Supervisory Guidance & Selective Amnesia

Most attribute recent bank failures, at least in part, to a lack of quick and effective actions by bank supervisors.  How much of the blame lies with Congress, senior regulators, or the banking industry lobby is more open to dispute.  Attempts to absolve the latter groups rely on some selective amnesia.  Actions that bank regulators took to clarify and deemphasize the role of supervisory guidance provide a good case in point.

Guidance on Guidance

In September 2018, the five federal financial regulators issued an interagency statement that instructed examiners to not criticize institutions for a “violation” of supervisory guidance.  The interagency statement noted that “unlike a law or regulation, supervisory guidance does not have the force and effect of law, and the agencies do not take enforcement actions based on supervisory guidance.”  Instead, guidance “outlines the agencies’ supervisory expectations or priorities and articulates the agencies’ general views regarding appropriate practices for a given subject area.”  This “guidance on guidance” especially stressed limits on the use of numerical bright lines.  While bright lines need to be developed and applied with some care, the absence of such bright lines can undermine effective supervision.

A petition from the American Bankers Association and Bank Policy Institute prompted the agencies to go a step further and codify the statement as a Final Rule in early 2021.  The elevation to a Final Rules binds the agencies and their staff to this interpretation of guidance.  That will make it more difficult for regulators to revert to a less banker-friendly interpretation after, say, the second, third, and fourth bank failures in history.

Both the 2018 Statement and 2021 Rule read a bit like a hostage tape.  However, savvy examiners know enough raise concerns without describing them as “violations” of supervisory guidance.  Still, the potential for a chilling effect is obvious.  Issuing a statement supposedly reiterating existing policy and then a Final Rule reiterating the reiteration suggest that agency management prioritized what examiners cannot do rather than what they can.

It could have been worse.  The petition called for limiting a wider range of supervisory actions, including matters requiring attention and ratings downgrades to explicit violations of law, regulation, or enforcement action.  Even determinations of whether an activity is unsafe or unsound would need to meet a legal rather than a prudential standard.  Following the ABA and BPI recommendations, they would have effectively outlawed examiner discretion and undermined any attempt at preventive supervision.

BPI Critiques the Fed’s Post-Mortem

These earlier recommendations put in some perspective the BPI’s opposition to more recent efforts to strengthen bank supervision.  Despite the academic-sounding name, BPI primarily serves as the advocacy arm for America’s largest banks.  Its board consists of large bank CEOs.  BPI has critiqued the Fed Vice-Chair Michael Barr’s post-mortem with its own review of the Fed’s supervision of SVB.  BPI attributes the failure of SVB to, “a misguided supervisory culture heavily focused on compliance processes and governance and not actual risk to safety and soundness.”  However, limiting supervisory actions to specific regulatory violations pretty much assures a focus on compliance rather than actual risk.  Avoiding bright lines does much the same.

BPI believes part of the problem is that the Fed issued too many MRAs to SVB.  The bank’s management must have been too darn busy remediating their MRAs to run the bank prudently.  Remember that these large banks have tens of thousands of employees and top managers receiving seven- and eight-figure compensation packages.

Examiners at SVB focused more on processes than on actual risks.  Some of that is inevitable if regulations and guidance focus on broad principles and discourage quantitative standards and bright lines.  BPI notes 31 open MRAs as evidence of the Fed’s focus on the trivial rather than the substantive.  Closer inspection indicates this is not the case.  Outstanding MRAs and MRIAs relate to such Banking 101 issues as contingency funding plans, liquidity limits, board effectiveness, and internal audit effectiveness.  Some relate to data quality and technology.  This activity was outside the scope of the Barr report, so we don’t have a lot in the way of specifics.  However, data and IT weaknesses are a leading source of operational risk for many banks.

BPI points to two regulatory violations that the Federal Reserve failed to address adequately.  One is that the Chief Risk Officer position remained vacant for much of 2022, which “represented a violation of a separate Regulation YY requirement that [the firm] maintain one at all times.”  Well, not exactly.  Reg YY requires the appointment of a CRO (12 CFR 252).  Some turnover at the CRO position is common, though the extended vacancy at SVB was no doubt problematic.  However, the previous CRO was clearly ineffective and apparently lacked “experience in identifying, assessing, and managing risk exposures of large, complex financial firms,” as the regulation also requires.

BPI also notes that “beginning in 2022, SVB was in violation of Regulation YY’s requirement that it hold a sufficient buffer of liquid assets to survive a 30-day period of liquidity stress.  BPI questions “why this aspect of Regulation YY was not enforced” and notes the supporting supervisory materials and exam ratings “make no reference at all” to the apparent regulatory violation.  The Fed’s supervision of liquidity risk is ripe for criticism, but BPI’s analysis overstates the case.  Regulation YY applies to the holding company rather than the bank and SVB Financial did not become subject to the buffer requirements until July of 2022.  The ratings as of date was June 2022.  The Fed’s supervision of SVB often lacked a sense of urgency and was slow to react to changing conditions, but that was quite different from failing to enforce existing regulations.

BPI’s analysis is all over the place when it comes to interest rate risk.  No regulation deals with IRR specifically except as part of broader safety and soundness requirements.  Additional guidance on IRR avoids bright lines.  BPI criticized the Fed examiners’ focus on processes rather than actual risk and particularly that the “examiners did not have any independent view of SVB’s interest rate risk.”  BPI criticized the “2” rating for Sensitivity, but also criticized plans to downgrade “a mere three months later.”  Apparently, “the relevant rating systems were too subjective and lacked clear standards, such that these ratings were frequently grounded in nothing more than examiner (mis)judgment.” 

Let me get this straight.  Examiners must stick to what’s explicitly in the regulations, but not focus on compliance.  Bright lines are a bad thing, but rating systems should have clear standards.  Examiners should have an independent view of a bank’s risk but should not exercise judgment.  Okay.

The point here is not to pick on BPI or the large banks they represent.  Politicians, former regulators, and the Wall Street Journal Editorial Page  have echoed BPIs talking points, though usually in less detail.  Large banks aren’t the only ones with selective amnesia.  Congress pared back requirements for banks with less than $250 billion in assets, predicated on the assumption that these banks were not systemically important.  Congress expressed that sentiment not just in the legislation itself but also in letters to regulators. The federal response to recent bank failures shows that this assumption has aged like milk. 

Large banks seem to want the best of both worlds.  Oppose any efforts to tighten supervision, often relying on dubious after the fact analysis.  At the same time, continue to benefit from a safety net that insures uninsured deposits and offers emergency funding at favorable terms.  It’s not as though imprudent actions by large banks ever blew up the financial system.  Oh wait.