Last week, I had the honor of appearing before Chair Elizabeth Warren, Ranking Member John Kennedy, and distinguished members of the Subcommittee on Economic Policy of the Senate Banking, Housing, and Urban Affairs Committee. My testimony at the hearing in a hearing ”Strengthening Accountability at the Federal Reserve: Lessons and Opportunities for Reform.” was based on my professional experience of three decades, consulting and training professionals at banks and financial regulatory agencies in over thirty countries on a wide range of risks that can threaten financial institutions’ safety and soundness. My fellow panelists were Dr. Peter Conti-Brown and Dr. Paul Kupiec; their written testimonies are here.
Lessons and Recommendations
Laws about banks are incredibly important. They lead bank regulators to define the type of rules they write, promote supervisory culture at the top, and design examination processes. The Economic Growth, Regulatory Relief and Consumer Protection Act of2018 greatly influenced Former Vice Chair of the Federal Reserve Randal Quarles to propose the Tailoring Rules. Speaking before the American Bankers Association, he said, “the Congress wants to see action and has, to a certain degree, specified some of the steps we need to take.” He also stated that “in conjunction with changing regulations, we also need to consider how such changes would be reflected in supervisory programs, guidance, and regulatory reporting.”
Throughout 2017 -2018, almost 400 financial institutions lobbied heavily in favor of EGRRCPA. Former Silicon Valley Bank CEO Greg Becker and many bank lobbyists and politicians were also in favor of EGRRCPA and argued that regional banks did not pose risks to the financial system. Barely five years later, those words did not age well.
I do not have schadenfreude when I remember that in August 2018, I wrote “Taxpayers should not be fooled into thinking that banks that are in the asset range of $100-250 billion are not systemically important, because regional and foreign bank organizations of that size range are incredibly interconnected to other financial institutions and to thousands of companies in the US due to the loans that they extend and the financial derivatives that they arrange for companies of every size. If any of those banks were to run into problems for being insufficiently capitalized or if they were to become illiquid, taxpayers would suffer the consequences.”
After conducting the Financial Sector Assessment Process (FSAP) of the United States in 2020, independent analysts and consultants hired by the International Monetary Fund were critical about the shortcomings of S.2155 as well as of the Federal Reserve’s tailoring approach. The IMF recommended that U.S. regulators introduce rules on concentration risk management and include more quantitative standards on interest rate risk in the banking book as well as recommending specific capital and liquidity recommendations for large banks that were not internationally active.
After analyzing all the CAMELS examination reports and supervisory letters released by the Federal Reserve, I know that Silicon Valley Bank’s CEO Greg Becker, his colleagues, and Board willingly ignored the numerous interest rate, liquidity, BSA-anti-money laundering compliance failures, data problems, IT weaknesses, and incredibly ineffective internal audit and credit risk management processes. These serious problems were identified by California and Federal Reserve Bank of San Francisco examiners.
Additionally, SVB
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did not disclose important interest rate risk measurements such as economic value of equity in its annual report or Basel III Pillar III risk disclosures leaving the market in the dark. The problem, however, is that there is so much we still do not know about SVB’s failure, because an independent postmortem has not been completed. Who at regulatory agencies ignored examiners’ findings, year after year, and why?
Recommendations
I recommended the following legislative and supervisory process changes; more details are in my written testimony.
· Order An Independent Investigation of the Silicon Valley Bank Failure.
The CAMELS and Supervisory Letters released by the Board of Governors and the Barr report helped give insight into SVB’s problems. The Government Accountability Report was also a good start, but as per the hearing on May 11, 2023, the GAO needs more time to conduct an in-depth postmortem and to address questions posed by Senate Banking Committee members.
· Appoint an Independent Inspector General for the Federal Reserve System.
An Inspector General should be appointed by the President of the United States and confirmed by the Senate. This individual should be allocated the necessary human and technological resources to be able to successfully fulfill all responsibilities. The Inspector General should testify before the House and Senate at least semi-annually.
· Revise Title IV of S2155 to Reinstate Dodd-Frank’s designation of Systemically Important Banks.
S2155 gutted essential parts of Dodd-Frank’s Title I, such those that designated banks over $50 billion as domestically systemically important. S2155 also influenced the supervisory culture and tone at regulatory entities. By designating banks above $50 billion as domestically systemically important, much more of the banking sector would be better regulated and supervised. This would send a strong signal to regulators to impose enhanced prudential standards on these types of banks to strengthen these banks and minimize systemic risk if they were to fail.
· Remove Heads of Banks From Federal Reserve District Boards.
While there is debate as to the extent of power of district boards over off-site supervision or on-site bank examinations, it cannot be denied that board members meet repeatedly with presidents and other key members of the Federal Reserve district banks. According to Becker’s response to Senator Hagerty during the ‘Examining the Failures of Silicon Valley Bank and Signature Bank,’ Becker met with the Federal Reserve Bank of San Francisco monthly and sometimes more frequently.
· Reform Remuneration for CEOs and Key Bank Professionals.
Legislators and not-for-profit organizations are proposing different ways in which remuneration should be reformed. Clawing bank executives’ bonuses when their banks fail should be explored. The bi-partisan bill Failed Bank Executives Clawback Act correctly points out that “currently, the Federal Deposit Insurance Corporation’s (FDIC) ability to claw back executive compensation in the event of a bank failure is limited. The Failed Bank Executives Clawback Act would give federal bank regulators the tools they need to hold executives of failed banks responsible for the costs those failures exact on the rest of the banking system and the economy and require the FDIC to act to prevent the unjust enrichment of bank executives.”
Additionally, it is important to remember that Section 956 was not finalized. As explained by Public Citizen “the regulators wisely proposed that a significant portion of senior executive bonus pay be deferred into a fund. In the case of misconduct or failure, this fund would be forfeited, either to help pay for the resolution of the bank, or to pay fines associated with the misconduct (instead of having shareholders effectively pay the fines). This dynamic would essentially deputize and incentivize all bankers to police one another.”
· Require Transparency from Banks about their Assets and Liabilities and Interest Rate and Liquidity Risk Measurements.
Large banks should disclose the amount and concentrations of assets as well as liabilities at least once a month to the public, if not more frequently. We know they can do this, because there is a Federal Reserve weekly report ‘H8’ that shows assets and liabilities at a high, anonymized level. Banks of the size of Silicon Valley Bank should have the technological and professional capacity to report asset and deposit levels on a weekly basis to the public.
· Utilize All of the Federal Reserve’s Existing Powers to Escalate Identified Risks at Banks and Impose Enforcement Actions on Non-Compliant Banks. According to Barr’s report “the Federal Reserve generally does not require additional capital or liquidity beyond regulatory requirements for a firm with inadequate capital planning, liquidity risk management, or governance and controls.”[1] Since its inception, national discretion is built into The Basel Accord framework, so that adopting countries have some flexibility in implementing rules that are most appropriate to their own circumstances.[2] As a member of the Basel Committee on Banking Supervision, the Federal Reserve can recommend stricter rules for our banks if it is appropriate for our circumstances.
In 2011, the Government Accountability Office recommended that the Federal Reserve and other bank regulators modify the existing Prompt Corrective Action Framework. The GAO recommended that. “to improve the effectiveness of the PCA framework, the heads of the Federal Reserve, FDIC, and OCC should consider additional triggers that would require early and forceful regulatory actions tied to specific unsafe banking practices and also consider the other two options—adding a measure of risk to the capital category thresholds and increasing the capital ratios that place banks into PCA capital categories—identified in this report to improve PCA. In considering such improvements, the regulators should work through the Financial Stability Oversight Council to make recommendations to Congress on how PCA should be modified.”
· Require Improvements In the Monitoring of Banks’ Interest Rate Risk Models.
Regulators need to take a closer look at models, especially those for interest rate and liquidity risk measurements. According to the last SVB annual report, the bank was measuring interest rate risk by using Economic Value Equity, which uses market values of assets and liabilities. It did not disclose what assumptions for discount rate it was using. If this information were disclosed, we could determine what SVB’s net economic value of equity was. In its Net Interest Income simulation, SVB disclosed that applied interest rate shocks of 100 and 200 basis points hikes and decreases. Given federal funds rate hikes by that time in 2022, SVB should have been applying larger shocks, more like 300 or even 400 basis points. Regulators need to require that relevant discount rates and interest rate shocks are applied to these interest rate risk measurements. Banks should be transparent about interest rate risk. I have worked with community banks that conduct gap analysis to test when they may have more liabilities than assets. There is no reason bigger banks cannot calculate this.
· Reinstate The Liquidity Standard for All Large Bank Organizations.
Bank regulators should require that banks that are $50 bn calculate and report the Liquidity Recovery Ratio. Had SVB been required to calculate and report on this measure, regulators and market participants would have seen that hiqh-quality liquid assets, declining in market value, would not cover net stressed cash outflows. Under the LCR, banks must test the effect of deposit decreases on their liquidity. Banks that are $100 billion in asset size should disclose their Liquidity Cover Ratio (LCR) at least once a month if not more often. Presently, our Globally Systemically Important Banks (G-SIBs) report LCR to their district Fed daily. This information is incredibly useful to bank regulators. And making it public through Basel III Pillar III’s risk disclosures would help the market discipline banks.
The Fed should also require these banks to calculate and report on the Net Stable Funding Ratio. This liquidity measure gives insight into whether a bank has the necessary stable funding for a twelve-month period.
· Provide Strong Protections for On-site Examiners and Off-Site Supervisors.
If off-site supervisors or on-site examiners discover that their findings about risks at banks are not being escalated, they need to be able to report this to the head of bank supervision without fear of reprisal.
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