31 May 2023

CEPR's Honahan: Lessons from missing the signals of failing banks

Barr [Report] is a valuable acknowledgment and dissection of the supervisory failures, it glosses over one of the most important: the failure to realise six months ago that the bank was likely to fail and needed to be dealt with by the Federal Deposit Insurance Corporation as resolution authority.

The collapse of Silicon Valley Bank revealed shortcomings in both prudential supervision and resolution of banks in the US. This column argues that while the report by Federal Reserve Vice Chair Michael Barr is a valuable acknowledgment and dissection of the supervisory failures, it glosses over one of the most important: the failure to realise six months ago that the bank was likely to fail and needed to be dealt with by the Federal Deposit Insurance Corporation as resolution authority. 

The collapse of Silicon Valley Bank (SVB) in March, the second largest commercial bank failure in US history, revealed shortcomings in both prudential supervision and resolution of banks in the US. Federal Reserve Vice Chair Michael S. Barr's (2023) report is a valuable acknowledgment and dissection of the supervisory failures that allowed SVB to get into trouble from which it could not escape. But the report glosses over one of the most important: the failure to realise six months ago that SVB was likely to fail and needed to be dealt with by the Federal Deposit Insurance Corporation (FDIC) as resolution authority.

Supervision seeks mainly to detect unduly risky behaviour and to ensure that management takes corrective action. But there comes a point when failure to detect or correct that behaviour results in the materialisation of the risk to the extent that the bank is failing or likely to fail. Such a bank needs to be resolved, using any of a range of procedures available to the public authorities, including liquidation, sale of all or part of its businesses, bail-in of creditors, and so on. It is now clear that in the case of SVB, that point was passed many months before such action was taken.

The role of the lead supervisor in acknowledging the need for resolution should be strengthened. Even then, of course, the exact timing and nature of resolution actions need to be carefully judged to minimise the contagion effect on confidence throughout the system. Not to speak of the spectre of that variant of ‘too big to fail’, namely, ‘too many to fail’.

Three sizable US banks have now failed within a matter of weeks; the Federal Deposit Insurance Fund has incurred considerable losses; and significant amounts of deposits have moved to large banks from regional banks, potentially limiting their customers' access to credit and causing further disruption. There are important lessons to be learnt.

As in other advanced economies, the practice of bank supervision in the US has accumulated an elaborate, legalistic superstructure of procedures, which has slowed corrective action and left several large banks operating openly even though frontline supervisors had enough information to realise that these banks were failing or likely to fail.

Lessons from the Barr report

The Barr report describes an inward-looking and scholastic approach to supervision at the Fed. We see the emphasis given to debate among different teams of experts about where to position each element of the bank's performance on a rating scale with a view to proposing elaborately graduated responses. For example, in November 2022, supervisors decided to downgrade their assessment of SVB's sensitivity to financial market risk from “Satisfactory-2” to “Less-than-Satisfactory-3”; although they did not realise that the bank was hurtling towards failure, it is remarkable that this downgrade was not finalised or issued by the time the bank had failed (page 64)...

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