Blog: Mutually Reinforcing Changes to Law, Regulation and Supervision Produced Crisis

Current Crisis Stems from Mutually Reinforcing Changes to Law, Regulation and Supervision
Conscious Choices on Policy Coupled with Light-Touch Approach at Powell Fed

We are already seeing distractions thrown up by the bank lobby and their allies in Congress to deflect from the lessons of Silicon Valley Bank. Claims of “wokeness” and diversity initiatives distracting bank executives from the bread and butter of banking are simply ludicrous. But arguments drawing technical differences between supervision and regulation, or dwelling on a particular number, all serve to distract us from a core problem of public policy.

At the behest of a bank lobby that pumps billions into the political system, Congress in 2018 relaxed laws on mid-sized banks like Silicon Valley Bank, at a time when regulators appointed by former President Trump were already eager to go easier on banks. The signal could not have been clearer, and AFR warned so at the time.

“The Trump administration is already pushing hard to deregulate,” AFR wrote in early 2018. “This legislation actively assists their efforts by removing requirements for strong regulation of some of the nation’s largest banks.”

The regulators, above all former Federal Reserve Vice Chair Randal Quarles, with cover from Chair Jerome Powell, took what Congress passed (S.2155) and ran with it, easing rules beyond what lawmakers directed. These changes drove an overall cultural and practical shift in which banks expected, and got, more lax treatment from their supervisors.

Regulation, Supervision, and Culture

Reports are already surfacing about shortcomings in Fed supervision of Silicon Valley Bank, and at the San Francisco Fed in particular, and incompetent management. More transparency into what went on in both cases is welcome, especially since the Fed tends to sweep embarrassing matters under the rug. But conscious choices about policy in Congress and at the Fed played a role in the bank’s downfall – something lobby groups are trying to downplay. It was a mutually reinforcing dynamic in which law, regulation, supervision, and culture all mattered.

Quarles, a multimillionaire hailing from the world of banking and finance, more or less bragged at the time his focus was on moving bank supervision away from the more stringent approach fostered by Congress and regulators after the 2008 financial crisis. He actively sought a lighter touch. “Particularly in the early stages and perhaps throughout my entire term, engaging on changing the tenor of supervision will probably actually be the biggest part of what it is that I do,” he said in 2017.

Quarles was eager to loosen bank supervision, and Congress directed him to go in that direction with a rollback of key provisions of the Dodd-Frank Act by passing S.2155, which had “regulatory relief” in its title, no less. The bill increased the threshold for enhanced supervision – a mixture of rules around liquidity, stress testing and capitalization – from $50 to $250 billion, on the theory that these banks, who were not Wall Street megabanks, could not cause a crisis.

In short, lawmakers bought into a line from Bob Jones, chairman of the Mid-Sized Bank Coalition, a lobby group that included Silicon Valley Bank, who said in 2017: “mid-size banks do not present even a marginal systemic risk” [emphasis added]. Regulators confirmed the folly of that argument when they invoked the “systemic risk exception” to deal with SVB and Signature Bank.

Fed Took Things Further

The Fed under Quarles, with the support of Powell, took things further than the legislation required. It had leeway to be tougher on banks in the $100-$250 billion range, but instead “tailored” requirements for those banks based on their assessed risk profile.

“Tailoring,” as we and other financial reform advocates pointed out at the time, became an excuse for looser rules, “fundamentally deregulatory,” in the words of one expert. And sure enough, this tailoring – not required by S. 2155, but advocated by many who supported the bill – snipped away a key requirement on liquidity that Silicon Valley Bank would otherwise have faced.

At the same time,  the Fed weakened supervision via regulation, a vital point to understand when lobby groups try to confine questions to what bank examiners did. First the Fed weakened the role of “guidance” in supervision. Then, at the behest of the bank lobby, the Fed codified a watered-down supervisory framework that clipped the wings of supervisors. AFR warned at the time that supervisor discretion is key to enforcing law and regulation.

When S. 2155 passed, SVB was between $50-100 billion in assets, and was thus immediately exempted from enhanced prudential standards, thanks to S.2155. Then, as SVB grew rapidly to $200 billion, fueled by the easy money its start-up depositors received from its venture capitalist firm, it faced a suite of lighter capital and liquidity requirements as a result of “tailoring.” And supervision was weaker.

From 2019 to the end of 2020, SVB’s assets – meaning loans, credit facilities, securities, and other investments – grew 63 percent. From 2020 to the end of 2021, total bank assets grew over 83 percent. All in the wake of the 2018 law.

The sheer growth of this bank should have given bank supervisors pause, according to former Fed governor Dan Tarullo. But they escaped the tougher standards, including more frequent stress tests and liquidity requirements, because of S.2155 and the Fed’s implementation of it. As late as June 2021, while Quarles was still at the Fed, it approved an acquisition by Silicon Valley Bank on the grounds that the combination did not create any systemic risks.

Regulators Can Act Now

Congress should absolutely repeal S.2155. Sen. Elizabeth Warren and Rep. Katie Porter, with more than 40 co-sponsors are on the case. But the Federal Reserve does not need to wait for legislative change; it can reverse mistaken regulatory choices and make supervision much more robust without any changes in the law. More broadly, regulators can finally complete unfinished rules like the Dodd-Frank provision prohibiting compensation at big banks that rewards excessive risk-taking (Section 956). The Financial Stability Oversight Council and all its tools need to be reinvigorated. The list is long.

But this crisis demonstrates the need to go beyond simply reversing damage, and catching up with what should have been done. We need existing accountability mechanisms aggressively enforced, and better tools to prevent failures like these from happening altogether. Otherwise, we will face a perpetual cycle of privatizing gains and socializing losses. Even more than that, we need to build a regulatory system that recognizes the breadth and depth of public support bank oversight.

Deregulation had everything to do with this crisis, and pretending otherwise is a recipe for favoring bank executive titans ahead of everyone else. Again.