FINANCIAL BREAKDOWN - Two major California banks — Silicon Valley Bank and First Republic — have failed.
While some banking industry leaders have said the immediate crisis is over, stock prices for other regional banks, including PacWest and Western Alliance, fell this week.
It’s important for the financial system that people believe their money is safe, and banks failing in quick succession tends to erode confidence. So what’s a state to do?
“Unfortunately, there’s not a lot that the state regulator can do that would change the risk dynamics that occurred, crippling Silicon Valley Bank,” said Todd Baker, a senior fellow at the Richman Center for Business, Law, and Public Policy at Columbia University, who also testified to California lawmakers at a hearing about the collapse of Silicon Valley Bank.
The failures of Silicon Valley Bank and First Republic alone are not cause “for revolutionary changes in regulation,” said Ross Levine, a banking and finance professor at UC Berkeley’s Haas School of Business. Shareholders profited when the banks were taking on risk and were “wiped out” when interest rates went up, said Levine. But depositors at both banks saw very little disruption, Levine said.
“For example, I am a depositor at First Republic, and I have a mortgage from First Republic, and basically nothing changed from Friday to Monday,” he said. “So, at some level things worked okay.”
The type of risk that led to Silicon Valley Bank’s demise is “the most basic type of risk in banking,” said Levine, and it should have been “extremely obvious” to regulators. So, the main thing the situation calls for is not new rules but “competent regulatory agencies,” said Levine.
In California, the regulatory agency in question is the Department of Financial Protection and Innovation, formerly known as the Department of Business Oversight. What was it doing during all this? And should it have done more to prevent these crises?
For now, it’s not talking.
The department told CalMatters it’s too busy to make someone available to answer questions for at least “a few weeks.” The department will be issuing a report, likely by early next week, explaining its oversight and regulation of Silicon Valley Bank, including a look at how the state can “strengthen and update” its financial regulations. The department is led by Commissioner Clothilde Hewlett, who was appointed by Gov. Gavin Newsom.
Who regulates banks?
In general, state and federal regulators — either the Federal Reserve or the Federal Deposit Insurance Corporation depending on the bank — work together to supervise banks, which happens partly in the form of bank “exams.”
That’s where government workers go in and investigate a bank’s solvency, management and more. Examiners look at things like the types of loans the bank has been making, to make sure that the bank is likely to get almost all of that money back, but also things like whether the bank has good cybersecurity measures in place. If they find problems, they can take a range of actions to make the bank to resolve them — everything from a resolution that the bank’s board quietly adopts, to a public consent order or cease and desist, said Michael Stevens, president of the Graduate School of Banking at Colorado and a former bank examiner himself.
Different banks have different regulators depending on whether the bank has a state charter or a national charter — you can think of a bank charter as a kind of business license for a financial institution. Banks with a state charter are regulated by both California and the federal government. Silicon Valley Bank and First Republic both had state charters. Other banks, including Bank of America or JP Morgan Chase, have national charters and are regulated primarily by the federal government. Banks can choose which charter to seek. The different charters have pros and cons: Banks might choose to work with regulators who they believe have more expertise relevant to their business model; federal regulatory fees are more expensive.
California regulators were probably helping with examinations of First Republic and Silicon Valley Bank. “I’d be shocked if we end up learning that they were not involved,” said Stevens.
State regulators also played a role in First Republic and Silicon Valley Bank’s final hours. It was the Department of Financial Protection and Innovation that had the decision-making power to take possession of First Republic on Monday, which it likely did in close coordination with federal regulators. Then, they turned the bank over to the FDIC, which provides insurance for depositors. The FDIC promptly sold the bank to JP Morgan Chase, like a game of procedural hot potato.
What can regulators do?
There are two things state regulators could do, said Columbia’s Baker. One would be to require that state-chartered banks of a certain size have one or more people with risk management experience on the risk management committee of the bank’s board. Already, banks are required to have a financial expert on their audit committee, or publicly explain why they don’t.
“Silicon Valley Bank had no outside directors who had any experience, really, in the banking business, and certainly not in the risk management business,” he said.
Second, California regulators could put in place new rules surrounding bank executives’ compensation, so that they are rewarded for prudent management, and are not incentivized to pursue risky strategies. Executive pay at Silicon Valley Bank rose as bank leaders pursued profits by buying risky assets.
“Silicon Valley Bank had no outside directors who had any experience, really, in the banking business, and certainly not in the risk management business.”
Todd Baker, senior fellow at the Richman Center for Business, Law, and Public Policy at Columbia Universitynone
A major federal financial regulation passed in the wake of 2008’s Great Recession, the Dodd-Frank Act, directed federal agencies to make rules prohibiting executive compensation strategies that incentivized risky behavior, but those rules were never completed, said Baker.
States are disincentivized from putting in place rules that are drastically more restrictive or protective than federal rules because banks could theoretically sidestep those regulations by seeking a national bank charter instead.
But, said Baker, it’s hard to argue with making sure a bank’s board has expertise, and if California added new executive pay rules, it would probably need to be done in parallel with the federal government. Those moves wouldn’t be likely to drive California banks away, since the federal regulators might tighten rules at the same time, he said.
More clarity should come soon. In addition to the report coming from California’s Department of Financial Protection and Innovation, on Wednesday, May 10 the state Assembly and Senate banking committees will hold a joint hearing on Silicon Valley Bank’s failure, and where regulations and supervision fell short.
(Grace Gedye covers California’s economy for CalMatters where this article was first published.)