What happens to a financial institution operating at the intersection of rapid growth, rising interest rates, and an undiversified customer base that’s banking up massive, uninsured deposits? Ideally, the institution’s top executives and board of directors would avoid such a risk trifecta by continually running stress scenarios on its business model and questioning the fundamental assumptions on which that model is built.
What’s happening today is far from ideal, as risk ripples out from two collapsing American banks. Yet it provides object lessons in what could’ve, should’ve, and can now be done going forward.
This Q&A captures insights and lessons-learned from Bill Dudley, former President and Chief Executive Officer of the Federal Reserve Bank of New York, current Board Member at UBS and Treliant. He recently spoke with Treliant CEO David Samuels.
David Samuels: The collapse of Silicon Valley Bank and Signature Bank, along with the recent bailout of First Republic Bank, raise questions about how the banking system is being regulated/supervised.
Bill Dudley: Well, to begin with, I would first put the responsibility for these problems on the banks. It’s a mistake to blame the supervisors and regulators for the fact that Silicon Valley Bank took a lot of interest rate risk in its portfolio, and then didn’t raise capital in a timely way. That said, we don’t really know all the details about the relationship Silicon Valley Bank has had with its regulators.
When I look back historically at supervision and regulation, I do think that supervisors often identify issues but don’t escalate them fast enough or with enough consequences for the bank to take it seriously and remedy in a timely way. So I’m guessing that the supervisors and regulators were pretty aware of a lot of these issues. But, you know, maybe they should have responded more forcefully.
It could very well turn out that the management of the Silicon Valley Bank did not remedy their shortcomings in a timely way. In the fullness of time, I would not be at all surprised if Silicon Valley Bank was cited for some of these potential problems.
DS: What if anything needs to change, and should there still remain a difference in approach in supervision between regional vs. large-sized institutions?
BD: I think there’s going to be a change. Remember that legislation in 2018 raised the asset ceiling for regulating banks as systemically important financial institutions (SIFIs) from $50 billion to $250 billion. And the Fed was given the discretion of dropping it back down to $100 billion, if they chose to, but they didn’t. Now, both of those changes are going to be revisited. I don’t know what’s going to happen on the legislative front. There will be a lot of arguing about whether the asset threshold should be lowered back down. But I would be very surprised if the Federal Reserve didn’t use its discretion under existing legislation to move its threshold back down to $100 billion.
The bottom line is that, if you’re a bank with assets between $100 billion and $250 billion, I would be starting to prepare for a tougher regulatory regime in terms of stress testing and a number of other things.
DS: The markets seem to be extrapolating what occurred with these banks to the rest of the industry, is that fair, and should we be concerned?
BD: These banks that have gotten into great difficulty have two features that are not really that broadly shared across the banking industry—notably, because the two features are occurring together.
No. 1, uninsured deposits tend to be a very high proportion of the liability on their balance sheets. And No. 2, they have large mark-to-market losses, typically more embedded in their hold-to-maturity portfolios. So people basically started to worry: Are these banks potentially in trouble?
We’ve seen this before. Say that there’s even a scant suggestion that a bank might turn out to be in difficulty. If you’re an uninsured depositor, and you have deposits at the bank that are not tied to your daily need for deposits to do your business—for example, to pay your payroll—you’re going to move those deposits at the first sign of trouble. This is one of the fundamental instabilities about banking: If everybody believes a bank is sound, it typically will be sound and stable because the deposits will stay there. But if people start to worry about whether their bank is sound or not, the deposits will leave, and no bank has the ability to turn all of its assets into cash instantaneously.
The thing that was so striking and new about Silicon Valley Bank was the speed of the run. Basically, in less than two days, it went from having enough liquidity to having none.
So what’s going to happen now is that banks with a lot of uninsured deposits are going to be very closely scrutinized. Banks that have large mark-to-market losses on their portfolio are going to be heavily scrutinized.
And are we going to see regulators do something temporary to broaden out deposit insurance across a larger set of institutions? For Signature Bank and Silicon Valley Bank, the FDIC invoked its systemic risk exception, so their deposits are protected. That puts a lot of pressure on the government to protect the uninsured deposits of other banks more generally. Otherwise, it could be seen as arbitrary and discriminatory.
But the problem with broadening insurance is that if you protect all depositors, then banks can get deposits pretty easily, engage in bad practices, and potentially end up costing the banking industry quite a bit of money. Remember that we already ran that experiment with the savings and loan (S&L) crisis, where S&Ls were allowed to operate with very deficient capital. They attracted deposits—in that case, insured deposits. Then, they went out and used those insured deposits to take a tremendous amount of risk, in a sort of “heads we win, tails you lose” attitude toward the U.S. government.
So it’s very difficult to know what to do right now about uninsured deposits. Maybe there’s a middle ground here—that you provide insurance for all deposits, as long as a bank is not growing really fast or isn’t really concentrated in terms of its business mix. That could at least apply a brake on banks that want to go off and do risky things in the future.
DS: To what extent did the crypto side of Signature Bank play a role when the NY Department of Financial Services stepped in?
BD: While I can’t read the mind of the head of the DFS, obviously, regulators do take a pretty cautionary view about crypto activities. So it could have been a contributing factor, but I think Signature Bank is also noteworthy for the fact that it was growing very rapidly with uninsured deposits. Those two problems are probably more germane.
DS: What are some of the potential emerging issues for both regional and large-sized banks, and how do they differ?
BD: Right now they differ, because the very largest banks are basically deemed as more secure than the smaller regional banks. And so money is basically flowing from the regional banks to the very largest banks. The largest banks now are becoming even more awash in deposits, as the regional banks are not. This probably means that the regional banks are going to have to pay a little bit more in interest for deposits. And the largest banks are not going to have to be as aggressive in terms of the rates that they pay depositors.
There’s going to be a bit of a windfall for the very largest banks. They’re just not going to have to compete very aggressively for deposits, because the deposits are flowing their way because of their greater perceived sturdiness.
DS: Was it the right call for the government to ensure deposits beyond the $250,000 threshold, and what are the ramifications of such a decision?
BD: It’s too soon to say. Regulators did what they did to stop the run. But the government didn’t say that it’s ensuring deposits beyond the $250,000 threshold for all banks—just Silicon Valley Bank and Signature Bank.
Still, it raised a question: Is this special provision going to be generalized to other banks, if they get into difficulty? The regulators didn’t really close off the risk to uninsured depositors elsewhere. But they probably reduced the risk a little bit by giving the sense that if they were going to guarantee uninsured deposits in these two cases, they presumably would in similar cases in the future.
DS: How did we get here, as some are blaming the decisions taken by the last administration to roll back aspects of the Dodd-Frank Act?
BD: It’s not clear that if we’d kept the lower threshold for bank regulations, we would have necessarily avoided this. But it would have given us a better chance of avoiding this.
You also have to consider interest rates. We’re coming out of a very long period in which interest rates have been very, very low. That environment encouraged banks to take more interest rate risk, to essentially stretch for yield, to try to boost earnings. Stretching for yield worked fine, as long as the Federal Reserve kept short-term interest rates very low. But once the Fed started to tighten very rapidly, in 2022, stretching for yield turned out to be a bad decision.
So, I think the increase in the asset threshold was a factor. But I also think the long period of very low interest rates was a factor behind this.
DS: What is your view on the tiering effect of the Fed, with different regulatory regimes for different size institutions. Should there be more homogenization in supervision?
BD: Well, the idea of proportionality makes some sense in some ways. The idea is that the government wants to pay the most attention to those institutions that, if they failed violently, would produce the worst consequences for the whole financial system. If a small credit union or small community bank fails, it’s not likely to have huge ripple effects in the broader financial system, and there’s not likely to be much consequence for the national economy, even though there would be consequences locally.
It’s also important to recognize that if you take the same set of regulatory requirements that you apply to the biggest banks and apply it to smaller banks, that regulatory burden would be disproportionately high. Smaller banks don’t have as much in assets and earnings to spread across the cost of actually complying with those regulations.
What’s not so sensible is allowing banks to grow very, very fast in very concentrated spaces with lots of uninsured deposits. Those three ingredients typically get you into difficulty.
You can go back through history and look at the kinds of banks that have typically failed. It’s usually banks that have a special new model. They’ve grown their assets very, very rapidly. And the model turned out to be flawed. So, paying close attention to banks that are growing fast is a really good place to start, in terms of regulation.
DS: The government has essentially guaranteed the uninsured deposits held at systemically important banks. What are the key policy issues here relating to “too big to fail,” and should this guarantee be extended to regional banks for greater industry stability?
BD: Well, it’s interesting, the government has not actually said that they’ve guaranteed the deposits at the systemically important banks. And in fact, they’ve set up a whole regulatory regime that basically implies that large depositors aren’t supposed to be protected.
If a large bank were to get into difficulty, it’s actually supposed to go to resolution. That is, if no buyer can be found, the FDIC is supposed to take over the bank and liquidate the various pieces of it. Now, whether that would actually happen in practice is a good question. We’re not going to know that until we actually get right to that point.
There’s another reason why the current situation has been more difficult than people anticipated. There are some significant constraints on the willingness of the largest banks to buy smaller banks. That’s because when the larger banks bought some of the smaller banks and securities firms back in the financial crisis of 2008, they discovered that they were not only buying the banks, but also those banks’ legal liabilities, which turned out to be extraordinarily high. This has made the largest banks reluctant to do this again, at least not without lengthy due diligence.
Another reason large banks have been more reluctant to step forward is that the government has made it clear that it doesn’t want big banks to get bigger. At the same time, as a large bank gets bigger and more complex, it can be pushed into a bigger SIFI category, in terms of its capital requirements. Conceivably, as it gets bigger and more complex, it might be moved up, for example, from a capital surcharge of 2% to a capital surcharge of 2.5% across its entire operation.
In other words, the marginal capital charge of buying a bank that’s going to push you up into a bigger SIFI bucket is really, really high. So the big banks don’t have the appetite to buy smaller banks this time. And that makes it more difficult for the government to figure out how to deal with these particular institutions.
DS: When the news broke about Signature Bank, it was referred to it as a systemically important bank, yet its assets fall below the typical threshold for that designation. What’s the thinking?
BD: It might be because Signature wasn’t the only bank that was in difficulty. Personally, I think this idea that size determines whether you’re systemically important is probably not the only criteria. If you’re a bank that’s in difficulty, and there are a lot of other banks that look exactly like you, your failure could actually be systemic.
Think about when the thrift industry got into great difficulty. A lot of the thrifts weren’t that big, but they were all in the same situation. And so the pressure on the industry was across all the institutions. So, I think smaller banks can be systemically important if they get into difficulty, and a lot of other banks look exactly like them or look similar to them.
DS: Could you talk about stress testing (CCAR and DFAST). Are these the right types of tests that financial institutions should continue to perform?
BD: As I understand it, the most recent stress tests assumed the continuation of a very low interest rate environment—not one in which the Fed rapidly raised rates. So I’d say that if the aspects of a stress test are on point, in terms of what’s actually happening in the economy, then stress tests are going to be pretty valuable. But if a stress test is stressing something totally different than what’s actually going on, then it’s not going to really capture what you’re trying to capture.
The big surprise last year, frankly, was interest rates. At the beginning of 2022, the Fed forecast that its federal funds rate for the end of the year would be around 90 basis points. It turned out to be over 4.5%. So that was where the stress came from. And obviously, the rise in short-term rates then drove up long-term rates so that banks suffered losses on their longer-maturity investments.
It would have been nice if that had been what the stress test captured. But that’s the problem. You don’t really know exactly where the stress is going to come from. So, I think it’s really important to stress your institution in many different ways.
This is why it’s really important to have a strong board that challenges the C-suite officers. A board that raises what-if scenarios and asks, “If X happens, are we going to be okay?” Some banks grow really fast, very successfully, and they probably become overconfident. They start to believe their own media relations package and think they’re invulnerable.
We’ve just seen that. It seems to me that Silicon Valley Bank had a great franchise and a great business, but they didn’t have a very good asset/liability management framework. And they were frankly taking on a lot of unnecessary risk. There was no need for them to stretch for yield; they had a viable franchise. But they were stretching for yield to get a little bit more in earnings, so that they have a little bit bigger boost in their stock price. And that was just an “own goal,” as they say in soccer.
What supervisors need to do is focus on whether a bank has the three lines of defense for risk. Is the front line really thinking about the risks they are taking? Is the second line evaluating what the frontline is doing, and does it view that conduct as appropriate? And then is the audit function taking a more holistic view?
This is also about looking at risk—not line item by line item—but holistically. Typically banks don’t fail because they made a single bad loan; they fail because they got a big, big question wrong in a fundamental way. Any bank basically has to ask itself: What’s the commonly held belief that our people have? And if it turns out to be wrong, are we going to be okay or not?