Banking Disruption: Banking Regulators Signal Updates To Supervisory And Regulatory Agendas In Wake Of Bank Failures - Financial Services

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.

i. FRB Report Identifies Supervisory Shortcomings

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:

Introduce more continuity between portfolios, so that as a bank grows in size and changes its supervisory portfolio, the bank will be ready to comply with heightened regulatory and supervisory standards more quickly, rather than slowly transitioning to compliance with heightened standards.
Be "attentive to the particular risks that firms with rapid growth, concentrated business models, or other special factors might pose, regardless of size."
Require additional capital or liquidity above regulatory minimum requirements for a firm with inadequate capital planning, liquidity risk management, or governance and controls. These measures may include limits on capital distributions or incentive compensation.
Develop a culture that empowers supervisors to act in the face of uncertainty.
Guard against complacency and encourage supervisors to "evaluate risks with rigor and consider a range of potential shocks and vulnerabilities, so that they think through the implications of tail events with severe consequences."

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:

Revisit the tailoring framework, including a re-evaluation of the range of rules that apply to banks with $100 billion or more in total assets.
Revisit how the Federal Reserve supervises and regulates interest rate risk management.
Revisit how the Federal Reserve supervises and regulates liquidity risk, starting with a re-evaluation of the risks of uninsured deposits, including assumptions about the stability of the uninsured deposits, as well as the treatment of held to maturity securities in the Liquidity Coverage Ratio (LCR) rule, Net Stable Funding Ratio (NSFR) rule, and internal liquidity stress tests.⁸
Evaluate the capital rules, including requiring more firms to take into account unrealized losses and gains or losses on available-for-sale securities.
Re-evaluate the coverage and timing of stress testing requirements.
Consider tougher oversight and minimum standards related to incentive compensation.

ii. FDIC Report

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.

iii. GAO Report

The GAO Report examines:

Bank-specific factors that contributed to the bank failures;
Supervisory actions regulators took leading up to these failures;
The basis for the systemic risk determinations made by Treasury;⁹ and
Factors that the FRB and Treasury considered to establish the Bank Term Funding Program, the Federal Reserve's emergency lending facility under section 13(3) of the Federal Reserve Act.

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."

iv. NYDFS Report

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."

v. CDFPI Report

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.

Key Takeaways

Initiatives already underway include a holistic review of capital requirements, a proposal to implement the Basel III endgame rule, the use of multiple scenarios in stress-testing, and an LTD proposal for large banks. An open question is whether new requirements will be "tailored."
The federal banking agencies are reviewing changes adopted in the 2019 tailoring rule (in particular, changes adopted for firms with $100 billion or more in total assets, but less than $250 billion in total assets). Regulators are expected to revisit the frequency of stress testing, whether "full" LCR and NSFR requirements should be required for banking organizations with $100 billion or more in total assets, whether additional risk-based measures should be included in the EPS rules (i.e., establishing a threshold based on the percentage of uninsured deposits), whether to adjust the frequency of the internal liquidity stress-testing requirement for banking organizations with $100 billion or more in total assets, and whether to shorten transition periods for firms that move into different bank portfolios (i.e., moving from the FRB's Regional Banking Organization portfolio to the Large and Foreign Banking Organization portfolio) or into a new category (i.e., moving from no category into Category IV).¹⁰
A change in the LCR rule's outflow assumption related to uninsured deposits is likely given the reports' discussions about uninsured deposits proving less "stable" than assumed. The agencies may also revisit changes to the definition and outflow assumptions for "operational deposits" and the treatment of securities in a bank's held to maturity portfolio as eligible high-quality liquid assets. As noted above, the agencies may revisit the appropriateness of requiring less than "full" LCR and NSFR requirements for banking organizations with $100 billion or more in total assets.¹¹
As Vice Chair Barr acknowledged, regulatory amendments would likely take years to become effective because of the rulemaking process and likely transition periods. However, certain changes may be effected through "new" legal interpretations. For example, current regulations on internal liquidity stress-testing and contingency funding plans leave room for interpretation. As such, expectations for satisfying the internal liquidity stress-testing and contingency funding planning requirements could meaningfully change without a change to regulation.
Unlike regulatory changes, changes to supervisory practices can be ramped up much more quickly. Banking organizations should be prepared for supervisors that are more willing to scrutinize practices, even if the supervisory team has doubts. In addition, supervisors will be empowered (and perhaps encouraged) to escalate issues if bank management fails to adequately remediate identified issues.
Bank management will be expected to identify and remediate risk management and governance issues. To encourage this action, the banking agencies may seek to require increased capital and/or liquidity if a banking organization is determined to have inadequate capital planning, liquidity risk management, or governance and controls. There may also be proposed rules limiting capital distributions or incentive compensation for banking organizations found to have deficient practices.¹²
Regardless of any legislative or regulatory changes, banks of all sizes can expect enhanced supervision of capital, liquidity, and interest rate risk management practices; general risk management governance and controls; and incentive compensation.

Footnotes

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).

Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.