WASHINGTON—For 15 years, regulators and legislators have assumed the biggest risks to the financial system came from a handful of “too big to fail” banks.
This month’s failure of Silicon Valley Bank and Signature Bank—and last week’s bank-led rescue of a third lender,
—suggests that focus on size may have blinded officials to the threat posed by smaller lenders, observers and former regulators say.
Since the 2008 crisis, the Federal Reserve saved its most significant tests for the largest global banks. In 2018, Congress moved to exempt many midsize lenders from the top level of scrutiny, signaling some regulations should apply to banks with more than $250 billion in assets, up from an earlier $50 billion threshold.
Now, recent events are calling that calibration into question. “They focused on a bunch of different things, and this is just one that they took their eyes off of that caused this crisis,” said Todd Phillips, a former attorney at the Federal Deposit Insurance Corp.
Policy makers took extraordinary actions in the wake of the failures of
and Signature out of fear their troubles could spark runs on multiple other, similarly situated lenders. That was a powerful reminder that small firms can fail as a group, with consequences as serious as one of the largest institutions failing.
The Fed was already in the process of reviewing its rules, led by
Michael Barr,
the central bank’s pointman on banking supervision. It is incorporating the collapses of SVB and Signature into that effort. Changes could include extending to more banks some restrictions that currently only apply to the biggest Wall Street firms, such as requirements that they show unrealized gains and losses on some securities in their regulatory capital.
Mr. Barr has said in the past that risks can aggregate across the financial system, including from institutions of a variety of sizes and types.
Martin Gruenberg,
the head of the FDIC, has warned banks face “significant downside risks” from rising interest rates designed to combat the effects of inflation.
The 2010 Dodd-Frank law imposed a series of new rules, including higher capital requirements on banks and requirements that they plan for their own failure. The Fed has long said it tailored its rules, meaning that regional firms were subject to less onerous rules than the biggest banks.
But many midsize banks said they were saddled with burdensome and unnecessary compliance costs that weren’t proportionate to the risk they posed.
President Barack Obama in 2010 with Sen. Christopher Dodd and Rep. Barney Frank, co-sponsors of the Dodd-Frank Wall Street Reform and Consumer Protection Act.
Photo:
larry downing / reuters
Harris Simmons,
the chairman and chief executive of
at the time just above the $50 billion threshold, told Senate lawmakers in 2017 that his bank didn’t feature “the type of systemic risk that is characteristic of the very largest banking organizations.”
The next year, lawmakers passed legislation that raised a key regulatory threshold to $250 billion in assets. The move more than halved the number of banks designated as systemically important and, as a result, subject to heightened Federal Reserve oversight.
“The 2018 legislation was built on the dubious premise that banks with less than $250 billion in assets are not, as a group, systemically important,” said Dan Tarullo, a former Fed governor who was the central bank’s point person on regulation following the financial crisis.
James Abbott, a spokesman for Zions, said the bank’s internal stress testing and diverse customer base has ensured its stability. While the firm believes it doesn’t feature the same degree of riskiness as the largest banks, he said, “it is also clear that a bank that has extreme concentrations of any type of asset or liability may create ripple effects through the system.”
Some observers say the 2018 legislation marked a cultural shift that led to a lighter regulatory touch for smaller and midsize banks.
During that same period, the Fed revamped some rules, led by
Randal Quarles,
a Republican who served as the central bank’s pointman on banking regulation from 2017 to 2021.
Mr. Quarles lowered regulatory costs for U.S. lenders with less than $700 billion in assets. He also worked to revamp big bank stress tests, an annual examination to ensure banks can survive a hypothetical crisis, and took steps to change the tone the Fed took with bankers behind the scenes, he said at the time.
Randal Quarles lowered regulatory costs for U.S. lenders with less than $700 billion in assets.
Photo:
Zach Gibson/Bloomberg News
Mr. Quarles’s regulatory moves at times frustrated Republicans who had been seeking a stronger rollback of the postcrisis rulebook during the Trump administration.
At the same time, his moves sparked strong criticism from some Democrats.
Lael Brainard,
a former Fed governor and now the president’s top economic adviser, frequently dissented from central-bank decisions to ease bank regulations. Ms. Brainard and others said the Fed moved beyond what had been required by Congress, weakening core safeguards against vulnerabilities that led to the 2008 crisis.
Mr. Quarles has said his changes clarified or better calibrated the central bank’s rules to reflect various sized firms’ risks to the financial system. He said his changes weren’t relevant to the failure of SVB.
It was “surgery…refining the regulations to ensure that they were as efficient as possible without creating additional risk,” Mr. Quarles said in an interview. Supervisory changes under his watch were focused on due process—essentially being more fair to banks—not an encouragement for examiners to change the substance of their decisions, he said.
Other critics, including congressional Republicans, have said the problem wasn’t with the rules but with how banking supervisors enforced them. SVB was overseen by examiners at the San Francisco Fed and at the California Department of Financial Protection and Innovation.
Representatives of the San Francisco Fed didn’t respond to requests for comment. A spokesman for the California state regulator said: “We are actively investigating the situation and conducting a thorough review to ensure the Department is doing everything we can to protect Californians.”
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In the past when banks have failed and were regulated by multiple entities, “each of them pointed fingers at each, leaving it unclear who was at fault,” said
Aaron Klein,
a senior fellow at the Brookings Institution. “But the Fed regulated SVB head to toe.”
Mr. Quarles said the current situation has shown that the Fed’s rules might need to change. He pointed to an assumption embedded in the central bank’s rulebook that customers with uninsured deposits—or those above the $250,000 deposit insurance cap—are “stickier,” or less likely to run in a crisis.
The majority of SVB’s deposits were uninsured, and customers tried to withdraw $42 billion—about a quarter of the bank’s total deposits—the day before its March 10 failure.
“Those assumptions, while reasonable given long experience, have turned out to be wrong,” Mr. Quarles said. “The question is: Were they wrong because of this particular customer base or are they going to be different for everyone in the future?”
Write to Andrew Ackerman at andrew.ackerman@wsj.com
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