The crisis at Silicon Valley Bank has the industry speculating on how a collapse of a bank could have taken place under today’s regulatory environment. The question then quickly becomes: How are the regulators going to respond and what is this going to mean for banks going forward?
In the aftermath of the financial crisis of 2008, Congress passed the Dodd-Frank Act in 2010, imposing stricter regulations on banks with $50 billion or more in assets. A hallmark of the legislations was the implementation of stress testing related to credit losses, coupled with tougher capital requirements. But aspects of Dodd-Frank were rolled back in 2018 via The Economic Growth, Regulatory Relief, and Consumer Protection Act ("EGRRCPA")—which effectively relieved banks under $250 billion in assets of stricter stress-testing requirements. Fast forward to March 2023: two midsize banks collapsed in the span of three days.
Following these collapses, there has been speculation that the Federal Reserve will enact tougher rules and regulations for midsize banks as a near-term outcome from the fallout. And if history is any sort of teacher, it will happen. The question is, how tight will the rules get?
From what we’ve seen historically and what we are hearing in industry, the following outlines what we believe is headed banks’ way—and fast.
1. A push to repeal the 2018 Senate Bill which eased several regulatory requirements for banks with less than $250 BILLION of assets. The repeal of this bill would reinstate requirements like the following for banks with greater than $50 billion in assets:
2. Heightened requirements and stress testing—specifically around liquidity
Historically, stress testing has largely been credit-oriented—these tests were designed to address the credit-related problems in prior banking crises. However, the Fed’s severe stress test, which involves a hypothetical widespread recession, likely would not have captured the current rising interest rate scenario (one of the primary drivers of the SVB collapse). Going forward, it’s likely that the Fed will design required stress testing for scenarios impacting liquidity and addressing interest rate risk sensitivity to a higher degree. Reporting will also require banks to model what will happen if a large liquidity run were to occur.
3. More sophisticated and modeled approach to a run-off of deposits and interest rate sensitivity of HQLA (high quality liquid assets)
We speculate that the future of regulation will not only require banks to have enough liquid assets to cover deposits but also require the skillset for robust modeling around forecasting their balance sheets among a variety of interest rate scenarios and liquidity events—with the ability to act fast in executing a plan if these scenarios were to occur.
4. Tighter capital requirements or further disclosure around capital against long-term assets like US Treasury bonds
Following the 2008 crisis, regulators deemed seemingly safe assets such as sovereign bonds of various durations as preferred assets to hold for capital requirements. SVB’s overweighted concentration of investment in these “safe” assets ultimately created liquidity issues as rates changed and forced the bank to take a significant loss in the sale of the assets—signaling major balance sheet management issues. We expect the Fed may re-evaluate what they deem as “safe” assets for capital requirements, concentrations around certain long-term assets, and further disclosure around how unrealized securities losses may impact capital ratios.
5. More thorough exams and less tolerance from regulators
Silicon Valley Bank was on the Fed’s radar for more than a year, beginning in 2021 when a Fed review issued several MRAs—those of which were never remediated and led to the bank being in full supervisory review by 2022. The Fed has begun an investigation into the oversight of SVB and anticipates findings to be publicly released by May 1. We expect the outcome of this investigation to lead to more public scrutiny against the regulators and a tightening of the regulatory review environment—with less tolerance when weaknesses are identified.
Even if only a few of the suspected changes come to fruition, midsize banks still need to be preparing for a different regulatory environment in the near future and should be taking the following actions to prepare:
While we don’t know exactly what changes are coming by way of regulation, we do know these best practices will help you prepare—and will be crucial in the new environment. It’s equally as important to note that upskilling talent, models, and governance practices won’t mean anything unless the implications are well understood by top-of-the-house executives who have the power to make decisions for the health of the bank.