FRB Concludes SVB Failure Was "Textbook Case" of Mismanagement, Slow Regulatory Response

Sebastian Souchet Commentary by Sebastian Souchet

The Federal Reserve Board concluded that the failure of Silicon Valley Bank ("SVB") was due to a "textbook case" of mismanagement of basic interest rate and liquidity risk, in addition to insufficient supervision from the bank’s board of directors and Federal Reserve supervisors.

In the report titled Review of the Federal Reserve’s Supervision and Regulation of Silicon Valley Bank, April 2023, the Federal Reserve Board evaluated the following factors contributing to SVB’s failure, in addition to the supervisory role played by the Federal Reserve:

  • Board of Directors and Management Failures. The FRB found that the board of directors and management failed to monitor risks "inherent" to the bank’s business model and implement a risk-management framework to keep up with SVB’s rapid growth. The FRB made clear that SVB’s failure can be directly linked to deficiencies in its governance, liquidity and interest rate risk management practices. For instance, the FRB said that management provided the board of directors with information reports that did not show SVB’s liquidity issues until November 2022. Additionally, the FRB said that as SVB was exposed to rising interest rates, management focused on protecting short-term profits instead of addressing threats to SVB’s overall profits and the reduced value of its securities. The FRB said that managers had an incentive to focus on short-term profit over "sound" risk management due to the compensation packages of senior management being tied to short-term earnings and equity returns.
  • Supervisory Assessment. The FRB said that despite rapidly growing from $71 billion to $211 billion in assets between 2019 and 2021, SVB was not subjected to heightened supervisory or regulatory standards. By the time of its failure in 2023, the FRB stated that SVB had 31 open supervisory findings, which is approximately triple the number at peer firms. In addition, the FRB stated that supervisory assessments indicated several weaknesses but did not "fully reflect" the bank’s vulnerabilities. For instance, SVB was rated "Satisfactory-2" in 2017 for governance management despite repeated observations of weaknesses in risk management. Not until 2022 was SVB rated "Deficient-1" in governance and controls which the FRB said was for governance and risk-management practices that were "below supervisory expectations." Additionally, the FRB found that SVB was rated a "Strong-1" and was subject to limited-scope liquidity reviews as part of the guidelines for smaller firms, despite its "significant asset growth and idiosyncratic business model."
  • Vulnerabilities. The FRB found that once supervisors did identify vulnerabilities at SVB, they were slow to downgrade their supervisory ratings and ensure steps to address the weaknesses were taken quickly enough by management and the board of directors. Once SVB was transitioned from a regional banking organization to a large and foreign banking organization ("LFBO"), the FRB said that it was provided with a long transition period to meet the more stringent supervisory expectations associated with LFBOs. As a result, the FRB said that the new supervisory team would need a greater amount of time to make their initial assessments. Once the supervisory team did release their supervisory findings and ultimately downgrade SVB in ratings, the FRB found that by that time SVB had been operating below supervisory expectations for "more than a year despite its growing size and complexity." The FRB said that reasoning for the delay in supervisory action is uncertain but speculated whether the FRB’s approach to delegated authority could have impacted the process.
  • Policy Stance. The FRB said that while SVB was growing rapidly in size in complexity, the FRB revised its regulatory and supervisory policies in response to external statutory changes, including the Economic Growth, Regulatory Relief, and Consumer Protection Act ("EGRRCPA"). Specifically, in 2019, the FRB said that it raised the threshold for enhanced prudential standards ("EPS") from $50 billion in assets to $100 billion in assets. As a result, once SVB reached the $100 billion threshold, it was subject to a less stringent set of EPS than would have been applied before 2019. The FRB said that the increased EPS threshold for supervision of an LFBO portfolio delayed the application of heightened supervisory expectations for SVB by at least three years. During the same time that SVB was transitioning to an LFBO portfolio, the FRB said that in conducting staff interviews for this report, FRB staff repeatedly noted shifts in supervisory practices under the direction of a newly appointed Vice Chair for Supervision. In these interviews, staff reported an emphasis on reducing burdens on firms while increasing the burden of proof for a supervisory conclusion. The FRB found that the resulting impact on staff was to approach supervisory findings and potential enforcement actions with a need to gather more evidence than in the past which delayed action by the FRB.

Improvements to Regulatory and Supervisory Framework

In a statement included with the report, FRB Vice Chair for Supervision Michael S. Barr highlighted regulatory steps the FRB plans to take moving forward, including: (i) greater continuity among portfolios so that as banks grow in size, they will be able to comply with heightened regulatory and supervisory standards more efficiently and (ii) preventing "complacency" which, he said, can be present in banks with stable and strong performance and lead "bankers to be overconfident and supervisors to be too accepting."

Additionally, Mr. Barr said that the FRB plans to increase resilience through stronger standards for banks by revisiting the tailoring approach under the EGRRCPA and reevaluate rules for banks with more than $100 billion in assets.

Commentary

The Federal Reserve Board’s report on the failure of SVB asserts that “a shift in the stance of supervisory policy impeded effective supervision by reducing standards, increasing complexity, and promoting a less assertive supervisory approach.” In particular the report states that while SVB was growing in size and complexity, the supervisory policy at the Federal Reserve “placed a greater emphasis on reducing [the] burden on firms, increasing the burden of proof on supervisors, and ensuring that supervisory actions provided firms with appropriate due process.”

Notably, the report does not identify a specific policy document that instituted such shift, but does appear to repeatedly allude to the shift coming “under the direction of” then Vice Chair for Supervision, Randal Quarles (see p. 11). Mr. Quarles himself was quoted back in 2017 saying that “perhaps throughout my entire term, engaging on changing the tenor of supervision will probably actually be the biggest part of what it is that I do.” (Former Vice Chair Quarles reportedly rejected this conclusion, saying there was "no policy leading to a change of supervision.")

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