Federal Reserve’s report on the Silicon Valley Bank failure calls for a more assertive supervision program and potential reversal of regulatory tailoring – key takeaways

The Board of Governors of the Federal Reserve System (Federal Reserve) has issued its report on the factors that contributed to the failure of Silicon Valley Bank (SVB).

The report, issued on April 28, focuses on the roles of both SVB management and the Federal Reserve, which was the primary federal supervisor for the bank and the bank holding company, in the failure of SVB.

While the report is highly critical of SVB management, it pulls no punches with respect to Federal Reserve supervision and suggests more assertive bank supervision and further reversal of supervisory or regulatory “tailoring” going forward.

The report

The report identified four “key takeaways” from review of the events leading up to SVB’s collapse.

First, the report concluded that that failure of SVB “can be tied directly to the failure of the board of directors and senior management.” The report found that the SVB board and management failed to effectively oversee the risks inherent in the bank’s business model and failed to take sufficient steps to build a governance and risk-management framework that kept up with the bank’s rapid growth and business model.

More specifically, when rising interest rates threatened profits and reduced the value of its securities, SVB “management took steps to maintain short-term profits rather than effectively manage the underlying balance sheet risks.”

Second, while bank examiners identified some of the material issues in SVB’s management, they also underappreciated important ones, particularly as SVB grew in size and complexity. For example, the report found that examiners concluded SVB’s management of interest rate risk (IRR) was satisfactory despite the firm repeatedly breaching its internal risk limits for long-term risk exposure over several years. IRR was also not viewed as a material risk until late 2022 and therefore not subject to a thorough examination.

As SVB grew in size, in 2021, supervisory responsibility for SVB within the Federal Reserve was transitioned from the Regional Banking Organization (RBO) portfolio to the Large and Foreign Banking Organization (LFBO) portfolio, where it would be subject to heighted supervisory standards. However, the report concluded that supervisors failed to conduct a more thorough evaluation of SVB’s liquidity prior to joining the LFBO portfolio; once it was within the LFBO portfolio, supervisors were slow to make more rigorous assessments of SVB’s liquidity and other material weaknesses.

Third, the report concluded that, despite widespread evidence of foundational governance and risk-management issues, supervisors were slow to downgrade supervisory ratings or to ensure that SVB’s board and senior management took sufficient and immediate steps to compensate for those widespread weaknesses. For example, during the second half of 2022 and into 2023, as SVB’s liquidity steadily weakened and unrealized losses accumulated on its securities portfolios, supervisors delayed escalating supervisory concerns into an informal enforcement action, known as a memorandum of understanding (MOU).

Fourth, the report was highly critical of the Federal Reserve’s past regulatory “tailoring” efforts.

Specifically, the report cited the 2018 passage of the Economic Growth, Regulatory Relief, and Consumer Protection Act (EGRRCPA), which amended the Dodd-Frank Act by raising the $50 billion minimum asset threshold for application of enhanced prudential standards (EPS) to bank holding companies, with some exceptions, with $250 billion or more in total assets. In 2019, following the passage of EGRRCPA, the Federal Reserve revised its regulatory framework for supervision, maintaining the EPS applicable to the eight global systemically important banks (known as G-SIBs) but tailoring requirements for other large banks. At the same time, Federal Reserve policymakers placed a “greater emphasis on reducing burden on firms, increasing the burden of proof on supervisors, and ensuring that supervisory actions provided firms with appropriate due process.”

As a result, during the period when SVB was experiencing tremendous growth, these policy changes resulted in lower supervisory and regulatory requirements, including lower capital and liquidity requirements. In particular, the report highlights that but for the legislative changes following passage of EGRRCPA, implementation of the Federal Reserve’s tailoring rule, and related rulemakings, SVB would have been subject to:

• additional liquidity risk management, internal liquidity stress tests, and standardized liquidity requirements
• the Federal Reserve’s advanced approaches capital framework – such additional capital standards include recognizing unrealized gains and losses on available for sale (AFS) securities in capital, using advanced approaches methodologies to calculate risk-based capital requirements, and a supplementary leverage ratio requirement, and
• additional stress testing requirements including (1) annual and semiannual company-run stress test requirements and (2) annual supervisory stress test, capital planning, and stress capital buffer requirements effective in 2020.

The report thus concludes that the passage of EGRRCPA, the 2019 tailoring rule, and related rulemakings “combined to create a weaker regulatory framework for a firm like” SVB.

Takeaways: Expect more challenges from the regulators

The Federal Reserve’s post-mortem on SVB’s collapse concludes that the failure was the result of “a complex interaction of many factors, some of which were idiosyncratic to the management and business model” of SVB, while other factors relate to effectiveness of the Federal Reserve’s oversight program. With respect to the Federal Reserve’s oversight program, the report identifies a number of “issues for consideration” in improving its supervisory program, including (1) enhance risk identification; (2) promote resilience; (3) change supervisor behavior; and (4) strengthen processes.

The report calls on supervisors to develop a more robust understanding of the risks banks face and how those might be evolving with the economic, financial, and technological environment. The report also calls on supervisors to focus less on “consensus-building and a perceived need to form ironclad assessments about what had already gone wrong,” and instead focus more “on inherent risk, and more willingness to form judgments that challenge bankers with a precautionary perspective.” Further, the report calls on the Federal Reserve to simplify its “complex oversight” processes to improve efficiency and provide greater clarity on portfolio expectations.

The report therefore calls for bank examiners to be more assertive and increasingly challenge management and boards to address risks and supervisory findings more quickly. This could result in supervisory criticisms being escalated to non-public and/or public enforcement actions, such as consent orders, more quickly than in the recent past.

Similarly, banks should expect less time to address concerns raised in examination as “matters requiring attention” or MRAs before they are elevated to an enforcement action.

And, while regulatory changes may also be on the horizon, bank examiners will be expected to heed the report’s call to “challenge bankers.”

If you would like to discuss or have any questions regarding the topics discussed in this alert or related matters, please contact any of the authors or your relationship attorneys.