Before the collapse of Silicon Valley Bank, the Fed saw big problems

WASHINGTON — Silicon Valley Bank’s high-risk practices were on the Federal Reserve’s radar for more than a year — an awareness that proved insufficient to halt 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 flaws in how it handled key risks. Regulators at the Federal Reserve Bank of San Francisco, which oversaw Silicon Valley Bank, issued six citations. Those alerts, known as “matters requiring attention” and “matters requiring immediate attention,” indicated that the company was doing a poor job of ensuring it had enough readily available cash on hand in case of problems.

But the bank did not fix the vulnerabilities. In July 2022, Silicon Valley Bank was undergoing a full regulatory review — it was being looked at more closely — and was ultimately judged deficient in terms of governance and controls. It was placed under a series of restrictions that prevented it from growing through acquisitions. Last fall, San Francisco Fed officials met with senior company leaders to discuss their ability to access enough cash in a crisis and potential exposure to losses as interest rates rise.

It became clear to the Fed that the company was using poor models to determine how its business would fare if the central bank raised interest rates: its leaders assumed that higher interest income would significantly improve their financial situation as interest rates rose, but that was not possible. step with reality.

In early 2023, Silicon Valley Bank was in what the Fed called a “horizontal view”, an assessment intended to measure the strength of risk management. That check revealed additional shortcomings, but at that point the bank’s days were numbered. In early March, it suffered a run and failed within a few days.

Big questions have been raised about why regulators failed to spot problems and take action early enough to prevent Silicon Valley Bank’s demise on March 10. Many of the issues that contributed to the collapse seem obvious in retrospect: measuring by value, about 97 percent of its deposits were uninsured by the federal government, prompting clients to walk away at the first sign of trouble. Many of the bank’s depositors have been in the tech sector, which has been going through some rough times recently as higher interest rates have weighed on business.

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

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

The picture that emerges is that of a bank whose leaders failed to plan a realistic future and neglected looming financial and operational problems, even as they were raised by Fed regulators. For example, according to a person familiar with the matter, company executives were made aware of cybersecurity issues, both by internal employees and the Fed, but ignored the concerns.

The Federal Deposit Insurance Corporation, which has taken control of the company, has not commented on its behalf.

Still, the scale of the bank’s known problems raises the question of whether investigators at the Fed Bank or the Washington Fed Board could have done more to force the institution to address weaknesses. Whatever intervention was organized, it was too little to save the bank, but why remains to be seen.

“It’s a failure of oversight,” said Peter Conti-Brown, a financial regulation expert and a Fed historian at the University of Pennsylvania. “What we don’t know is whether it was a failure of supervisors.”

Mr. Barr’s discussion 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 announced its first set of issues requiring attention. The existence of those first warnings was previously reported by Bloomberg. It will also look at whether regulators believed they had the authority to escalate the issue, and whether they brought the issues to the Federal Reserve Board level.

The Fed’s report is expected to reveal information about Silicon Valley Bank that is usually kept private as part of the bank’s confidential oversight process. It also includes any recommendations for regulatory and supervisory solutions.

The bank’s demise and the chain reaction it set off is also likely to lead to a broader push for tighter banking supervision. Mr. Barr already conducted a “holistic assessment” of Fed regulation, and the fact that a bank that was big but not huge could cause so many problems in the financial system is likely to determine the results.

Typically, banks with less than $250 billion in assets are excluded from the toughest parts of banking supervision — even more so since a “customization” law passed in 2018 during the Trump administration and introduced by the Fed in 2019. As a result of these changes, smaller banks were given less strict rules.

Silicon Valley Bank was still below that threshold, and its collapse underlined that even banks that are not big enough to be considered globally systemic can wreak havoc on the US banking system.

As a result, Fed officials could consider stricter rules for those big, but not massive, 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 bond holdings falls — an “unrealized loss.” Such an adjustment would most likely require a settling in period as it would be a substantial change.

But as the Fed works to complete its assessment of what went wrong at Silicon Valley Bank and work on next steps, it is facing intense political backlash for its failure to fix the problems.

Part of the concerns revolve around the fact that the bank’s CEO, Greg Becker, was 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 situation looks bad.

“One of the most absurd aspects of the Silicon Valley bank failure is that its CEO was a director of the same agency responsible for regulating it,” said Senator Bernie Sanders, an independent Vermont professor. wrote on Twitter on Saturday, announcing that he would “bring forward a bill to end this conflict of interest by banning CEOs of major banks from serving on Fed boards.”

Other concerns center around whether Fed Chairman Jerome H. Powell allowed too much deregulation during the Trump administration. Randal K. Quarles, who served as the Fed’s vice chairman for oversight from 2017 to 2021, enacted a regulatory rollback law in 2018 in a comprehensive manner that some onlookers at the time warned would weaken the banking system.

Mr. Powell typically speaks out about the Fed’s supervisory vice chairman on regulatory issues, and he did not vote against those changes. Lael Brainard, then a Fed governor and now a top White House economic adviser, voted against some of the adjustments — marking them as potentially dangerous in dissenting statements.

“The crisis has clearly shown that the distress of even non-complex large banking organizations generally first manifests itself in liquidity stress and quickly transmits contagion through the financial system.” she warned.

Senator Elizabeth Warren, Democrat of Massachusetts, has asked for an independent review of what happened at Silicon Valley Bank and has insisted that Mr. Powell would not be involved in that effort. He “bears direct responsibility for — and has a long track record of – banking regulation,” she wrote in a letter on Sunday.

Maureen Farrell reporting contributed.