A Big Question for the Fed: What Went Wrong With Bank Oversight?

WASHINGTON — Jerome H. Powell is likely to face more than the typical questions about the Federal Reserve’s latest interest rate decision on Wednesday. The central bank chair will almost certainly be grilled about how and why his institution failed to stop problems at Silicon Valley Bank before it was too late.

The collapse of Silicon Valley Bank, the largest bank failure since 2008, has prompted intense scrutiny of the Fed’s oversight as many wonder why the bank’s vulnerabilities were not promptly fixed.

Many of the bank’s weaknesses seem, in hindsight, as if they should have been obvious to its regulators at the Fed. An outsize share of its deposits were over the $250,000 insurance limit, making depositors more likely to flee at the first sign of trouble and leaving the bank susceptible to runs.

The bank had also grown rapidly, and its depositors were heavily concentrated in the volatile technology industry. It held a lot of long-term bonds, which lose market value when the Fed raises interest rates, as it has over the past year. Still, the bank had done little to protect itself against an increase in borrowing costs.

Governors at the Fed Board in Washington allowed the bank to merge with a small bank in June 2021, after the first warning signs had surfaced and just months before Fed supervisors in San Francisco began to issue a volley of warnings about the company’s poor risk management. In 2022, the Fed repeatedly flagged problems to executives and barred the firm from growing through acquisition.

But the Fed did not react decisively enough to prevent the bank’s problems from leading to its demise, a failure that has sent destabilizing jitters through the rest of the American financial system.

Mr. Powell is likely to face several questions: What went wrong? Did examiners at the Federal Reserve Bank of San Francisco fail to flag risks aggressively enough? Did the Fed’s board fail to follow up on noted weaknesses? Or was the lapse indicative of a broader problem — that is, did existing rules and oversight make it difficult to quickly address important flaws?

The Fed has already announced a review of the bank’s collapse, with the inquiry set to conclude by May 1.

“The events surrounding Silicon Valley Bank demand a thorough, transparent and swift review by the Federal Reserve,” Mr. Powell said in a statement last week.

Congress is also planning to dig into what went awry, with committees in both the Senate and House planning hearings next week on the recent bank collapses.

Investors and experts in financial regulation have been racing to figure out what went wrong even before the conclusion of those inquiries. Silicon Valley Bank had a business model that made it unusually vulnerable to a wave of rapid withdrawals. Even so, if its demise is evidence of a blind spot in how banks are overseen, then weaknesses could be more broadly spread throughout the banking system.

“The SVB failure has not only gotten people asking the question, ‘Gee, are other banks in similar enough circumstances that they could be in danger?’” said Daniel Tarullo, a former Fed governor who oversaw post-2008 regulation and who is now a professor at Harvard. “It’s also been a wake-up call to look at banks generally.”

Politicians have already begun assigning blame. Some Democrats have blasted regulatory rollbacks passed in 2018, and put into effect by the Fed in 2019, for weakening the system, and they have pointed a finger at Mr. Powell for failing to stop them.

At the same time, a few Republicans have tried to lay the blame firmly with the San Francisco Fed, arguing that the blowup shouldn’t necessarily lead to more onerous regulation.

“There’s a lot, obviously, that we don’t know yet,” said Lev Menand, who studies money and banking at Columbia Law School.

Understanding what happened at Silicon Valley Bank requires understanding how bank oversight works — and particularly how it has evolved since the late 2010s.

Different American regulators oversee different banks, but the Federal Reserve has jurisdiction over large bank holding companies, state member banks, foreign banks operating in the United States and some regional banks.

The Fed’s Board of Governors, which is made up of seven politically-appointed officials, is responsible for shaping regulations and setting out the basic rules that govern bank supervision. But day-to-day monitoring of banks is carried out by supervisors at the Fed’s 12 regional banks.

Before the 2008 financial crisis, those quasi-private regional branches had a lot of discretion when it came to bank oversight. But in the wake of that meltdown, the supervision came to be run more centrally out of Washington. The Dodd-Frank law carved out a new role for one of the Fed’s governors — vice chair for bank supervision — giving the central bank’s examiners around the country a more clear-cut and formal boss.

The idea was to make bank oversight both stricter and more fail-safe. Dodd-Frank also ramped up capital and liquidity requirements, forcing many banks to police their risk and keep easy-to-tap money on hand, and it instituted regular stress tests that served as health checkups for the biggest banks.

But by the time the Fed’s first official vice chair for supervision was confirmed in 2017, the regulatory pendulum had swung back in the opposite direction. Randal K. Quarles, a pick by President Donald J. Trump, came into office pledging to pare back bank rules that many Republicans, in particular, deemed too onerous.

“After the first wave of reform, and with the benefit of experience and reflection, some refinements will undoubtedly be in order,” Mr. Quarles said at his confirmation hearing.

Some of those refinements came straight from Congress. In 2018, Republicans and many Democrats passed a law that lightened regulations on small banks. But the law did more than just relieve community banks. It also lifted the floor at which many strict bank rules kicked in, to $250 billion in assets.

Mr. Quarles pushed the relief even further. For instance, banks with between $250 billion and $700 billion in assets were allowed to opt out of counting unrealized losses — the change in the market value of older bonds — from their capital calculations. While that would not have mattered in SVB’s case, given that the bank was beneath the $250 billion threshold, some Fed officials at the time warned that it and other changes could leave the banking system more vulnerable.

Lael Brainard, who was then a Fed governor and now directs the National Economic Council, warned in a dissent that “distress of even noncomplex large banking organizations generally manifests first in liquidity stress and quickly transmits contagion through the financial system.”

Other Fed officials, including Mr. Powell, voted for the changes.

It is unclear how much any of the adjustments mattered in the case of Silicon Valley Bank. The bank most likely would have faced a stress test earlier had those changes not gone into place. Still, those annual assessments have rarely tested for the interest rate risks that undid the firm.

Some have cited another of Mr. Quarles’s changes as potentially more consequential: He tried to make everyday bank supervision more predictable, leaving less of it up to individual examiners.

While Mr. Quarles has said he failed to change supervision much, people both within and outside the Fed system have suggested that his mere shift in emphasis may have mattered.

“That ethos might have been why supervisors felt like they couldn’t do more here,” said Peter Conti-Brown, an expert in financial regulation and a Fed historian at the University of Pennsylvania.

Mr. Quarles, who stepped down from his position in October 2021, pushed back on the contention that he had made changes to supervision that allowed weaknesses to grow at Silicon Valley Bank.

“I gave up the reins as vice chair for supervision a year and a half ago,” he said.

Fed supervisors began to flag Silicon Valley Bank’s problems in earnest in the fall of 2021, after the bank had grown and faced a more extensive review. That process resulted in six citations, often called “matters requiring attention,” which are meant to spur executives to act. Additional deficiencies were identified in early 2023, shortly before the failure.

A critical question, said Mr. Menand, is “were the supervisors content to spot problems and wait for them to be remediated?”

But he noted that when it came to “bringing out the big guns” — backing up stern warnings with legal enforcement — supervisors must, in many ways, rely on the Fed Board in Washington. If bank leadership thought the Board was unlikely to react to their deficiencies, it might have made them less keen to fix the problems.

Banks often have issues flagged by their supervisors, and those concerns are not always immediately resolved. In a rating system that tests for capital planning, liquidity risk management and governance and controls, consistently only about half of large banking institutions score as “satisfactory” across all three.

But in the wake of Silicon Valley Bank’s collapse, how bank oversight is performed at the Fed could be in for some changes. Michael Barr, who President Biden appointed as the Fed’s vice chair for supervision, was carrying out a “holistic review” of bank oversight even before the failures. Either that or the review of what happened at SVB is now more likely to end in tighter controls, particularly at large regional banks.

“There’s a lot of buck-passing,” said Mr. Conti-Brown. “I think it was likely a joint failure, and that’s part of the design of the system.”