A Note on SVB & Banking Regulation

This week Bennett did a full breakdown on the recent bank failures and their implications. We’ve included the full report in the body of this email.

01. How big is “medium”?

From Bennett Fees, Economic Research Associate

Within a week, three regional banks, Silvergate, Silicon Valley, and Signature failed, but coverage of their regulation has been less clear. The failures in SVB’s risk management, suspect investment decisions, and fuel-adding capital raise are well known but let’s take a closer look at their regulation. Here are two of the most important pieces.

1. How big is “medium”: In 2018, the “Economic Growth, Regulatory Relief, and Consumer Protection Act” rolled back several banking regulations for small and midsized banks present in the 2010 Dodd-Frank Act. This change redefined what banks were deemed systemically important to the threshold of $250 billion in assets up from $50 billion. This leaves just 12 banks in the US over this line. For banks like SVB under this threshold, the change frees them from the same oversight and capital requirements enforced on larger banks. More specifically, banks under this level don't need to follow the net stable funding ratio or the liquidity coverage ratio. The former makes banks over the $250 billion threshold hold a decent proportion of their liabilities in long-term funding, while the latter allows SVB to hold less high-quality liquid assets.

2. HTM Accounting: Under current accounting rules, held-to-maturity debt securities are reported at amortized cost, and all other financial assets at fair value. In SVB’s case (as of December), $91 of SVB’s $120 billion investments were classified as HTM. This is important in two ways. First, this can dissuade interest rate hedging because the bank assumes they will sell the bond at maturity, making any hedge an unattractive interest rate speculation with immediate effects on the balance sheet. Usually, banks would hold mostly short-term bonds to account for this, but SVB held an abnormally high proportion of long-term bonds while unwinding its interest rate swaps that would have helped insulate SVB from tightened monetary policy. Second, if a bank needs to raise capital quickly and interest rates aren't at zero, they are forced to sell these long-term bonds at a loss and at a much lower price than what is recorded on the balance sheet, thereby adding to the panic.

While both of these might have contributed to SVB’s failure, neither was the primary cause. Regarding the 2018 changes, even if SVB went through the same stress tests as larger banks, this likely wouldn’t have changed much. Douglas Dimond, whose work with Philip Dybvig on bank runs won him the Nobel Prize in Economics last year, along with Ben Bernanke, points out this flaw:

“I looked at the latest stress test, and the Fed was assessing how the banks would perform at rates from 0% to 2%, as if 2% was as high as they’d ever go. So almost any bank would pass. The standard should have been 0% to 7%.”

As for the accounting rules, this is much more of a consequence than a cause as it was SVB’s fragile deposit base that forced the sale of $21bn of bonds at a $1.8bn loss. In fact, many other banks also face the same unrecognized losses. Regardless, regulators were faced with a problem. Let’s walk through their solution.

To start, all of SVB’s deposits were guaranteed using the FDIC’s Deposit Insurance Fund, paid through required insurance premiums from other banks. Additionally, there are already measures in place to help banks in need of liquidity. The Federal Home Loan Bank System, known as the lender of the next-to-last resort, saw increasing demand over the past year, and last Friday, banks also started to make use of the discount window, the main direct lending facility the Fed provides to Banks. In the discount window, the two main programs used are the primary credit program which is reserved for sound banks that can receive loans at the discount rate and the secondary credit program which entails shorter loans and steeper rates for depository institutions not eligible for primary credit.

Starting on March 12, the Fed announced that discount loan collateral would be valued at par, making the losses in long-term bonds caused by interest rate increases irrelevant. On top of this, the Fed also created the Bank Term Funding Program (BTFP), which offers loans to depository institutions for up to one year against high-quality collateral backstopped by another $25 billion from the Treasury’s Exchange Stabilization Fund. Crucially, the collateral in the BTFP is also valued at par.

But what does this mean looking forward? Here are two notable problems.

First, Hung Tran, former deputy director at the International Monetary Fund, asks what will happen if a bank runs out of high-quality bonds to cover its liquidity pressure, even with the par value adjustment. Uncertainty arises regarding how the Fed might relax current rules under the BTFP whether that means accepting lower-quality collateral or otherwise. Additionally, there is a problem concerning the scope of the valuation losses in response to HTM assets being marked for sale. The degree to which this will increase depositors’ flight to safer bakes remains to be seen.

The second is how uninsured deposits will be treated in the future. Shelia Bair, Former Chair of the FDIC during the Financial Crisis, recently wrote how in 2008, uninsured deposits were temporarily backstopped, with banks charged a fee for any losses. However, this far-reaching policy was outlawed by congress while retaining the Fed’s emergency lending for “unusual and exigent” circumstances and the FDIC for systemic risk exceptions. The result is an increased grey area of what is considered systemically important and what uninsured deposits will be protected. Furthermore, with the new collateral valuation in the discount window and BTFP at par, the importance of interest rate risk has dramatically diminished, adding further uncertainty to balance sheet regulation.

Clearly, many decisions will need to be made by regulators, not just in preventing contagion but in managing these institutions moving forward.

Stick around for the next updates to come.

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