Is the Trump administration to blame for failed banks?

Good morning. As of filing time, there was not yet an announcement about the sale of First Republic; all we know is that three banks have submitted bids for all or part of it.

Meanwhile, evidence continues to pile up that the economy slowed — or rather slowed more — in March and April. On top of dreary reports from the transport sector, China PMIs reflected contraction in manufacturing activity in April. Even US consumption, presently the biggest asset on the global economic balance sheet, is slowing. For all that, as we have argued repeatedly, we don’t think recession is close. Hence the markets’ confidence, and ours, that the Fed will raise rates this week. Are we missing something? Email us: [email protected] and [email protected].

Is the banking mess the Trump administration’s fault?

Michael Barr, the Fed’s vice-chair for bank supervision, released his report on the failure of Silicon Valley Bank on Friday. It says three things about the failure of SVB — and therefore, obliquely, about First Republic and other troubled banks. First, SVB’s management and board did a bad job; second, the bank’s supervisors did a bad job; and third, the Trump administration’s softening of bank regulations, which took effect in 2019, contributed to the supervisory failures.

Claims one and two are uncontroversial. The dangerous combination of largely uninsured deposit liabilities and long-duration bond assets should have been recognised by both management and regulators years ago. Heck, I feel bad that I didn’t recognise it three years ago, and it was only sort of my job (as a bank reporter) to do so.

The third claim is harder to judge and more controversial. Randal Quarles, Trump appointee, advocate for the rule changes, and Fed vice-chair for bank supervision when they went into effect, unsurprisingly rejects it. From Bloomberg:

‘The [Barr] report provides no evidence at all for what it describes as one of its main conclusions — that a ‘shift in the stance of supervisory policy’ impeded effective supervision of the bank,’ said Quarles.

The Economic Growth, Regulatory Relief, and Consumer Protection Act (EGRRCPA), enacted in 2019, lowered the asset threshold under which banks would be subject to the strictest standards for capital, liquidity, and risk management — the “enhanced prudential standards” (EPS). In 2019, the Fed officially interpreted the EGRRCPA law to mean that only a softened version of the EPS applied to banks with between $100bn and $250bn in assets. Previously the EPS applied to all banks over $50bn. SVB passed the $100bn threshold in June of 2021.

The Barr report does not demonstrate that if the older, more stringent standard would have applied, SVB would have been, or even probably would have been, protected from failure. “While higher supervisory and regulatory requirements may not have prevented the firm’s failure,” the report says, “they would likely have bolstered the resilience of Silicon Valley Bank.”

The closest the report comes to finding a smoking gun is this:

Under the pre-2019 regime, SVBFG would have been subject to the full [liquidity coverage ratio] and would have had an approximately 9 per cent shortfall of [high quality liquid assets] in December 2022, and estimates for February 2023 show an even larger shortfall (approximately 17 per cent) . . . 

In terms of capital, under the pre-2019 regime, SVBFG would have been required to recognise unrealised gains and losses on its available-for-sale securities portfolio in its regulatory capital; by including the unrealised losses on its AFS securities portfolio, in December 2022 SVBFG’s reported regulatory capital would have been $1.9 billion lower

SVB had $14bn in cash in December of 2022, paired with $194bn in long duration assets. If there had been twice as much cash, I’m not sure that would have been enough (recall that $40bn of deposits left the bank in a single day). Similarly, SVB had capital well in excess of regulatory minimums, and I doubt another $2bn would have provided depositors with much reassurance (if bank liquidity and capital experts out there take a different view, email me).

The report does, however, make a more subtle and important point about the effect of the rule change. One effect of the change was to move SVB from one tier of the regulatory system to another, and that change came with a transition period. As a result,

[At]t the time of its failure, an important subset of . . . capital and liquidity requirements, including supervisory stress testing, the stress capital buffer, the liquidity coverage ratio, and the net stable funding ratio, were not yet applied to [SVB] because of applicable transition periods in the rules. For example, [SVB’s] first supervisory stress test would have occurred in 2024, more than two years after SVBFG became a [$100bn] firm.

The Barr report makes a strong case that a multi-tiered regulatory regime, designed to lighten the regulatory burden on smaller institutions, adds to risks by creating regulatory “handoff” periods for growing institutions. Financial regulations should always be strong but simple.

There is another point in the report, which may be the most important of all but is certainly the vaguest. It is that the spirit of the rule change had a softening effect on the attitudes of supervisors. Here’s the key par, which, strikingly, calls out Quarles directly:

[U]nder the direction of the Vice Chair for Supervision [Quarles], supervisory practices shifted. In the interviews for this report, staff repeatedly mentioned changes in expectations and practices, including pressure to reduce burden on firms, meet a higher burden of proof for a supervisory conclusion, and demonstrate due process when considering supervisory actions. There was no formal or specific policy that required this, but staff felt a shift in culture and expectations from internal discussions and observed behaviour that changed how supervision was executed. As a result, staff approached supervisory messages, particularly supervisory findings and enforcement actions, with a need to accumulate more evidence than in the past, which contributed to delays and in some cases led staff not to take action.

Quarles says Barr lacks evidence. And indeed it is hard to imagine what hard evidence that a change in attitudes caused delay and inaction would look like. But anyone who has ever worked in a large organisation knows that attitudes (ethics, expectations, tone, culture, and so on) matter hugely, and cannot be replaced by ever more specific rules. Checklists are necessary but not sufficient.

We will never get a conclusive proof that changes in these intangible factors contributed to the problems at SVB. The closest we can come is examples like this:

During the second half of 2022 and into 2023, as SVBFG’s liquidity steadily weakened, unrealised losses accumulated on its securities portfolios, and its performance outlook deteriorated, supervisors continued to accumulate evidence of widespread weaknesses and delayed escalating supervisory action. For example, it took more than seven months to develop an informal enforcement action, known as a memorandum of understanding (MOU), for [SVB] to address the underlying risks related to “oversight by their respective boards of directors and senior management and the Firm’s risk-management program, information technology program, liquidity risk management program, third-party risk-management program, and internal audit program. [SVB] failed before the MOU was delivered.

One final note. Barr’s report points out that the pay packages of SVB’s management team “were tied to short-term earnings and equity returns and did not include risk metrics.” Given that the report also details remarkable risk-seeking behaviour by the bank’s leadership (changing established modelling assumptions to make interest rate risk appear lower, removing rate hedges, ignoring failed internal liquidity stress tests), the issue of management incentives is very important. It may be that SVB is not best understood as the first major bank failure in 2023, but rather the second large American company — after Bed, Bath and Beyond — to fail in large part because of horrifically designed management pay plans.

One good read 

Charlie Munger thinks he has lived during “a perfect period to be a common stock investor”