According to congressional testimony from Federal Deposit Insurance Corporation (“FDIC”) Chairman Martin J. Gruenberg, the FDIC began developing a resolution strategy on the evening of March 9, 2023—just hours before the bank failed. As has been documented rather extensively heretofore, in resolving SVB, the FDIC ultimately invoked the statutory systemic risk exception (“SRE”), which effectively allowed the FDIC to guarantee repayment of all of SVB’s deposits, whether insured or not. The ability to invoke the SRE requires approval by two-thirds of both the FDIC board and the FRB, approval by the Treasury secretary, and consultation with the president. Having successfully invoked this measure, on March 13, the Monday following SVB’s failure, the FDIC stated that “[d]epositors will have full access to their money beginning this morning [and] all depositors of the institution will be made whole . . . both insured and uninsured. . . .” The FDIC has estimated that SVB’s failure will cost the deposit insurance fund $20 billion but noted that “[t]he exact cost will be determined when the FDIC terminates the receivership.”
The commentary from regulators in the wake of the March 2023 turmoil has included a diverse collection of thoughts, empirical reporting, and proposed solutions for a path forward. Some, including Barr, have focused on the need for stronger capital requirements, saying, “[B]anks with inadequate levels of capital are vulnerable, and that vulnerability can cause contagion.” Others, like FDIC Director Jonathan McKernan, have focused on the idea that “an effective resolution framework [is part of] our best hope for eventually ending our country’s bailout culture that privatizes gains while socializing losses.” And while the Treasury Department’s Assistant Secretary for Financial Institutions Graham Steele approves of the current focus “on the unrealized losses in banks’ available-for-sale and held-to-maturity securities as important metrics to assess a bank’s solvency,” FRB Governor Michelle Bowman has observed that the recent failures rest squarely on “poor risk management and deficient supervision, not . . . a lack of capital.”
Dan Tarullo, a professor at Harvard Law School and a former FRB governor, framed it this way:
I think the agencies need to be especially careful here not to overreact to the events of this spring. It’s of course critical to address the vulnerabilities that were exposed and, as I said earlier, to make sure banks that are undershooting their profit targets do not take excessive risks. But the agencies need to think through whether some ideas for increased regulation would just exacerbate the competitive problems of these banks while not efficiently containing those vulnerabilities.
In the spirit of Tarullo’s comments, the discussion below reviews potential policy tools that are available to address what the spring 2023 turmoil revealed, apart from the broader and more divisive debate about capital calibration and the appropriateness of tailoring the prudential regulatory framework based on the size of a banking organization.
Revising Early Remediation
On consideration is whether the FRB should promptly implement the DFA’s early remediation requirements.
Certainly, it should be possible to look back and evaluate how such requirements could have helped avoid the use of the SRE and the hectic resolution of SVB. For example, what triggers could have required swift action as SVB experienced a slow-motion run on 8 percent and 30 percent of its average total and average noninterest-bearing deposits, respectively? If those triggers had been in place, would the March 9 run have been avoided—or at least been less of a surprise? Could triggers be designed that would have prevented the accumulation of SVBFG’s negative equity balance, described above? Or required prompt action once it had accumulated?
Of course, picking the right triggers and remedial actions is no easy task, and it is also worthwhile to avoid fighting the last battle when designing policy. Moreover, remedial actions should be designed to avoid exacerbating a firm’s deteriorating financial condition. Nevertheless, the problems the FRB described when proposing early remediation rules in 2012 (“that the condition of large banking organizations can deteriorate rapidly even during periods when their reported capital ratios are well above minimum requirements”) appear to still be present and to have been a part of the reason why the SRE needed to be used in resolving SVB. Moreover, it is not clear, for example, that given the problem that section 166 is designed to address, whether higher capital requirements would avoid a similar situation in the future.
Accordingly, DFA section 166 seems like a targeted tool that can be evaluated and used to fill the regulatory gaps that March 2023 revealed. In all events, the fact that designing rules involves complicated policy judgments, such as those described above, does not seem like a reason for the agencies to avoid faithfully implementing the laws on the books.
Capitalizing Unrealized Losses on Investment Securities
As also reviewed above, the agencies previously said that having AOCI flow through to regulatory capital results in a capital measure that better reflects banking organizations’ actual loss absorption capacity at a specific point in time. This prior statement appears, in hindsight, to have been correct and worth revisiting, as the agencies recently have proposed. Indeed, in this regard, the way unrealized losses were treated for SVB appears to show that, at least in this respect, capital did in fact play a role in its failure, given that the negative equity position likely caused depositors to have concern about the bank’s financial condition.
That said, the agencies naturally will have to grapple with the question that they previously noted, in particular, whether “tools used by larger, more complex banking organizations for managing interest rate risk are . . . readily available for all banking organizations” and, if not, the size threshold at which having AOCI flow through to capital is not necessary. Making this judgment should involve considering the size above which resolution of an institution is likely to threaten financial stability. This question, however, should not be viewed in isolation. For example, if clear and strong early remediation requirements are in place, as discussed above, and the way in which the FDIC plans for resolution, as discussed below, is enhanced, then the likelihood that the failure of even a relatively large firm would threaten financial stability should be (perhaps materially) lower.
Preparing for Resolution and Developing an Effective Resolution Framework
Another lesson from SVB’s failure is perhaps one of the more obvious—beginning the process to resolve a $200 billion bank the evening before its failure does not provide sufficient runway to conduct an orderly resolution. Thus, the natural question that follows is this: When should the FDIC begin to actively plan for resolution?
For example, if there had been triggers for the FDIC to begin to prepare—such as SVB’s deposit outflows or the dramatically large unrealized losses on SVBFG’s balance sheet and the effective result that had on equity levels—would the SRE have been needed? If the FDIC had begun to prepare for SVB’s resolution, for example, in September 2022 (when the equity balance was negative ~$2.9 billion (see Chart C)) or after year-end 2022 (with average total and average noninterest-bearing deposits down ~8 percent and ~30 percent, respectively, in twelve months (see Chart D)), would the firm’s failure have been easier to manage? Perhaps the FDIC and other regulators would have been able to use this time to identify impediments to a sale, remedy them, and be ready to sell the firm to one or more buyers over a weekend. In addition, this time could have allowed the FDIC and other regulators to evaluate the type of resolution that was best suited to the circumstances. For example, was a resolution of the bank and bankruptcy of the holding company most appropriate, or would invocation of the DFA’s Title II orderly liquidation authority have been useful?
Further, would SVB’s management and board have been spurred to act more swiftly to address the firm’s deteriorating condition if they were advised by the FDIC that the agency was beginning plans for the resolution and sale of the firm? Experience suggests that hearing that message from the FDIC is sobering for management and a board and stiffens the spine to take difficult, and perhaps previously hard to imagine, actions.
Another adjacent question is whether clear and strong early remediation requirements could have worked in tandem with earlier resolution preparedness. Of course, important questions would need to be considered, such as: What are the appropriate triggers for resolution preparedness? Which agency should be responsible for calling in the FDIC to begin that preparation?
All of the above policy considerations, and the others being considered by policymakers, are complex, and different solutions have associated pros and cons. Financial regulatory policy is sufficiently complex that no one proposal is ever likely to provide a magic bullet. The above, however, shows that the DFA had provisions designed to address situations like the one that transpired earlier in 2023, but those provisions were never implemented. To that end, this article aims to put forward for consideration targeted proposals for using those tools in a way that would address the vulnerabilities revealed in the spring of 2023 and would help forge a more resilient financial system—and, in doing so, hopefully avoid, as Tarullo said, an overreaction that could exacerbate broader structural problems facing the banking sector.