Supervision of regional banks in the United States and beyond 

Former Prudential Regulation Authority (PRA) and the Financial Conduct Authority (FCA) Senior Supervisor and Regulatory Consultant, Mete Feridun, draws insights from his supervisory and consulting experience.

The recent collapse of Silicon Valley Bank underscores the importance of the regulatory oversight of the regional banks in the United States (US), which are supervised by a combination of federal and state regulatory agencies. The specific agency responsible for overseeing a regional bank depends on the bank’s charter type and the state where it is headquartered.

The rollback of the Dodd-Frank Act in 2018 meant that many large banks in the US including Silicon Valley Bank (SVB) were no longer subject to stringent regulations such as capital and liquidity rules, enhanced risk management standards and stress testing requirements. However, as the collapse of the bank has shown, these standards are crucial for all banks, regardless of their size. 

The collapse of the bank emphasises the need for regulators to balance macroprudential and microprudential considerations when setting financial regulations to ensure financial stability, while at the same time protecting consumers and investors. As a Category IV bank with less than $250 billion in average total consolidated assets, less than $50 billion in average weighted short-term wholesale funding and less than $75 billion in cross-jurisdictional activity, the bank was not subject to the Basel Committee’s banking standards with respect to Interest Rate Risk in the Banking Book (IRRBB), Liquidity Coverage Ratio (LCR) and Net Stable Funding Ratio (NSFR). 

Easing oversight of small and regional lenders by lifting the threshold for being considered systemically important lowered their costs of complying with regulations. However, it has also weakened their regulatory oversight from a prudential standpoint. SVB’s failure was mainly a result of poor interest rate risk and liquidity risk management. Meaning a concentrated customer base of venture capital-backed companies withdrawing their short-term volatile deposits forced SVB to liquidate its long-dated mortgage-backed securities and US government bonds.  

In the absence of these requirements and lack of regulatory reporting of the relevant metrics due to a rollback of the Dodd-Frank Act, it was not easy to gauge how much SVB’s business model exposed the bank to interest rate risk. As a result, the bank’s supervisors missed signs of mounting liquidity and interest risk exposures. 

What’s next for the supervision of regional banks in the US? 

Regulators in the US would now be expected to reconsider their decision with respect to the application of IRRBB, LCR and NSFR, among other regulations, to non-systemic banks. These regulations are indeed important for all banks regardless of their size.

In particular, IRRBB is one of the key components of the Basel Pillar II framework and is crucial because excessive IRRBB can pose a significant risk to banks’ current capital base and/or future earnings. Likewise, LCR is important as it measures the emergency funding capacity of a bank over a 30-day survival horizon. NSFR, on the other hand, measures structural funding liquidity aiming to ensure that a bank’s long-term and illiquid assets are matched by an equivalent or higher amount of long-term and stable liabilities.  

The Federal Reserve (Fed) has recently announced a review of the supervisory failures that led to SVB’s collapse, with results due by early May. As a result of this review, it would not be unrealistic to expect the Fed to decide to subject all banks above $50 billion in assets to annual supervisory stress tests, meaning that these institutions will become subject to the stress capital buffer more quickly. This will require banks to reconsider their capital planning and long-term strategies, and even their business models.

Likewise, for these banks, the Fed would also be expected to restore the modified LCR and supervise their funding models and interest rate risks more stringently, as well as focusing the viability of their business models. This will require these banks to take a more proactive approach to managing liquidity and interest rate risks to comply with regulatory requirements. This involves implementing robust risk management policies, particularly to identify and assess IRRBB and liquidity positions and establishing appropriate limits, as well as maintaining adequate liquidity buffers. 

What’s next for the supervision of smaller banks in other jurisdictions? 

Basel standards apply to large and internationally active banks. However, most jurisdictions apply the Basel rules to their entire banking system, usually in a proportionate way. Regulatory relief passed in the US in 2018 raised the Dodd-Frank Wall Street Reform and Consumer Protection Act’s threshold for enhanced regulatory standards from $50 billion to $250 billion. As a result, the Fed approved lighter regulations for all but the largest banks in the US. This was based on the argument that large regional or medium-sized banks did not pose a systemic risk to the financial system. 

Recently, the Basel Committee on Banking Supervision met to discuss the financial stability risks of higher interest rates to the global banking system. It also reviewed regulatory and supervisory implications stemming from recent events, stressing the importance of robust regulatory standards, strong supervision and effective bank governance and risk management practices in a period of high inflation. The Committee cautioned that broad-based repricing in asset markets could bring additional risks and that banks and supervisors should be vigilant to the evolving outlook. In response, national regulators are expected to intensify their implementation of the remaining aspects of the Basel III framework.  

SVB’s collapse is an important reminder that Basel liquidity and interest rate standards should be applied to all banks regardless of their size but in a proportionate fashion. It also presents an important policy lesson that inflation and any relevant implications with respect to macroprudential and microprudential implications should always be taken into account when setting new regulations. 

How will persistent inflation and further interest hikes affect financial regulation globally? 

The collapse of SVB is also a timely reminder of why inflation should matter when it comes to the regulation and supervision of financial institutions, highlighting the importance of implementing regulatory standards and metrics that take inflation into account, regardless of the size of the bank. 

Inflation can affect different types of financial institutions in various ways, and it poses different types of risks. For instance, at the very basic level, it can increase the default risk of borrowers for banks, while increasing the cost of claims for investment firms. It can also reduce the real returns on investments for investment firms. In addition, inflation usually results in Central Banks increasing interest rates, which has direct implications for prudential and financial conduct regulation. 

In the wake of SVB’s failure, the Fed would be expected to consider toughening the rules for midsized banks and intensify its supervision on interest rate risk, market risk, liquidity risk, as well as business model viability and financial conduct. On the other hand, the regulator would also be expected to have a more careful monetary policy stance, bearing in mind that hiking interest rates further to bring down inflation could reduce the value of bond holdings of financial institutions and increase funding risks, resulting in financial stability risks. 

Finally, inflation is expected to affect conduct risk regulation as well. This is because an increase in the level of prices can increase the risk of harm to consumers who are already facing the cost of living challenges. The pandemic recovery and the Ukraine-Russia conflict could result in further rising in commodity and agricultural prices, which means that inflation is likely to hit the most vulnerable consumers the hardest. On the other hand, households could become more vulnerable to income shocks from unemployment and interest rate rises from today’s low levels. They could also be attracted to higher returns but also higher risk assets. These would require financial regulators to ensure that firms act in their customers’ interests. 

Therefore, inflation can have significant implications for prudential and financial conduct regulation and supervision, particularly with respect to interest rate risk, market risk, liquidity risk, and business model viability. Hence, the future of financial regulation is likely to place greater emphasis on measures to manage inflation-related risks and ensure the stability of financial institutions. As regulators worldwide consider toughening the rules, particularly for smaller banks, they will need to balance the need for regulatory oversight with the potential risks associated with raising interest rates to combat inflation. 

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