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.

Comments

[SivaDancer]

As a former FDIC bank examiner who is also a former practicing attorney and a former bank compliance officer, I mostly agree.

The only caveat I have is that accountability for the situation should not be shunted onto the shoulders of rank and file examiners. Many, perhaps most of them, find lots of emerging issues at their banks and report them upward to field offices and regional offices.

However, emerging issues die at those offices primarily because 1) emerging issues usually appear to be small at first, and 2) the next level up is inadequately educated about the law. While training programs at the banking agencies certainly exist, they are focused on finding things which were identified in the past as issues, and not on a general understanding of risk from a legal or financial standpoint.

As a result, even if a bright field examiner spots a new type of issue, they are usually unable to persuade the next level up about the issue, for similar reasons: 1) field examiners are trained in the same inadequate way and often lack the education needed to clearly articulate, in writing, the potential for larger risks; and 2) the new issues are usually small when first identified, and thus easy to ignore at the field office level.

By the time the (more highly educated) regional and DC offices become aware of emerging risks, they are no longer small, and therefore much more difficult to manage - because they usually are quite profitable to the banks.

So, yes - federal bank regulators are certainly failing in their jobs. But responsibility for that falls squarely on the upper echelons, not on the field.

[Mike]

The problem with rate hikes, since they came after a lengthened ZIRP, is that many banks are now sitting on large unrealized losses on their portfolio, which would become realized if they start managing risk for the Fed hikes (who will take the other side of a swap now?) The long ZIRP forced everyone to take the low rate bonds, and now the rate hikes are forcing them to eat the losses. Forcing the banks to acknowledge the losses will spur bank runs on all small and mid-tier banks, so FDIC is forced to guarantee, to keep everyone calm.

It was a capital raise by SVB, to manage the portfolio loss and deposit drawdowns caused by the rate hikes, that caused the panic.