Vibes-Based Supervision

and two other quick notes on the OIG report into SVB

Today the Office of Inspector General for the Federal Reserve System and CFPB released a review of the Federal Reserve Board’s supervision of Silicon Valley Bank.

In a letter responding to the OIG’s report,¹ the Federal Reserve Board’s Director of the Division of Supervision and Regulation says that the OIG’s findings “reinforce the results of” the April 2023 review conducted by Federal Reserve Board Vice Chair for Supervision Barr.

I think that is mostly true, but there are also some interesting divergences, or at least differences in points of emphasis. This post looks at a few of them.

Bank Exams Tailored to Vibes

The OIG report, as is typical for OIG reports into bank failures,² notes various instances where supervisors could have been more assertive or where supervisors missed opportunities to take effective action sooner. The report also finds that the supervision of SVB failed to “evolve commensurately with its growth and increased complexity,” even before SVB crossed the $100 billion assets threshold.

The OIG report attributes to various factors this failure of supervision to keep up with the relatively early stages of SVB’s growth, but cites as the leading issue the fact that “after EGRRCPA’s enactment and the Board’s 2019 tailoring rule, firms with assets under $100 billion, including SVB, were no longer subject to EPS.”

It followed from this, the OIG report implies,³ that SVB had to continue to be supervised as part of the Board’s Regional Banking Organization (RBO) portfolio with other firms having assets between $10 billion and $100 billion, rather than moving to the Large and Foreign Banking Organization (LFBO) portfolio. The report cites a statement from an unidentified Board official:

[A] Board official noted that the examination framework changed when the RBO portfolio expanded to include firms with up to $100 billion in assets, becoming more “small bank like” and less intense because banks with $10 billion or $95 billion in assets are treated the same.

The OIG report compared to the VCS Barr report⁴ also spends quite a bit more time on the Board’s Bank Exams Tailored to Risk (BETR) program, which aspires to be a data-driven process to “guide the supervisory activities for RBO Supervision and generate the recommended number of hours for specific topics.” The report details how some RBO supervisors feel constrained by what BETR spits out.

While some interviewees noted that examination teams can challenge BETR outputs and request exceptions, others indicated that they had to accept the BETR outputs. A Reserve Bank interviewee described the BETR-recommended hours as “a detrimental handcuff.” A Board official noted that if FRB San Francisco was doing what it was supposed to do, it would have been following the BETR program, which would not have allowed for the amount of work needed for SVB. The official further noted that the Reserve Bank was told to follow the supervisory program and, because SVB had a lot of liquidity, the RBO examiners did not look at risk management in detail. A Reserve Bank official noted that Systemwide, the expectation was for examination teams’ hours to approximate the BETR-recommended hours.

***

This discussion is interesting, but something the OIG report effectively glosses over is that the EGRRCPA changes to the thresholds for the application of enhanced prudential standards did not need to result in changes to (a) the composition of the RBO portfolio (i.e., grouping all $10 billion - $100 billion banks in the same category) or (b) the banks to which the BETR approach applied. These were choices made by the Federal Reserve Board and the Board alone.

Why, then, if not required by statute, were these choices made? The OIG report says those are the vibes the Board intuited from the EGRRCPA:⁵

A Board official stated that the message the Board took from EGRRCPA becoming law in 2018 was to reduce the regulatory and supervisory burden; the intensity for firms below the $100 billion threshold was to be much lower than for those firms above $100 billion.

Similarly, later in the report an unidentified interviewee expresses fears of being on the wrong side of a “tug of war” with the industry, should supervisors have been perceived to be too aggressive in expecting SVB to be prepared to transition to enhanced prudential standards.

One interviewee stated that the System would try to prepare firms for the transition but felt it was placing requirements on those firms prematurely, noting a constant “tug of war” between industry and supervisors

I am a little torn over how to feel about this.

On the one hand, you can understand where the Board and Reserve Bank staff are coming from. It is certainly true that there was a significant push in the late 2010s to re-orient supervision. It is also certainly plausible — though both the VCS Barr report and now the OIG report steadfastly avoid giving specific examples — that this affected the day-to-day decision-making of the Board and Reserve Bank staff.

I have also found some of the post-SVB-failure commentary from members of Congress saying that the Board under the EGRRCPA had the authority to subject SVB (once it crossed $100 billion in total assets) to additional enhanced prudential standards to be a little too cute. Although certainly true, it is tough to believe that, had the Board actually taken this action, some of these same members of Congress would not have been firing off letters chiding the Board for doing that. So I think it is fair for the Board and Reserve Bank staff to have perceived constraints from the EGRRCPA, even if not reflected in the text of that law itself.

On the other hand, I feel that the OIG report goes too far in pointing the finger at the EGRRCPA to the extent it does. At the end of the day, whatever the vibes the Board was getting from Congress or big scary trade associations or whoever, the construction of supervisory portfolios and the intensity of supervision of banks within these portfolios were choices very much within the Board’s discretion, even after the EGRRCPA. True, banks like SVB were not subject to things like the liquidity coverage ratio or supervisory stress testing, but it is not clear why enhanced prudential standards like those, though not necessarily a bad idea, should have been necessary for the Board and Reserve Bank to be able to effectively supervise a bank for interest rate risk. And sure, it would have been annoying or unpleasant for the Board or its staff to be criticized by members of Congress or industry groups, but that is sort of the deal you sign up for.

Bottom line, I just worry that in focusing on implicit messages from Congress and perceptions of what outside actors would have done, the OIG report misses an opportunity to examine the actual decisions made by the Federal Reserve Board and its staff. Decisions that were not, despite what the OIG report implies, dictated by the EGRRCPA.

Misplaced Focus

The VCS Barr report and other commentary have focused on the significant number (31) of MRAs and MRIAs SVB had outstanding, “about triple the number observed at peer firms.” Vice Chair for Supervision Barr in his report characterized these outstanding supervisory findings as focusing on “core areas” such as “governance and risk management, liquidity, interest rate risk management, and technology.”

The OIG report includes only a paragraph on this, but nevertheless can be read to suggest that, even after SVB’s transition to the LFBO portfolio, perhaps some of these areas of focus were not in fact “core,” that supervision was overly process-focused, and that supervisory attention would have been better devoted elsewhere:⁶

• “We believe that LFBO Supervision did not sufficiently act to mitigate the risks from interest rate changes because it was focused on risk management and associated processes.”

• “Interviewees noted that while the LFBO Supervision team was focused on SVB’s risk management and associated processes, it did not pay close attention to changes in the financial condition of the institution.”

• “[I]nterviewees shared that when evaluating components for LFI ratings, LFBO examiners tend to focus more on risk management than the institution’s financial condition.”

• “A Board official noted that LFBO Supervision was highlighting risk management deficiencies when more serious problems were emerging and that LFBO Supervision missed the deficiencies in the bank’s financial condition.”

To address this misplaced focus, OIG recommends that the Board take steps to better focus supervisors on “salient risks.”

The Board says it concurs in this recommendation,⁷ but reading behind the headline it is not clear to me how much one should expect to see meaningful changes in the focus of supervisory findings. The Board’s response is generic enough to suggest a number of outcomes.

We concur with the need to re-assess the LFBO supervisory planning process to ensure that risks are being supervised according to the risk profile of each LFBO. […]

Financial risks as well as risk management will be considered in the supervisory planning process. Communication to LFBO supervision staff on how to balance known risks, emerging risks, and financial risks will be developed in time for the 2024 supervisory planning cycle . . . and will incorporate improvements and learnings from the discussions conducted this year.

Reserve Bank Boards

At the end of its report, the OIG includes a discussion of the service of SVB’s CEO on the Board of Directors of the Federal Reserve Bank of San Francisco. Here, unlike elsewhere in the report, the OIG does not make a recommendation but instead raises a “matter for management consideration.”

In particular, the report states that although the OIG did not in its interviews “hear of any conflicts of interest or issues with the CEO’s service as a board member influencing any aspect of FRB San Francisco’s or the Board’s supervisory activities” this nonetheless “created an appearance of a conflict of interest.” To mitigate the potential for such appearances, the OIG suggests that, in looking to fill the seats on Reserve Bank boards that statutorily must be elected by member banks, the Board should “encourage member banks to consider having retired bank executives” fill the roles, rather than active ones.

The OIG report also notes that it was particularly awkward for SVB’s CEO to serve on the FRBSF Board of Directors while his bank was in unsatisfactory condition. Evidently the FRBSF and the Federal Reserve Board “considered” kicking him off, but decided not to out of concern that this could necessitate “revealing confidential supervisory information and potentially signaling to the market the bank’s declining condition.”

On this point the OIG report concludes by sort of shrugging and recommending that the Federal Reserve Board think about “whether standards for service and removal can be established for class A directors currently employed by supervised institutions that appropriately balance all competing interests, including avoiding signaling to the public a bank’s declining condition.”

Thanks for reading! I have a feeling no one is going to like this post very much, but in any case feedback is welcome at bankregblog@gmail.com

1. This is included at Appendix B to the OIG report, starting at page 48.

2. I mentioned this in a post earlier this week, but see for example this summary by the OIG of its reports into failed state member banks from 2009-2011:

We noted in our 20 reports that examiners often identified many of the SMBs’ key safety and soundness risks, but did not take sufficient supervisory action in a timely manner to compel the Board of Directors and management to mitigate those risks. In many instances, supervisors eventually concluded that a supervisory action was necessary, but that conclusion came too late to reverse the bank’s deteriorating condition.

3. The OIG report says that “RBO examiners and SVB management started to discuss SVBFG’s transition to the LFBO portfolio; however, once EGRRCPA became law, RBO Supervision continued its oversight of the bank after SVB’s total assets exceeded $50 billion.”

It is true that the second thing happened after the first thing, but the OIG report leaves it at that and does not inquire further into the reasoning behind the Board’s choice to narrow the scope of the LFBO portfolio.

4. These are the only mentions of BETR in the VCS Barr report:

• “For the RBO portfolio, the frequency and intensity of continuous monitoring and institution-specific exams is set in part through the Bank Exams Tailored to Risk (BETR) program, designed to leverage data and surveillance to reduce staffing and burden on firms deemed low risk and to enhance supervision of high-risk firms” (p. 30).

• “The BETR model provides guidance on allocation of examination hours so that resources spent on low-risk firms can be limited, shifting regulatory attention and Federal Reserve examiner resources to high-risk firms” (p. 32).

The OIG, in contrast, has previously written about BETR at length, and perhaps that explains some of the difference in focus.

5. I am not sure who to credit with first framing the supervision of SVB in terms of vibes. I used it in a couple posts in April, but before that it looks like it was used on Twitter by Mike Konczal and Todd Phillips. It also shows up in this Revolving Door Project post.

I expect my point of view expressed in this post differs from the viewpoints of those persons cited above and, just to be clear, I am not claiming they would endorse any of the views represented herein.

6. Here the OIG report sounds sort of strikingly like some of the industry groups it mentions elsewhere. For instance, compare the OIG statements quoted in the main text above to this post from Greg Baer of BPI back in May:

Consider the May 3, 2021 examination report, the first issued after SVB moved from regional bank to large bank supervision at the Federal Reserve, after two years of rapid asset growth. It contained the following list of MRAs and MRIAs. […] None of those MRAs or MRIAs relates to financial condition, much less to interest rate or liquidity risk, which were the key problems at SVB. […]

These documents would seem to warrant an analysis of how examination priorities were set by Board or Reserve Bank management and whether they were unduly focused on governance, process and immaterial risks. […]

More broadly, the underlying documents seem at war with a central contention of the report that the preceding Vice Chair for Supervision set a tone of laxity. In fact, the examination materials reflect a highly energetic focus on the governance and procedural topics listed above, just not on matters of actual financial risk.

7. See the bottom of page 50 and the top of page 51 in the report.