It's Not Just an SVB Problem: the Systemic Nature of the Bank Regulation Failure

A mid-sized regional bank specializing in lending to tech start-ups, crypto companies, or law firms hardly seems of systemic importance, even if its failure would have caused disruption in some industries regionally and might have triggered a cascade of corporate bankruptcies because of large uninsured deposit balances. That sort of collateral damage from a bank failure is unfortunate and painful for those involved, but that's the nature of market discipline.

If that's where things ended with Silicon Valley Bank, I suspect regulators would have said too bad, so sad, as they were initially prepared to do. Yet the problem with Silicon Valley Bank's failure was that it had the potential spark for a banking-industry-wide panic, in which depositors pull their funds from smaller banks and move them either to big banks or to money market funds. That sort of panic could have been devastating to small and medium banks, as they would have faced a liquidity crunch that many could not meet...for the very same reason that SVB got into trouble, namely that they are sitting on large unrealized losses on their bond portfolios because they failed to manage interest rate risk appropriately. And if we had a correlated failure of lots of small and medium-sized banks, it would have resulted in serious economic disruption in small business and agricultural lending and a lot more spillover insolvencies of firms that had large uninsured deposits at those banks. That's the systemic risk scenario with SVB, and I suspect that as the weekend after the SVB failure advanced, that's what scared federal bank regulators into guarantying all deposits at SVB and SBNY.

But notice the nature of the problem: it wasn't just SVB that mismanaged its interest rate risk. It was lots and lots of other banks. Mismanaging rate risk is a Banking 101 screw-up, but it's also a Bank Regulation 101 screw-up. Rate risk is hardly a novel problem, and it's an easy one to address through derivatives like interest rate swaps, but those eat into profitability. Why bank regulators let rate risk get out of control almost across the board is something Congress needs to understand—I suspect that the story is much like consumer protection violations, which historically were tolerated because they were profitable. This much is clear, however:  if regulators had done their job generally, SVB's bank would not have posed systemic risk because there wouldn't have been the possibility of a panic. It would have been a one-off bank failure and nothing more. Regulators should have been on SVB's problems much sooner, but the real regulatory failure was an across-the-board failure to ensure that banks managed their rate risk because that's what set up the panic scenario.

Put another way, this isn't just a problem that can be hung on the neck of the Federal Reserve Bank of San Francisco. The problem here implicates every federal bank regulator.

FDIC's Poor Track Record in Holdco Bankruptcies

Last week I did a post about how the FDIC as receiver for Silicon Valley Bank probably doesn't have a claim against SVB Financial Group, the holdco of the bank. I got some pushback on that (including from a former student!), but I'm sticking to my guns here. It's a result that seems wrong and surprising, but if you look at the three most recent big bank holdco bankruptcies (this takes some digging in old bankruptcy court dockets), the FDIC has ended up with little or no claim.

SVB Financial Group's Manhattan Venue

As I have previously blogged, SVB Financial Group seems to be trying to do venue by declaration. Consider the grounds for venue under 28 USC 1408 and how they apply to SVBFG:  

• Location of principal place of business for majority of past 180 days.  All of SVBFG's regulatory filings in the last 180 days said its address—principal place of business—is in Santa Clara, CA.
• Location of principal assets for majority of past 180 day. The majority of its assets for the last 180 days—Silicon Valley Bank—were in Santa Clara.
• Location of domicile for majority of past 180 day.  SVBFG is incorporated in Delaware and always has been. 
• Location of pending affiliate's case's venue for majority of past 180 day. SVBFG does not have any affiliate cases pending, much less in SDNY.

SVBFG's claim to SDNY venue seems to be based on the location of its principal assets. Those principal assets are as of today the equity of two of its non-debtor subsidiaries. But for almost all of the past 180 days, the principal assets were the equity in the bank. Not only is SVBFG trying to ignore the 180 days rule (which exists precisely to prevent this sort of gaming), but its argument that its assets are located in NY is simply wrong.  

Both of the SVBFG subsidiaries are Delaware entities according to SVBFG's last annual report. The subsidiaries might have their principal offices in Manhattan, but that's irrelevant. The corporate stock is not located in Manhattan (I really hope they aren't suggesting that the DTC's holding of stock certificates does the trick--if so, everyone can file in Manhattan). When a parent owns a subsidiary's stock, the stock either has no location as an intangible or is located where the subsidiary is domiciled.  Nothing else makes sense.

To see why, consider the following: suppose a car is my principal asset. It's titled in Delaware, but currently illegally double-parked in Manhattan. In that case SDNY venue would be proper. There's direct ownership of a physical asset that has a location and that's enough for the venue statute. It's no different than owning a building in Manhattan. But now imagine that my principal asset is not the car, but stock in a Delaware corporation, and the corporation's sole asset is a car that's illegally double-parked in Manhattan. In this scenario, I do not directly own the asset that is in Manhattan. To impute it to me would render the venue statute meaningless.  Congress knows how to talk about indirect ownership when it wants. It didn't in the venue statute. The statute is about the principal assets of the debtor, not the debtor's non-debtor subsidiaries. Trying to bootstrap in this way is akin to LTL trying to bootstrap on non-debtor J&J's "distress." Bankruptcy law has clear boundaries—debtor vs. non-debtor—but if it's going to be ignored, then what are the "rules"? 

While I'm thumping on the venue issue, what of the "no harm, no foul" argument? I don't know what the harm is of SDNY venue at this point. This isn't an obvious issue like Boy Scouts going to Delaware to avoid 5th Circuit law on non-debtor releases. But I can say this with confidence: Sullivan & Cromwell clearly thought there was some benefit to their client in having SDNY venue, rather than Delaware or California venue. It's not that these other venues are somehow not equipped to handle a case like this (and notice how insulting that argument is to most of the 375 bankruptcy judges in the country...). Delaware and (Central District) of California have both done large bank holding company bankruptcies:  WaMu and IndyMac. Perhaps S&C simply doesn't want to take the Acela to Wilmington and stay at the Hotel Dupont, just as the California-based creditors don't want to fly out to LaGuardia. But it's also possible that there's some substantive legal issue S&C is concerned about that led it to file the case in SDNY. The very fact that the debtor ordered "off-menu" when there were two good, legitimate, alternative venue choices should set everyone's spidey sense tingling. I was pleased that the court has not put in "venue is proper" language in its orders so far; we'll have to see if there's an objection. That might turn on whether other parties can suss out a potential disadvantage to being in SDNY and want to risk the possibility that the judge takes umbrage with a venue motion, even if it's about governing law, rather than a question of getting a fair shake. 

The Death of Dodd-Frank: Banking Law's Dobbs Moment

Last year, I savored a bit of schadenfreude watching my con law scholar colleagues despair about their field after cases like Dobbs v. Women's Health Organization or West Virginia v. EPA. Con law scholars see themselves as the royalty of the legal academy, far above those folks who do blue collar law like bankruptcy and commercial law or grubby stuff like banking and money. And that's fine--we always laughed at them as slightly clueless toffs, not realizing (or wanting to admit) that their field is largely a battle of normative opinions, without any quasi-objective touchstone or clearly right or wrong answers. In contrast, we can point to things like express deadlines and numerical ratios that must be maintained and efficiency principles like "least cost avoider". That's what's made the Supreme Court's recent jurisprudence so delicious--it shows what every non-con law scholar has long known--that con law is as much politics as it is law. There was a certain joy in watching the con law field realize that the emperor had no clothes.  

But there's karma in the universe, and Silicon Valley Bank is sticking it right back the banking law scholars. I don't usually teach the core prudential regulation banking law class, but I really feel for colleagues who do. The response to Silicon Valley Bank is banking law's Dobbs moment. In 2010, in the wake of the 2008 crisis, Congress erected an enormous legal edifice to govern financial institutions--the Dodd-Frank Act. And we saw in the course of a weekend that it was all an expensive and wasteful Potemkin village. What good does it do to have a massive set of regulations...if they aren't enforced? To have deposit insurance limits...if they are disregarded? Dodd-Frank is still on the books, but its prudential provisions are as good as dead. Why should anyone follow its requirements now, given that they'll be disregarded as soon as they're inconvenient? And why should the public have any confidence that they are protected if the rules aren't followed? Indeed, did anyone even look at SVB's resolution plan or was it all a show? 

I really don't know how one can teach prudential banking regulation after SVB. How can you teach the students the formal rules—supervision, exposure and concentration limits, prompt corrective action, deposit insurance caps—when you know that the rules aren't followed? This is going to be a real challenge for folks who teach banking regulation. So, I invite our con law colleagues to snicker back at us. 

P.S. Anna Gelpern will say that I'm being naive--as she noted in a great 2009 article, the rules always get tossed out the window in financial crises and then there's a lot of finger wagging and new rules that are followed until the next crisis, when they aren't. And she's right. But the cycle of rules-crisis disregard-new rules had its own internal credibility:  this time I mean it! That internal credibility required there to be a certain time lag between crises, enough that a new king would arise over Egypt, who did not know Joseph, that is a new crew of regulators who could not be counted on to act the same way as in the past. When it's the same crew as from the last crisis, the internal credibility of "this time I mean it!" doesn't fly. 

SDNY: EFTA Applies to Crypto

I'm teaching cryptocurrency today in my Payment Systems class, and I'd been puzzling about why no one has applied the Electronic Fund Transfers Act and Reg E thereunder to crypto: after all, if you have a crypto account with an exchange, it would seem to be an "account" at a "financial institution" that is primarily for personal, family, or household purposes and is used for electronic transfers of "funds." In fact, I had just emailed Bob Lawless for a sanity check on this, when I came across a very recent SDNY decision that held that the EFTA applies to crypto. That's a huge consumer protection win. Reg E has important consumer protections regarding unauthorized transactions, error resolution, and provision of receipts and periodic statements. It also creates huge compliance headaches for crypto exchanges, which are not set up for dealing with any of those problems. All of the Zelle scam error resolution issues are now going to become crypto scam error resolution issues. And the ruling also indicates that consumer protection at cryptocurrency exchanges is now squarely within the existing regulatory authority of the Consumer Financial Protection Bureau. This could get interesting. 

The Regressive Cross-Subsidy of Uncapping Deposit Insurance

There's talk about removing the FDIC deposit insurance caps in response to the "Panic of 2023"®.  There's a refreshing realism about such a move. But let's also be clear about the distributional impact of such a move:  it's a huge cross-subsidy from average Joes to wealthy individuals and businesses.>

If FDIC insurance coverage caps are removed, banks will pay more in insurance premiums. They will pass those premiums through to customers because the market for banking services is less competitive than the market for capital. In particular, the higher costs for increased insurance premiums are likely to flow to the least price-sensitive and most “sticky” customers:  less wealthy individuals.  So average Joes are going to be facing things like higher account fees or lower APYs, without gaining any benefit. Instead, the benefit of removing the cap would flow entirely to wealthy individuals and businesses. This is one massive, regressive cross-subsidy. It's not determinative of whether raising the cap is the right policy move in the end, but this is something that should be considered.

The Financial Regulatory Credibility Problem

Financial regulation has a credibility problem. Actually, it's got two credibility problems.

It's not credible any more to think that financial regulators will shut down troubled institutions until they are forced to do so. And it's no longer credible that financial regulators will allow depositors to incur losses. Both are really problematic.

Oops. How the FDIC Guaranteed the Deposits of SVB Financial Group

When President Biden announced the rescue of Silicon Valley Bank depositors, he emphasized that "investors in the banks will not be protected.  They knowingly took a risk and when the risk didn’t pay off, investors lose their money.  That’s how capitalism works." Unfortunately, that's not how US law works. 

There seems to be a gap in the Federal Deposit Insurance Act that is going to protect some investors in Silicon Valley Bank’s holding company, SVB Financial Group. The holdco’s equity in the bank will be wiped out in the FDIC receivership, but the FDIC doesn’t have any automatic claim on the holdco. This is basic structural priority/limited liability:  creditors of a subsidiary have no claim on the assets of a parent.

What's worse is that the holdco, which filed for bankruptcy today, has substantial assets including around $2 billion on deposit with SVB. Almost all of that $2 billion deposit at SVB would have been uninsured, but by guarantying all the deposits, FDIC accidentally ensured that the holdco’s bondholders would be able to recover that from that full $2 billion deposit.

There isn't any provision in the Federal Deposit Insurance Act that subordinates the claims of insiders—like corporate affiliates or executives—that exceed the insured deposit limit to other creditors. So once FDIC guaranteed all deposits, it necessarily guaranteed the deposits of the holdco and other insiders. 

Who Knew Silicon Valley Was in Manhattan?

Silicon Valley Bank's holding company, SVB Financial Group, filed for Chapter 11 bankruptcy this morning...in the Southern District of New York. Who knew that Park Avenue South was in the heart of Silicon Valley?

Seriously, the venue here looks problematic. SVB Financial Group's petition lists its principal place of business as 387 Park Avenue South, Manhattan. There's a SVB location there with about 20,000 square foot of space. That's sure doesn't seem like a corporate headquarters for the 16th largest bank holding company in the US. Instead, it seems to be more of a bank branch. But the petition does bear the signatures, under penalty of perjury, of SVB Financial Group's CRO and, not so clearly under penalty of perjury, of SVB Financial Group's attorney at Sullivan & Cromwell. 

Curiously, SVB Financial Group has been telling federal bank regulators a different story about where it's located. On its Bank Holding Company Report, Systemic Risk Report, Consolidated Financial Statement, and Parent Company Only Financial Statement for Large Bank Holding Companies—documents filed with the Federal Reserve Board—SVB Financial Group said its address is 3003 Tasman Drive, Santa Clara, California. Hmmm.

What's Going on with First Republic Bank?

Following the failure of Silicon Valley Bank, a lot of other regionals have experienced depositor runs and serious pressure on their stock prices. But there's actually a lot of variation among regionals, and the solutions to SVB's problems don't necessarily fit the other regionals' problems, as the case of First Republic Bank shows.

Why Weren't Silicon Valley Bank Depositors Using CDARS?

Silicon Valley Bank seems to have had large amounts of uninsured deposits from businesses and high net worth individuals. And those uninsured deposits are likely to be impaired in the receivership, meaning that they will not get paid 100 cents on the dollar whenever they do get paid.

But here's the thing:  there are turnkey products that enable depositors to insure much, much larger amounts than the FDIC-insurance cap of $250k/depositor/account type. For years and years there's been deposit brokerage services that spread out deposits at multiple banks, all in amounts under the FDIC insured cap. The best known service is called CDARS-Certificat of Deposit Account Registry Service. It's offered by IntraFi (formerly Promontory). I don't know if SVB participated in CDARS, but it's a pretty straightforward solution to the deposit insurance cap.

What Could Go Wrong When a DIP Maintains a Large, Uninsured Deposit Account at Silicon Valley Bank?

You gotta feel for BlockFi customers. First, they find themselves creditors in BlockFi's bankruptcy. And now they've found out that BlockFi had a large, uninsured deposit...at Silicon Valley Bank. Yup, it seems that BlockFi had $227 million in a money market deposit account at SVB. (The UST refers to it as a "money market mutual fund," but that cannot be right, or it wouldn't be at SVB or have any insurance. [See "Another update" below regarding possibility that it was a money market mutual fund sweep account, in which case the money would in fact be protected.]) That would mean there's a $226.75 million uninsured deposit. Given what we know about SVB, part of that $226.75 million in uninsured funds is likely lost if it's still at SVB.  

The US Trustee filed a motion today to force BlockFi to put the funds in insured accounts, but it sure looks as if the cow's out of the barn already. If the money's lost, then the question is who's going to pay for this screw up, and it's especially juicy because it's all tied up with venue competition.