sometimes M.R.I.A.s are especially egregious instances of, say, risk mismanagement or failures of processes. And sometimes they are escalated from M.R.A.s because the bank has done nothing about them. We don’t know what the M.R.I.A.s were, but I would imagine they’re both of those things.
I would imagine that the bank’s reliance on lower interest rates would be the type of thing that would generally set off alarms for regulators.
And I’ve read that there were other red flags. One of them was that Silicon Valley Bank was borrowing from the Federal Home Loan Banks system. Why was that a red flag?
Examiners sometimes will flag overreliance on the Fed’s own nonemergency lending facilities. And the reason is that the Federal Home Loan Banks, as with the Federal Reserve Banks, are creatures of Congress that are meant to be lenders of last resort. An aggressive use, as there was here, suggests that Silicon Valley Bank didn’t have first-resort creditors to which it could turn. And that’s usually a sign that markets are suspicious of the viability of the firm.
I want to take a step back and talk about Dodd-Frank. What did Dodd-Frank do to make the banking system safe? What are its most important legacies?
It is important to recall that Dodd-Frank is seventeen different laws. And the one that we are debating in this case is really Title I of Dodd-Frank. Title X is the Consumer Financial Protection Bureau. Title VII is about derivatives. And so, when we say Dodd-Frank, we’re talking about a lot of changes to the financial system. The biggest change of all was that all banks with assets above fifty billion dollars were subject to a much more aggressive, much more open-ended, and much more discretionary supervisory regime. This is known as enhanced prudential supervision. It includes stress tests. One stress test was created by Dodd-Frank itself, and the others are ones that the Fed had already been doing and which were now ratified by Congress.
The other part of this—this refers to Title II—is that the banks had to submit a so-called living will: in the event of a crisis, this is how we will die in an orderly way. And the orderly death did not include the Federal Deposit Insurance Corporation (F.D.I.C.) guaranteeing the uninsured liabilities for its depositors, as was done here. In that sense, a living will, had it been submitted—the change to the law in 2018 eliminated that requirement—would have identified other kinds of loss-absorbing capital, other kinds of liquidity.
Before the 2018 rollback, we would’ve been having stress tests in an annual cadence that would’ve picked up on the concentration of risks. The strangest part of this story is that Silicon Valley Bank mismanaged its risk using the safest, plain-vanilla assets you can imagine. The way that our capital regime denominates those securities means that they might have got by a stress-test system, had it been applied. That’s an indictment of the stress-testing regime; it’s not an excuse for Silicon Valley Bank. But that blunts the critique that the stress test would have saved Silicon Valley Bank had it still been applicable. At this point, I’m going to say that we don’t know yet whether a stress test, a living will, or enhanced prudential supervision would have done what we needed them to do.
Those are the innovations of Dodd-Frank. The biggest point of all, though, is that, even before Dodd-Frank, and even after 2018, the supervisors retained all of the tools necessary to pursue any question of risk concentrations or risk mismanagement up to and including forcing a bank into liquidation. And that’s what we did not see. We saw the red flags, and Bloomberg’s report says that the supervisor saw those red flags, too. What they didn’t do is act on them. And that’s the question we still don’t have an answer for.
How did the 2018 law change things—both very specifically in terms of what was mandated by law and also in the ways that regulators went about their jobs?
In this era of omnibus bills, often hundreds or thousands of pages long, the 2018 bill is interesting for a lot of reasons, not least because of how short it is. The entire thing is seventy-five pages. The part that is relevant to our discussion right now is only five pages long. In the original Dodd-Frank bill, banks with fifty billion dollars or more in assets were subject to enhanced stress testing and the rest. Those five pages moved that number to two hundred and fifty billion. So, for all banks above two hundred and fifty billion, nothing changed.
It also included a different band for banks between a hundred billion and two hundred and fifty billion—it says that the Fed can continue to treat those banks however it would like. What the Fed needs to do is take into consideration a long list of things: capital structure, riskiness, complexity, financial activities and the rest, or any other factor the Fed views as appropriate. It’s a very big punt. They also include a rule of construction in the bill, which says, “Nothing in [this act] shall be construed to limit . . . the [Fed’s] supervisory, regulatory, or enforcement authority.” The Fed gets to choose.
In essence, Congress said, “We’re going to stop the legal requirements for banks of a certain size, but regulators can do whatever they want”?
Was there a broader message being sent?
The title of the bill is Tailoring Regulations for Certain Bank Holding Companies. The rest of the bill is highly deregulatory, including for credit unions, mortgages, mobile homes, Section 8 housing providers, and international insurance supervision. The bill even makes it easier for banks to take a digital picture of your driver’s license, which wasn’t clear in the law before. The entire ethos of the bill is to make each of the regulatory and supervisory packages match the bank in question—the term of art is “tailor.” Before, we had an off-the-rack, relying-on-rule regime. With tailoring, the Fed turned more regulation and supervision into less.
The congressional instruction, as understood by just about everybody who voted in favor of the bill and who has a public statement about it, was, “We need to pull back. Dodd-Frank went too far. Leave the big banks as they were, and provide some relief to all the rest.” The regulators took their cue from Congress to do just that. And not only the Fed but also the Treasury Department, the F.D.I.C., and others.
That’s the strongest case we have that 2018 wasn’t just a part of the story but a central part of the story, because it turned the supervisors from people who might raise matters requiring attention and then do something about it, acting on the basis of those matters, to people who simply file the reports.
Did supervisors ask Congress what the bill intended, or did they just read the bill and say, “Well, Congress doesn’t want us to take regulations too seriously”? How does that process work?
The Fed is an extremely politically cautious entity. It does not seek confrontation with Congress. It is constantly seeking to understand the view not only of individual members of Congress but of an over-all, default congressional intent. This is different from the way lawyers or judges might say, “What did Congress mean with this statute?” The Fed is in a live dialogue with Congress. It’s saying not only, “What is the legal meaning of the statute?” but also, “What is its spirit so that we can be in synch, especially when it comes to regulation and supervision?”
This is appropriate, let’s be clear, because the Fed works for Congress, and elections have consequences. When Congress writes a law and gives direction, even if it’s broad direction, to the entities it has created, we want those entities to follow that general instruction. For this reason, it is very appropriate to blame the legislative sponsors of the 2018 law for sending a not-very-subtle message to the Fed to pull back. Congress sent that message, and the Fed heard it.
Is the Fed a good regulator of banks, or should that be left to other parts of the system? What are the contours of that debate?
Sean Vanatta and I are finishing a book on the history of bank supervision in America from the Civil War to the present. By our count, there have been nineteen legislative proposals to strip the Fed of supervisory authority and either give it to other entities or consolidate all supervision into a single separate entity, such as a federal banking commission. These have always failed, always with the Fed’s resolute opposition, and we’re going to have that debate again. More and more people are looking at this, and they’re saying that the Fed is not good at what it does.
There’s something different about this debate in 2023, though. Before, the Fed was being accused of ignoring supervision because it was focussed on other things, or it was being accused of being too cozy with the banks, that it was captured by industry. The accusations here might chime with that historical critique, but there’s something fundamentally different, and that is, if this is indeed a systemic crisis, as the Fed tells us that it is, it’s systemic because the Fed’s own aggressive monetary policy has destabilized banks that were not ready for that policy aggression. These are banks that could have been made ready had the Fed’s own supervisors done more to prepare them for it.
Now, I have no sympathy for these banks, because the Fed told all of us everywhere exactly what it was doing, starting fifteen months ago, and most banks got the message and took the appropriate steps. But, if the Fed was just focussing on monetary policy, it wasn’t only that they were ignoring supervision. It’s that they weren’t using supervision to see how their own monetary policy was being felt within the system. If the Fed was great at doing that, then we wouldn’t have a “systemic crisis”—and the Fed overreacted to the failure of Silicon Valley Bank. That’s worthy of a condemnation of a different sort.
Either the Fed is mischaracterizing what’s going on now or, in its own words, it’s not functioning as a regulator correctly.
Put this crisis aside. Should the Fed be an important regulator of the banking industry? Why or why not?
Before the past couple of weeks, one of the reasons that I’ve generally been supportive of the role of the Fed as a supervisor is that there’s real, secretive, privileged informational content that comes through the supervisory process, and that is very important for the Fed to know as it seeks to calibrate monetary policy. The stakes are never low when it comes to monetary policy. Every decision has consequences, and, even though it’s not the same as firing an individual employee or sending a grocery bill that’s fifty per cent higher than it was the year before, getting monetary policy wrong has real impacts on real people.
We want a central bank that has as much information as it can possibly have so that the calibration is done well, and bank supervision is not orthogonal to that policy discussion. The information that supervisors gain and pass up to other regulatory officials and central bankers is not only relevant but quite vital. That’s the best case to say that these two functions should be combined.
The case against this is that, even if that is true, the Fed doesn’t actually use that information, because they’re all a bunch of bookish economists who use complex models to think through data that are publicly available, and to advise central bankers to make decisions on that basis. They are just so divorced from the real world, in a different kind of an ivory tower, that even the information that is unique and special from bank supervision is just squandered by them. Why not put that supervision in the hands of people who will use the information, if not for monetary policy then for financial stability, or for making sure that risks are appropriately managed for the protection of customers and clients?
Are there potential regulators who aren’t off in their own versions of an ivory tower? Which regulators fit that bill?
That’s great to wonder about—this is one of the reasons the debate is so complex. It’s always: compared to whom? The answer right now would be the F.D.I.C., which is the primary regulator for First Republic, or the Comptroller of the Currency, which is the primary regulator of, let’s say, Wells Fargo. There are no clean hands in federal banking regulation.
Each of these entities has a history, has a set of practices, and, for all kinds of reasons, we don’t have perfection in regulation or supervision. The question we have to ask ourselves now is: what is the right kind of institutional framework and arrangement that will best insure that the public-private partnership between banking and bank supervision works well? All we know right now is that it is not working well.
Signature Bank, which was also shut down, had been very involved with cryptocurrency. Silicon Valley Bank was very much involved with tech. Is there an inherent risk for large banks in getting involved in one specific industry or sector?
I don’t think so, but I think that there’s something here about where two axes might converge. The largest banks, by their very size and scope, are so diversified that they’ll have other problems, to be sure, but it won’t be this. The smallest banks are so deeply rooted in their communities that they lack complete diversification. They’re really exposed to the local economy. They have other benefits to them. Their failures are unfortunate for their stakeholders, but don’t have any systemic consequences.
There’s something, though, about an axis between size and complexity, rooted in community and diversification, that converges on a bank like Silicon Valley Bank or Signature, where they go all in on both asset and liability size—assets maybe because of bad risk management, liabilities because they’re focused on a single clientele. That makes their lack of diversification an idiosyncratic risk to them, but also a systemic risk to all of us. I think what we’ve hit is the bitter spot at that convergence, where the size of the bank was big enough to matter, but not so big that they had succeeded in diversification.
Source: New Yorker