(Bloomberg) — All through the period when trouble was brewing at Silicon Valley Bank, the Federal Reserve was taking steps that effectively discouraged examiners from doing much about it.
That's the picture of the Fed's supervisory culture, and the way it evolved in recent years, that emerges from interviews with more than half-a-dozen people familiar with the central bank's oversight of lenders. Following the deregulatory winds blowing from the White House and Congress, U.S. bank watchdogs set out to clarify and revise rules that could lead to more consolidation of finance. The unwritten rules were changing, too. There was a shift in how some institutions were supervised on the ground, particularly mid-size and small banks that officials didn't see as obviously posing system-wide risks.
Yet regulators did end up having to treat SVB's failure as a systemic event. Now the Fed has to explain why it didn't take preventive action. That starts with publication of a report by Vice Chair for Supervision Michael Barr on Friday. Barr testified last month that Fed supervisors knew about risks at SVB, and had the tools to address them. Michael Barr Examiners at the San Francisco Fed were mostly responsible for the day-to-day oversight of SVB before 2021.
But any credible examination of what went wrong must also scrutinize the directions coming from the highest levels of the central bank in Washington, according to the people interviewed for this story.
Attitude, Not Rules
They describe a change that got under way around 2017 and gained traction the following year, when Congress passed legislation to lighten the regulation of mid-sized banks. At roughly the same time, Fed chiefs in Washington were tailoring their supervision of all but the largest lenders.
"The question is not what rules were changed, but what the attitude toward supervision was at the Board of Governors," said former Kansas City Fed President Thomas Hoenig, who also served as vice chairman of the Federal Deposit Insurance Corp. from 2012 until 2018.
A spokesman for the Federal Reserve Board declined to comment.
Examiners at the regional Fed banks found they were being asked more questions about why they were devoting so much time to lenders that were deemed too small to be systemically risky, according to several of the people. They say the bar was raised for escalating concerns via formal supervisory actions. Attempts by regional staff to flag novel kinds of risk, from crypto to new financial technologies, didn't result in supervisory direction from the Washington board.
Underlying the shift in views among government officials and Fed leaders was a mix of motives. There was concern that the cost of regulation and compliance fell heaviest on smaller lenders — adding to a wave of consolidation that could leave a handful of mega-banks even more dominant. That's a powerful argument in the US, where there's a long history of support for local provision of credit, and community banks have plenty of clout in Congress. And there was a belief that whatever missteps occurred at mid-size regional banks, there wouldn't be much impact on the overall financial system.
'Question and Challenge'
In fact, the regulatory changes of 2018 – which raised the threshold at which banks would be subject to more stringent oversight — opened the door for SVB to expand rapidly and become more systemically important as it did so. SVB's assets jumped from slightly over $50 billion in 2017 to $211 billion by 2021. Such rapid growth might have been another red flag for supervisors. When SVB collapsed the Fed had to launch a lending facility to support all banks, and regulators took the unusual step of extending deposit insurance beyond the standard $250,000 limit, to prevent contagion.
"It's very hard to tell a story of how a bank directly supervised by the Fed failing in a messy way, and requiring a systemic risk exception, isn't the result of a supervisory failure," said Kathryn Judge, a professor at Columbia Law School. "The role of supervisors is to question and challenge business plans, to really probe what could go wrong."
To the frustration of rank-and-file examiners, that wasn't always the role they were encouraged to play, the people said.
Successful financial regulation has an inherent tension. It needs to be efficient and transparent — banks should be subject to well-understood criteria — but the financial system runs ahead of the rules, so examiners also need to be a bit paranoid and have the discretion to probe risks wherever they appear. It's not just the on-paper rulebook that determines how the balance is struck.
The steer that hands-on bank examiners get from their superiors is crucial, according to Daniel Tarullo, a Fed governor for eight years through 2017 who led the central bank's retooling of supervision after the financial crisis.
"Changes in supervisory policy as they are implemented on the ground at the banks are very opaque. It's not like changing a regulation," Tarullo said. "When supervisors are told 'you have to show that it's a legal violation or an immediate safety and soundness issue,' those messages are very important — but they're not visible."
Interviewees with hands-on experience of supervision describe persistent friction with the Fed Board, as it gradually shifted its approach toward too-small-to-threaten banks.
Among the issues they highlight: Intensive monitoring by the Fed Board of supervisory hours spent on banks and business lines, even when on-the-ground staff argued that following the Board's recommendations on time allocation would mean leaving some risks unattended.
Revision of a tool used to set expectations for banks, known as supervisory guidance, which now specifies that the Fed will not issue an enforcement action even if banks don't comply with supervisors' intentions.
A raising of the bar for powerful supervisory tools such as Matters Requiring Attention, typically used to note serious flaws in a bank's structure or management. A lack of direction about how to respond to the growing role that crypto and financial technology were playing at banks — and the new risks they were creating. An emphasis on "efficiency" that at times overrode supervisory discretion.
Some regional leaders pushed back. One former senior Fed official said they got on the phone and made the case to the Board in Washington that resources needed to be focused on some small institutions because of unusual risks.
'Core Requirements'
Ultimately, it was interest-rate risk on a giant portfolio of government-backed bonds — along with a high proportion of uninsured deposits, and a concentration of customers in a single industry — that proved fatal to SVB. Barr is expected to address in his report why action wasn't taken — and what the neglect says about the culture of bank supervision under his predecessor as vice chair for supervision, Randal Quarles, who left the post in October 2021.
In a detailed response to Bloomberg News, Quarles said there was never a "policy initiative" to scrutinize supervisory hours, nor did staff discuss that with him. He said it is "not true" that guidance was weakened.
"The guidance on guidance is expressly not intended to relax or weaken or to circumscribe" the supervisory tool, Quarles said. The intent was to "clarify what actions the law requires to be accomplished through regulatory channels, and which ones can be accomplished through supervisory channels," he said, noting that Lael Brainard, a former Board member who dissented from many of the Board's measures during his tenure, voted for the rule change in
Quarles acknowledges that there were diverse policy views about the risks and benefits of crypto and fintech that may have heightened supervisory uncertainty about how to respond. And he agrees that consistency and transparency in oversight were themes he emphasized as vice chair for supervision. Those are "core requirements for government action to be constitutional," and they're "consistent with strong and effective bank supervision," he said. Quarles said he traveled to all 12 reserve banks and spoke to staff, telling them his intention wasn't to lighten supervision. "We needed to be more transparent," he said. "This was never about weakening the system."
'Much Lighter'
Brainard, who left the central bank this year to lead President Joe Biden's National Economic Council, is now speaking out on the prior regime.
"Not only were the rules weakened, but there was a change in supervision to much lighter supervision, with messaging that fewer issues should be escalated, that examiners should not be as intrusive for this size-class of banks," Brainard said at an April 12 event in Washington, in one of her first comments on the topic. "In retrospect, we know that was a mistake."
Deregulation gained momentum after the election of Donald Trump, with growing complaints that the 2010 Dodd-Frank Act — a tightening of rules in response to the crisis two years earlier — was especially burdensome for smaller lenders. The argument was that over-regulation was deterring the creation of new banks, and extending a wave of consolidation among community lenders.
"We were losing about a bank a day because of the high costs of Dodd-Frank," said Kevin Hassett, who was chair of the Council of Economic Advisers from 2017 to 2019 and helped out on some of Trump's Fed appointments. "All banking regulators were taking that loss seriously."
Between 2017 and 2020, the total number of commercial banks in the US declined by more than 500, according to FDIC data.
In Congress, lawmakers began negotiating a measure that would retool the Dodd Frank Act, one that eventually passed — with bipartisan support — in May 2018. Among many provisions, it instructed the Fed to increase the threshold at which certain prudential banking standards would kick in.
The Fed followed Congress with its own rule in 2019, which also eased requirements for mid-sized lenders like SVB to undergo the annual stress tests that regulators use to determine a bank's soundness. Quarles and the supervisory staff supported it. Powell said it struck "an appropriate middle ground." Brainard — in an unusual break with consensus — dissented, saying it went beyond what Congress wanted.
Tarullo, who supported an increase in the asset-size threshold — but a smaller one than Congress enacted — said the legislation was built on a "false premise" that banks of that magnitude aren't systemically important. "They are."
More importantly, he said, the shift was "a bellwether of the instinct in 2018 in both Congress and the agencies to sort of back off some. And that's I think where the problem really lay."
