U.S. rules for banks adjust requirements depending on the bank’s size and exempt smaller community banks from some long-standing regulations. Congressman Andy Barr has proposed legislation to make a larger group of banks eligible for these relaxed requirements. Other legislators and regulators have made similar proposals and have also suggested adjusting thresholds for regional banks and global banks. One senior regulator believes easing regulatory requirements will “unleash” growth. But how much growth do we want to unleash? Explosive growth preceded some of the biggest bank failures. Meaningful asset-based thresholds encourage banks to pause growth as their risk infrastructure catches up.
Overview of Tailoring
Tailoring of bank supervision falls into two broad categories. The largest, riskiest, and most complex banks are subject to enhanced supervision. The smallest, cleanest banks receive lighter touch supervision and relief from some longstanding regulatory requirements. Those that fall somewhere in-between face what amounts to normal supervision. There is some gradation within each category. I discussed the risks and benefits of tailoring more broadly in an earlier post.
Legislative and regulatory changes in 2018 and 2019 significantly loosened capital, liquidity, and reporting requirements for all but the very largest megabanks. Regional banks ($50-$750 billion received the most significant relief, though some requirements remain in effect. Following the failure of three large regional banks in 2023, regulators sought to scale back some of the regulatory relief available to regional firms. These efforts went nowhere, and members of Congress and key regulators now appear headed in the opposite direction. Current efforts focus primarily on extending light touch supervision to a broader group of banks, and some proposals would also raise the thresholds for regional banks and even for Global Systemically Important Banks (G-SIBs).
Banks under $10 billion in total assets are generally exempt from the Volcker Rule and can opt out of risk-based capital requirements. (They are still subject to minimum leverage ratios.) Lenders under $10 billion are also subject to less stringent ability to pay requirements under the Qualifying Mortgage (QM) rule. Finally, supervision by the CFPB kicks in at $10 billion. Rep. Barr’s legislation would raise that asset threshold to $50 billion. Some less ambitious proposals would make more modest adjustments.
Regulatory “burden” can reflect either a higher resource commitment in the form of systems, reporting, and personnel or a restriction on activities. Exemption from the Volcker Rule and from CFPB supervision primarily reflects the former. Exemption from risk-based capital requirements and QM primarily reflect the latter. The risk-based capital calculation involves some additional reporting, but these reporting requirements have been in place for 35 years and involve little more than elementary school arithmetic.
The Virtue of Speedbumps
Beyond the burden itself, incremental regulatory requirements can affect behavior. Acting Comptroller of the Currency Rodney Hood advocates easing of regulatory requirements to “unleash growth.” Hood made the important qualification that banks need to operate in a safe and sound manner but was vague on the details and failed to acknowledge any tradeoff between prudence and growth.
The Conference of State Bank Supervisors (CSBS), which represents state banking regulators, was less equivocal. Noting “more than 50 key regulatory thresholds and exemptions that are explicitly tied to a bank’s assets,” CSBS describes these thresholds as creating “costly regulatory cliffs.” As a result, community banks “must work with consultants, lawyers, and others to build out new systems, reporting capabilities, training programs, and more.” CSBS sees these thresholds as “an unnatural impediment to organic growth.”
But is this really such a bad thing? Shouldn’t a bank’s risk infrastructure grow as assets grow? Increasing assets without a corresponding enhancement of systems and personnel is analogous to an army outrunning its supply lines. Meaningful asset-based thresholds act as a sort of speed bump to constrain growth to a prudent level. That a group of bank supervisors would miss this point might explain why eleven of the past twelve bank failures have involved state-chartered institutions.
Let’s look at the record. The table below shows the five costliest U.S. bank failures since 2000. These banks followed similar patterns in their paths to failure. Aggressive growth played a key role in each failure.
The 2023 Failures
SVB, First Republic, and Signature all failed in 2023. These failures followed tailoring changes that meant less stringent supervisory oversight for banks in the $50-250 billion range. And the three banks grew like gangbusters, as shown below.
The Fed’s post-mortem for SVB notes that the bank “did not take sufficient steps in a timely fashion to build a governance and risk-management framework that kept up with its rapid growth and business model risks.” One SVB director even acknowledged to bank supervisors that “controls always lag growth.” The bank’s liquidity stress testing, contingency funding plans, and interest rate risk modeling were all deficient. The bank operated for eight months without a Chief Risk Officer.
Signature Bank followed a similar pattern. The Material Loss Review found that “management prioritized aggressive growth over the implementation of sound risk management practices needed to counterbalance the liquidity risk associated with concentrations in uninsured deposits.” As with SVB, contingency funding was deficient. Bank management struggled to “identify and pledge collateral to meet deposit outflows.” Management also made disastrous assumptions regarding the stability of its uninsured deposits. Meanwhile, one open matter requiring board attention and 11 supervisory recommendations stemming from a 2019 liquidity exam remained open at the time of the bank’s failure. Supervisors usually expect these types of findings to be resolved within 18 months.
Risk management deficiencies at First Republic were less egregious. However, management failed to take any actions to address repeated IRR limit breaches and its liquidity stress testing seriously underestimated liquidity stress. Actual deposit outflows exceeded the bank’s “realistic worst case” by a factor of five. In addition, management’s primary strategy to address its underwater mortgage portfolio was to keep pumping out more mortgages, essentially doubling down on the risk.
Rapid growth also meant unbalanced growth. Each bank funded growth with uninsured deposits. There were also concentrations within these concentrations as SVB and First Republic drew much of their deposits from venture capital investors and Signature from crypto-related firms. Both SVB and First Republic had large asset concentrations in fixed rate mortgages and MBSs.
BankUnited and IndyMac
Rapid and unbalanced growth also characterized BankUnited and IndyMac. The Material Loss Review for BankUnited tied the bank’s failure to “a high-risk growth strategy with excessive concentration in option adjustable-rate mortgages (option ARM) without implementing adequate controls to manage the associated risks.” Total assets nearly doubled between June 2003 and December 2006. Its concentration of option ARMs increased from 67% to 640% of capital over the same period. More than 90% of the option ARMs had negative amortization features (the loan balance increases over time) and 87% were underwritten under reduced documentation standards. The Material Loss review noted that BankUnited embarked on its growth strategy without board-established “underwriting policies, monitoring practices, limits, or risk controls commensurate with the risks posed by such growth.”
Aggressive, unbalanced growth also characterized IndyMac’s rise and fall. The bank grew from $13 billion to $31 billion between June 2005 and June 2007. As with BankUnited, the loan growth consisted primarily of option ARMs and other nontraditional mortgage products, usually with negative amortization features and requiring less than full documentation of income and assets. Funding was also concentrated. IndyMac had historically sold a significant share of its loans to the secondary market. But this funding source dried up as the market lost its appetite for the kinds of high-risk loans that IndyMac was originating. FHLB advances and brokered deposits eventually represented more than half of total liabilities. IndyMac’s Material Loss Review described the bank’s business strategy as placing “loan production and growth ahead of underwriting controls.”
Conclusions
Each failed bank fails in its own way, but bank failures tend to follow a consistent theme. Fast and concentrated growth outpacing compensating controls could describe each of the bank failures noted above and many, many more. Material Loss Reviews could practically write themselves. Just fill in the name of the failed bank.
The extent to which the 2018-19 tailoring initiatives contributed to the 2023 bank failures remains a hotly debated topic. Defenders of tailoring typically focus on specific aspects of the rules. For example, regulators continue to define the severely adverse scenario under CCAR as a sharp recession with declining interest rates. Such a scenario would not have represented much of a stress for SVB, Signature, or First Republic. Similarly, an asset can be deeply underwater and still meet the regulatory definition of “high quality liquid assets.” On the other hand, SVB’s liquidity coverage ratio likely fell below the 100% threshold that in effect pre-tailoring. Recognizing unrealized losses on AFS securities would have reduced SVB’s regulatory capital.
The focus on specific regulatory provisions misses a larger point. More stringent requirements tied to asset size incentivize bank management to pause aggressive growth plans and allow systems, processes, and personnel to catch up. We can’t know for sure what might have transpired under such an alternative scenario. But the presence of these speed bumps can at least keep incentives in line with more moderate, balanced, and prudent growth.
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