(Bloomberg) - Months before Silicon Valley Bank and Signature Bank collapsed, US financial regulators received warnings about how the industry’s mounting unrealized losses had the potential to spark a crisis.
In letters and calls from October through December, trade groups and lawmakers told senior agency officials that the losses undermined banks’ liquidity access and might hurt the economy. The losses and the letters were public, but the issue wasn’t treated as a top priority or a harbinger of what transpired in March, according to four people involved in at least one of the calls. The attendees, who included regulators, didn’t want to be identified discussing private conversations.
The communications, including to Federal Reserve and Federal Deposit Insurance Corp. officials, were among the first indications to regulators that lenders, particularly regional and community banks, were coming under serious stress due to rising interest rates. They also raise questions about why the troubles at banks flew under the agencies’ radar. Michael Barr, the Fed’s vice chair for supervision, is leading an internal review of SVB’s oversight and regulation set for release Friday.
“Regulators should have interpreted this as sign of a deeper structural problem,” Aaron Klein, an Obama-era Treasury official now at the Brookings Institution, said in an interview. “This should have told them to pull up a list of banks and credit unions that have increased their home loan bank borrowing the sharpest, and dig in deeper on what’s going on there.”
Stressed Banks
The Independent Community Bankers of America and American Bankers Association had sounded the alarms as they sought a rule change that would allow stressed banks to maintain access to the Federal Home Loan Banks, lenders overseen by the Federal Housing Finance Agency.
“Without your immediate and proactive intervention and collaboration with FHFA in resolving this issue, community banks may soon be forced to realize what are now only unrealized losses – an unfortunate outcome that during unprecedented times could ignite itself to create a crisis,” Rebeca Romero Rainey, ICBA’s president, wrote in November to Barr and the heads of the FDIC, the Office of the Comptroller of the Currency and the Federal Housing Finance Agency.
Regulators regularly receive requests from trade groups for rule changes. In this case, the appeals to the FHFA were denied, according to the housing finance regulator. Officials told the attendees at the meetings that if a bank were experiencing liquidity issues due to paper losses, it should contact its regulator individually, according to the four people.
The Fed, the FDIC and the OCC declined to comment. It’s unclear whether the bank crisis, which cost the FDIC’s deposit insurance fund about $23 billion, could have been avoided if the agencies had taken the recommended actions. Though regulators have stressed that the banking system is resilient, First Republic Bank reignited investors’ concerns after a worse-than-anticipated drop in deposits in the first quarter. Bloomberg on Tuesday reported that the lender is considering divesting $50 billion to $100 billion of assets.
Deposits have soared since March 2020, and US banks invested billions of dollars in safe, interest-earning assets like Treasury bonds. When the Fed raised interest rates in 2022, those assets lost value.
Depending on how a bank accounted for these investments, those losses could reduce what counted as capital at the bank, under FHFA accounting rules. If this measure of capital turned negative, a bank would be cut off from accessing advances from the Federal Home Loan Banks unless it got a waiver from its regulator.
By late last year, the Fed’s hikes led to some banks having negative capital under the FHFA’s accounting, according to one of the people familiar with their situation.
For many banks, the FHLB system is a vital source of cash. To pay depositors who withdraw their cash in times of crisis, banks often get loans from the Federal Home Loan Banks. These loans, known as advances, are implicitly backed by the US government, and they don’t carry the heavy stigma associated with borrowing from the Fed. For smaller banks, the FHLB and the Fed can be the only sources of quick cash.
‘Liquidity Tool’
In October, the ABA and ICBA wrote a joint letter to the FHFA that asked for the housing finance regulator to change its accounting of the losses. Officials at the Fed, OCC and FDIC were also sent the letter.
Unlike the FHFA, banking regulators don’t count those losses, known as paper losses, against a bank’s capital. If the housing finance regulator changed how it treated the losses, stressed banks would have “seamless access to an important liquidity tool,” the trade groups said in their letter. Failing to address the regulatory issue “may exacerbate a stress.”
“Our October letter was intended to highlight potential challenges that could make it harder for banks with available collateral to access the FHLBs’ longstanding, reliable liquidity – something that is always important but especially so in times of stress,” Blair Bernstein, an ABA spokeswoman, said in a statement. “The recent period only highlights the rationale behind our concern last fall.”
Five members of the US House of Representatives also sent a letter to the heads of the FHFA and the bank regulators in December. They urged FHFA to “act immediately to avert an unnecessary economic challenge” and asked the bank regulators to grant waivers for banks to keep access to the home loan banks.
In calls with senior financial regulators in November, the trade groups pressed the issue, according to the four people.
Paper Losses
The FHFA declined to change how it treated paper losses because the home loan banks have “less access to information about the member’s financial condition than the member’s primary regulators,” Joshua Stallings, an FHFA deputy director, said in a statement.
“Further, unilateral action by FHFA on this matter would compromise the ability of the primary regulators to provide their supervisory perspectives on affected members, potentially undermining cooperative efforts to protect systemic safety and soundness,” he said.
Paper losses were on at least one regulator’s mind late last year. FDIC Chairman Martin Gruenberg said in Nov. 15 testimony that banks reported $470 billion in such losses in the second quarter of 2022.
“The FDIC expects this trend to be an ongoing challenge as interest rates continued to rise in the third quarter, especially if banks need to sell investments to meet liquidity needs,” Gruenberg said in written testimony before the Senate banking panel.
He also cited the paper losses in a March 6 speech but added that banks were “generally in a strong financial condition, and have not been forced to realize losses by selling depreciated securities.”
Later that week, SVB Financial Group, the parent of Silicon Valley Bank, said it had taken a $1.8 billion loss tied to selling those securities, sparking a bank run that led to its closing.
(Updates date in third paragraph and First Republic developments in eighth.)
By Austin Weinstein and Katanga Johnson
With assistance from Jenny Surane
