The Fed has the rules to regulate banks: Why weren’t they enforced?

The fallout of Silicon Valley Bank (SVB) exposed serious problems in how federal and state regulators do their jobs. That is, they have the tools and rules in place to do their jobs, but they are not using them very well.

The Biden administration is blaming insufficient regulation. The Federal Reserve Bank of San Francisco is blaming Fed Vice Chair for Supervision Michael Barr. Barr is pointing the finger at his predecessor, former Vice Chair Randal Quarles, and 2018 efforts to tailor — or right-size — regulation. A recent congressional report concluded that tailoring was not the cause of SVB’s failure. 

In classic Washington fashion, everyone is pointing fingers at someone else, and the danger is that the private sector may end up paying the price for this latest blame game.

Getting to the true cause of the SVB fallout should be somber business because the wrong “solution” could prove harmful to small businesses. Misplaced regulation imposed on blameless private sector players — in this case responsibly run regional banks — would squeeze capital availability more tightly, which would then generate much more painful and widespread outcomes than the actual failures of a few mismanaged banks accelerated and exacerbated by conditions largely created by the Federal Reserve.  

The Government Accountability Office (GAO) and the Federal Reserve’s Office of the Inspector General noted the shortcomings of regulators (not regulations) as early as 2011. Attempts to avoid responsibility or exploit this current crisis by mandating higher capital and liquidity requirements for all banks distract from the true problem and downplay the uncomfortable truth: The Fed’s been asleep at the wheel for more than a decade.

In its preliminary report released April 28, the Federal Reserve highlighted that “both banks were slow to mitigate the problems the regulators identified, and regulators did not escalate supervisory actions in time to prevent the failures.” It also cited a GAO report published in 2015 on previous bank failures. That report noted, “although regulators often identified risky practices early in previous banking crises, the regulatory process was not always effective or timely in correcting the underlying problems before the banks failed.”

Obviously, these findings do not excuse the faults of SVB’s management. The bank made critical mistakes leading up to its collapse this past March. However, reports make it abundantly clear that the Federal Reserve was busy occupying itself with “check-the-box” exercises rather than addressing underlying problems.

For example, SVB neglected to fill the chief risk officer position for eight months. The Fed did nothing about it. The Fed was aware of risk management issues at SVB, yet the bank was allowed to continue operating with significant interest rate and liquidity risks. There were six citations issued by the Fed, and regulators had access to the results of SVB’s internal liquidity stress tests but failed to act. These examples only scratch the surface of oversight deficiencies that have been outlined in the report.

Given these findings, the fact that the Fed — not an independent third party — is reviewing its internal actions is quite concerning.

To ensure that political agendas and self-preservation at any cost do not get in the way of appropriate solutions and governance, Congress should call for an independent review of the Fed’s actions leading up to the run on SVB. An independent third-party review would ensure an unbiased investigation while precluding any conflicts of interest.

Allowing a whitewashing of what could have been done to mitigate SVB’s crash will not be helpful. Moreover, it will likely lead to regulatory punishment for banks that are responsibly serving their customers and investors. Burdening an already highly regulated sector will only result in…