Banking Disruption: Banking Regulators Signal Updates to Supervisory and Regulatory Agendas in Wake of Bank Failures
Republished in the June 2023 INSOL Restructuring Alert
Banking Disruption: Banking Regulators Signal Updates to Supervisory and Regulatory Agendas in Wake of Bank Failures
Republished in the June 2023 INSOL Restructuring Alert
On April 28, 2023, the Board of Governors of the Federal Reserve System (FRB), the Federal Deposit Insurance Corporation (FDIC), the United States Government Accountability Office (GAO), and the New York Department of Financial Services (NYDFS) released reports related to the failures of Silicon Valley Bank (SVB) and Signature Bank. These reports were issued prior to the sale of First Republic Bank. On May 8, 2023, the California Department of Financial Protection and Innovation (CDFPI) released a report related to its supervision of SVB. Additional reports by the public sector are expected.[1]
These reports signal that the banking agencies intend to update their supervisory and regulatory agendas in the wake of these bank failures. This client alert focuses on the reports’ findings about how weaknesses in supervision and regulation may have factored into the bank failures and provides key takeaways.
In a cover letter accompanying the report, FRB Vice Chair for Supervision Michael Barr characterizes the FRB Report as the “first step” in the FRB’s “self-assessment.”
Vice Chair Barr notes that a firm’s distress may have systemic consequences through contagion, even if the firm is not extremely large, highly connected to other financial counterparties, or involved in critical financial services. According to Vice Chair Barr, the bank failures demonstrate the need to bolster resiliency in the financial system, particularly given the limits of regulators to assess and identify new and emerging risks. He also notes certain initiatives already underway to bolster the resiliency of banking organizations, including a holistic review of the capital framework, implementation of the Basel III endgame rules,[2] the use of multiple scenarios in stress testing, and a new long-term debt (LTD) rule for large banks.
The FRB Report concludes that the SVB failure was due, in part, to supervisory and regulatory weaknesses. The FRB Report also finds that supervisors did not appreciate SVB’s vulnerabilities and did not take sufficient steps to ensure that the bank addressed its vulnerabilities in a timely fashion. In addition, the FRB Report asserts that the bank failure was due, in part, to the changes in the legislative and regulatory framework enacted in 2018–2019. Another contributing factor was supervisory posture—perhaps due to the “tone at the top”—that led supervisors to be less assertive and more eager to build consensus before providing supervisory feedback. In light of the FRB Report’s findings, Vice Chair Barr outlined his recommendations to “improve” and “strengthen” the FRB’s supervisory and regulatory agenda.
Supervisory Agenda. Vice Chair Barr recommends that the Federal Reserve:
Regulatory Agenda. Prior to passage of the Economic Growth, Regulatory Relief, and Consumer Protection Act in 2018 (EGRRCPA),[3] the minimum asset threshold for applying enhanced prudential standards (EPS) was $50 billion in total assets.[4] The EGRRCPA raised the minimum threshold to $250 billion in total assets and provided the FRB with discretion to rebut a statutory presumption and apply EPS to bank holding companies with greater than $100 billion in total assets. In 2019, the FRB established four (4) categories of standards for large U.S. and foreign banking organizations: Categories I, II, III, and IV.[5] Category IV banking organizations are those with $100 billion or more in total assets that do not otherwise meet the criteria to be a Category I, II, or III banking organization.[6] Under this tailored framework, regulatory requirements increase as a banking organization’s asset size increases or it exceeds certain risk-based thresholds.[7] Upon moving into a new category, current regulations provide banking organizations with a transition period before full compliance with the relevant regulations is required; these transition periods effectively delay the application of the rules.
Against this backdrop, Vice Chair Barr recommends that the Federal Reserve:
The FDIC Report also identifies, among other things, deficiencies in supervisory practices, including delays in communicating examination results to the bank board and management and the assignment of rating downgrades. In addition, the FDIC Report concludes that resource challenges contributed to “timeliness and work quality issues and slowed earlier identified and reporting of [the bank’s] weaknesses.” Although the FDIC Report provides that the coincidence of these two failures and their unprecedented speed may lead to changes in regulation and supervision and re-evaluating liquidity risk management, neither the FDIC Report nor FDIC Chair Martin Gruenberg’s accompanying statement recommends specific regulatory changes. The FDIC Report identifies certain items for consideration or future study, including ways to improve supervision of banks’ risk management practices, evaluation of supervisory processes, and ways to address resource challenges.
In mid-April, Travis Hill, the FDIC Vice Chair, delivered a speech addressing the recent bank failures. In his remarks, he attributed the recent failures primarily to interest rate risk mismanagement and warned against “overcorrecting” by imposing additional regulation.
On May 1, 2023, the FDIC released a separate report providing a comprehensive overview of the deposit insurance system and laid out options for deposit insurance reform. That report suggests that targeted coverage where “business payment accounts” receive significantly higher coverage than other accounts may be the best option to achieve the objectives of deposit insurance (i.e., promotion of financial stability and protection of depositors from loss) relative to its costs. Such targeted insurance coverage would require a legislative change.
The GAO Report examines:
The GAO Report finds that, although regulators identified risks and shortcomings in the failed banks, regulators failed to escalate identified issues in a timely manner. Such failures to escalate in a timely manner contributed to the bank failures by allowing the banks to operate without remediating identified issues. These deficiencies were also found to be contributing factors in the 2007–2009 financial crisis, following which the GAO recommended that the federal banking regulators consider additional “noncapital triggers” that would require “early and forceful regulatory actions tied to specific unsafe banking practices.”
The NYDFS Report focuses on the failure of Signature Bank, a New York-chartered state nonmember bank. The NYDFS Report identifies several areas for improvement in its supervision, including: (i) updating its policies and procedures to streamline and simplify internal processes, (ii) stress-testing operational readiness (e.g., considering whether to require banking organizations to conduct table-top exercises demonstrating operational readiness to collect and produce accurate financial data in a stress scenario), (iii) adding examination resources, (iv) adopting clear guidelines for how examiners should escalate issues, (v) revisiting assumptions used in liquidity models, and (vi) developing “appropriate new regulatory tools.”
The CDFPI Report notes that although most supervisory letters to the bank were jointly issued by the Federal Reserve Bank of San Francisco (FRBSF) and the CDFPI, the FRBSF had assumed the lead oversight role over many supervisory activities. The CDFPI Report concluded that the agency did not take adequate measures to ensure that identified deficiencies were timely remediated by SVB. The CDFPI plans to require banks to consider how to manage risks posed by social media and real-time withdrawals. The report also outlines steps that the CDFPI can take to improve its supervision of state-chartered banks, including reviewing its internal staffing processes to ensure that additional staff is assigned in a timely manner for banks with assets of more than $50 billion, commensurate with accelerated growth or increased risk profile for an institution, and adding another level of supervisory review to exam reports before they are issued.
[1] In addition to these three reports, other government actors have issued or plan to issue reports or statements related to the bank failures. On March 30, 2023, the White House issued a statement calling for increased supervision and regulation for large regional banks. In addition, the House Committee on Oversight and Accountability is investigating the Federal Reserve Bank of San Francisco’s role in a recent bank failure.
[2] The implementation of the Basel III Endgame reforms would represent a significant revision to current capital requirements by changing how much capital needs to be held against operational, credit, and market risk exposures.
[3] Pub. L. No. 115–174, 132 Stat. 1296 (2018).
[4] The EPS rule is codified in the FRB’s Regulation YY (12 C.F.R. Part 252). EPS were extended to “Covered Savings and Loan Holding Companies” as part of changes adopted by the FRB in 2019. See 12 C.F.R. Part 238 (Regulation LL).
[5] See 12 C.F.R. §§ 252.2 and 252.5 for the relevant definitions of Category II, Category III, and Category IV. A Category I banking organization is a U.S. global systemically important bank holding company (GSIB) as identified under the FRB’s GSIB surcharge rule (see 12 C.F.R. § 217.402). Relevant definitions for savings and loan holding companies are contained in the FRB’s Regulation LL.
[6] Category IV foreign banking organizations are those with average combined U.S. assets of $100 billion or more.
[7] The additional risk-based factors are average weighted short-term wholesale funding, nonbank assets, cross‑jurisdictional activity, and off-balance sheet exposure.
[8] The LCR and NSFR are essentially joint rulemakings of the FRB, the Office of the Comptroller of the Currency, and the FDIC, and it is highly unlikely that any individual agency would amend these rules unilaterally. In contrast, the FRB may act unilaterally to amend EPS requirements contained in Regulation YY and Regulation LL.
[9] 12 U.S.C. § 1823(c)(4)(G).
[10] For example, additional risk-based triggers could include being funded by heightened levels of uninsured deposits or a concentrated customer base.
[11] Under the LCR and NSFR rules, Category III firms with less than $75 billion in average weighted short-term wholesale funding are subject to an 85% outflow adjustment percentage and stable funding adjustment percentage, respectively. Under these rules, Category IV firms with $50 billion or more in average weighted short-term wholesale funding are subject to a 70% outflow adjustment percentage and stable funding adjustment percentage, respectively. The LCR and NSFR rules do not apply to depository institution subsidiaries of Category IV firms.
[12] There is potential for additional regulatory guidance or rulemaking on incentive compensation. See “Incentive‑Based Compensation Arrangements,” Proposed Rule, 76 FR 21169 (April 14, 2011); “Incentive-Based Compensation Arrangements,” Proposed Rule, 81 FR 37669 (June 10, 2016). See also “Guidance on Sound Incentive Compensation Policies,” 75 Fed. Reg. 36,395 (June 25, 2010), Board of Governors of the Federal Reserve System, “Supervisory Guidance on Board of Directors’ Effectiveness,” SR letter 21-3 (February 26, 2021).
Practices