Before the Silicon Valley Bank collapse, the Fed spotted big trouble

WASHINGTON — Silicon Valley Bank’s risky practices have been on the Federal Reserve’s radar for more than a year — an awareness that has proven insufficient to stop the bank’s demise.

The Fed repeatedly warned the bank that it was in trouble, according to a person familiar with the matter.

In 2021, a Fed review of the growing bank found serious weaknesses in how it handled key risks. Supervisors at the Federal Reserve Bank of San Francisco, which oversaw Silicon Valley Bank, issued six citations. These warnings, known as “matters needing attention” and “matters needing immediate attention”, indicated that the company was doing a poor job of ensuring that it had enough easy-to-use cash in hand. problem case.

But the bank did not fix its vulnerabilities. In July 2022, Silicon Valley Bank was undergoing a full supervisory review – gaining closer scrutiny – and was ultimately found to be deficient in governance and controls. It was subject to a set of restrictions that prevented it from growing through acquisitions. Last fall, San Francisco Fed staffers met with senior company executives to discuss their ability to access sufficient liquidity in a crisis and their potential exposure to losses as interest rates were rising.

It became clear to the Fed that the company was using the wrong models to determine how its business would fare as the central bank raised rates: its executives assumed that higher interest income would significantly improve their financial position as the rates were rising, but that was out of the question. out of step with reality.

In early 2023, Silicon Valley Bank was in what the Fed calls a “horizontal review,” an assessment intended to gauge the strength of risk management. This check identified additional shortcomings – but by then the bank’s days were numbered. In early March, he faced a run and failed within days.

Major questions have been raised about why regulators failed to spot the problems and take action early enough to prevent Silicon Valley Bank’s March 10 collapse. Looking back, many of the problems that contributed to its collapse seem obvious: In terms of value, about 97% of its deposits were not federally insured, making customers more likely to flee at the first sign. of difficulty. Many of the bank’s depositors were from the technology sector, which has recently fallen on hard times as rising interest rates weighed on business.

And Silicon Valley Bank also held a lot of long-term debt that had fallen in market value as the Fed raised interest rates to fight inflation. As a result, she suffered huge losses when she had to sell these securities to raise funds to meet a wave of customer withdrawals.

The Fed has opened an investigation into what went wrong with the bank’s oversight, led by Michael S. Barr, the Fed’s vice chairman for oversight. The results of the investigation are expected to be made public by May 1. Lawmakers are also investigating what went wrong. The House Financial Services Committee has scheduled a hearing on the recent bank meltdowns for March 29.

The picture emerging is of a bank whose leaders failed to plan for a realistic future and overlooked impending financial and operational issues, even as they were raised by Fed supervisors. For example, according to a person familiar with the matter, company executives were told about cybersecurity issues by both internal employees and the Fed — but ignored the concerns.

The Federal Deposit Insurance Corporation, which took control of the company, did not comment on its behalf.

Still, the extent of the bank’s known problems raises questions about whether Fed bank examiners or the Fed’s Board of Governors in Washington could have done more to force the institution to address its weaknesses. Whatever intervention was staged was too little to save the bank, but why remains to be seen.

“It’s a supervisory failure,” said Peter Conti-Brown, a financial regulatory expert and Fed historian at the University of Pennsylvania. “The thing we don’t know is if it was a failure of the supervisors.”

Mr. Barr’s review of the Silicon Valley Bank collapse will focus on a few key questions, including why the problems identified by the Fed did not stop after the central bank issued its first set of questions requiring a particular attention. The existence of these initial warnings was reported earlier by Bloomberg. It will also look at whether supervisors believed they had the authority to escalate the issue and whether they reported issues at the Federal Reserve Board level.

The Fed report is expected to disclose information about Silicon Valley Bank that is generally kept private as part of the confidential banking oversight process. It will also include all recommendations for regulatory and monitoring fixes.

The bank’s downfall and the chain reaction it triggered should also translate into broader pressure for tighter banking supervision. Mr. Barr was already conducting a “holistic review” of Fed regulations, and the fact that a bank that was big but not huge could create so many problems in the financial system is likely to inform the results.

Typically, banks with less than $250 billion in assets are excluded from the most onerous parts of banking supervision — and this has been even truer since a “tailor-made” law passed in 2018 under the Trump administration and put in place by the Fed. in 2019. These changes left smaller banks with less stringent rules.

Silicon Valley Bank was still below that threshold, and its collapse underscored that even banks that aren’t big enough to be considered globally systemic can cause considerable problems for the US banking system.

As a result, Fed officials could consider tougher rules for these big, but not huge, banks. Among them: Officials could ask whether banks with $100 billion to $250 billion in assets should hold more capital when the market price of their bonds falls — an “unrealized loss.” Such an adjustment would most likely require a transition period, as it would be a substantial change.

But as the Fed scrambles to complete its review of what went wrong at Silicon Valley Bank and come up with next steps, it faces intense political backlash for failing to stop the problems.

Some of the concerns relate to the fact that the bank’s chief executive, Greg Becker, served on the board of directors of the Federal Reserve Bank of San Francisco until March 10. Although board members play no role in banking supervision, the optics of the situation are bad.

“One of the most absurd things about the Silicon Valley bank’s failure is that its CEO was a director of the same body responsible for regulating it,” said Sen. Bernie Sanders, an independent from Vermont. wrote on Twitter on Saturday, announcing that he would “introduce legislation to end this conflict of interest by banning the CEOs of big banks from serving on Fed boards.”

Other worries center on whether Fed Chairman Jerome H. Powell allowed too much deregulation under the Trump administration. Randal K. Quarles, who served as the Fed’s vice chairman for oversight from 2017 to 2021, implemented a 2018 regulatory rollback act in an expansive manner that some onlookers at the time believed would weaken the banking system.

Powell generally defers to the Fed’s vice chairman for regulatory matters, and he did not vote against these changes. Lael Brainard, then Fed governor and now a top White House economic adviser, voted against some of the adjustments — and flagged them as potentially dangerous in dissenting statements.

“The crisis has clearly demonstrated that the distress of large banking organizations, even non-complex ones, usually manifests first as liquidity stress and quickly transmits contagion through the financial system,” she warned.

Senator Elizabeth Warren, Democrat of Massachusetts, requested an independent review of what happened at Silicon Valley Bank and urged Mr. Powell not to get involved in this effort. He “bears direct responsibility for — and has a long record of failure involving” banking regulation, she wrote in a letter on Sunday.

Maureen Farrel contributed report.