Federal Reserve criticized for missing red flags before SVB collapsed

WASHINGTON (AP) – The Federal Reserve is facing sharp criticism for missing what observers say were clear signs that Silicon Valley Bank was at high risk of collapsing into the second-largest bank failure in U.S. history.

Critics point to many red flags surrounding the bank, including its rapid growth since the pandemic, its unusually high level of uninsured deposits and its many investments in long-term government bonds and mortgage-backed securities, which fell in value as interest rates rose.

“It is inexplicable how Federal Reserve regulators could not see this clear threat to the safety and soundness of the banks and to financial stability,”[ads1]; said Dennis Kelleher, CEO of Better Markets, an advocacy group.

Wall Street traders and industry analysts “have been screaming publicly about these issues for many, many months going back to last fall,” Kelleher added.

The Fed was the primary federal supervisor for the Santa Clara, Calif.-based bank that failed last week. The bank was also overseen by the California Department of Financial Protection and Innovation.

Now the consequences of the fall of Silicon Valley Bank, along with New York-based Signature Bankwhich failed over the weekend, complicating the Fed’s upcoming decisions about how high to raise the benchmark interest rate in the fight against chronically high inflation.

Many economists say the central bank would likely have raised interest rates by an aggressive half-point at its meeting next week, which would represent a step up in the inflation battle, after the Fed implemented a quarter-point hike in February. The percentage is currently around 4.6%, the highest level in 15 years.

Last week, many economists suggested that the Fed’s policymakers would raise their estimate for future interest rates next week to 5.6%. Now it is suddenly unclear how many additional interest rate increases the Fed will estimate.

With the collapse of the two major banks fueling anxiety about other regional banks, the Fed may focus more on boosting confidence in the financial system than on its long-term efforts to tame inflation.

The latest government report on inflation, released Tuesday, shows rate hikes remain far higher than the Fed prefers, putting Chairman Jerome Powell in a tougher spot. Core prices, which exclude volatile food and energy costs and are seen as a better gauge of long-term inflation, rose 0.5% from January to February – the most since September. That is far higher than is consistent with the Fed’s annual target of 2%.

“Absent the fallout from the bank failure, it might have been a close call, but I think it would have tipped them toward a half point (rate hike) at this meeting,” said Kathy Bostjancic, chief economist at Nationwide.

On Monday, Powell announced that the Fed would review its oversight of Silicon Valley to understand how it could have better managed the regulation of the bank. The review will be conducted by Michael Barr, the Fed deputy chairman who oversees banking supervision, and will be released on May 1.

A spokesman for the Federal Reserve declined to comment further.

Elizabeth Smith, a spokeswoman for the California Department of Financial Protection and Innovation, said, “We are actively investigating the situation and conducting a thorough review to ensure the department is doing everything we can to protect Californians.”

By all accounts, Silicon Valley was an unusual bank. Management took excessive risks by buying billions of dollars of mortgage-backed securities and government bonds when interest rates were low. As the Fed continually raised interest rates to fight inflation, leading to higher interest rates on Treasurys, the value of Silicon Valley Bank’s bonds steadily lost value.

Most banks would have sought to make other investments to offset this risk. The Fed could also have forced the bank to raise additional capital.

The bank had grown rapidly. Its assets quadrupled in five years to $209 billion, making it the 16th largest bank in the country. And about 94% of deposits were uninsured because they exceeded the Federal Deposit Insurance Corporation’s $250,000 insurance cap.

That percentage was the second highest among banks with more than $50 billion in assets, according to ratings agency S&P. Signature had the fourth highest percentage of uninsured deposits.

Such an unusually high share made Silicon Valley Bank highly susceptible to the risk that depositors would quickly withdraw their money at the first sign of trouble – a classic bank run – which is exactly what happened.

“I’m at a loss for words to understand how this business model was deemed acceptable by their regulators,” said Aaron Klein, a former congressional aide now at the Brookings Institution who worked on the Dodd-Frank banking regulation law enacted after the 2008 financial crisis.

The bank failures are likely to color an upcoming Fed review of rules that dictate how much money big banks must hold in reserves. Barr said last year that he wanted to conduct a “holistic” review of those requirements, raising concerns in the banking industry that the review would lead to rules forcing banks to hold more reserves, which would limit their ability to lend .

Many critics also point to a 2018 law that softened banking regulations in ways that helped Silicon Valley fail. Pushed by the Trump administration with bipartisan support in Congress, the law exempted banks with $100 billion to $250 billion in assets — the size of Silicon Valley — from requirements that included regular examinations of how they would fare in tough economic times, known as “stress tests.” “

Silicon Valley CEO Greg Becker had lobbied Congress in support of rolling back the regulations, and he sat on the board of the Federal Reserve Bank of San Francisco until the day of the collapse.

Sen. Elizabeth Warren, a Democrat from Massachusetts, questioned him about his lobbying in a letter released Tuesday.

“These rules were designed to protect our banking system and economy from the negligence of bank executives like yourself — and their rollback, along with appalling risk management policies at your bank, have been implicated as the main causes of its failure,” Warren’s letter said.

The 2018 law also gave the Fed more discretion in banking supervision. The central bank then voted to further reduce regulation for banks the size of Silicon Valley.

In October 2019, the Fed voted to effectively reduce the capital banks had to hold in reserve.

Kelleher said the Fed could still have pushed Silicon Valley Bank to take steps to protect itself.

“Nothing in that law in any way prevented the Federal Reserve supervisors from doing their job,” Kelleher said.

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AP Economics writer Paul Wiseman contributed to this report.