The failures of Silicon Valley Bank and First Republic Bank in 2023 caused plenty of finger-pointing at bank regulators. Many US financial institutions including SVB and First Republic were covering large portions of their liabilities with assets such as government bonds that stood to lose value if interest rates rose significantly—which is exactly what happened. As the Federal Reserve hiked interest rates, rumors swirled that the two banks might not have sufficient assets to cover all their deposits. Customers yanked their money out, causing runs at both.

Indiana University’s Yadav Gopalan and Chicago Booth’s João Granja find through some rough calculations that had regulators acted two quarters earlier, they would have averted $9 billion in losses. However, the researchers also say their analysis of the events reveals a more complicated picture than examiners being oblivious to systemic risks—plus it’s particularly hard to assess regulators’ performance given how necessarily secretive their work is. “Regulators may receive the blame for some very public failures but no glory for the bank failures that they prevented from happening,” write Granja and Gopalan.

To understand what transpired, the two researchers matched information maintained by banking regulators with publicly available data about banks’ financial conditions. The regulatory data, which covers late 2020 through early 2023, show the risk scores supervisors assigned to the banks, while the publicly available data include factors such as interest-rate risk exposure, exposure to uninsured deposits, bank size, bank capitalization, and asset quality.

Some saw the risks

For each financial institution, US bank regulators assess six categories and issue what’s known as a CAMELS rating. As interest rates rose, regulators most frequently downgraded the “Liquidity” and “Sensitivity to market risk” components of CAMELS. This suggests that they understood the increased risks associated with higher interest rates.

The onset of interest-rate hikes in early 2022 served as a natural laboratory for assessing how bank examiners managed a credit shock. “In our setting, a well-defined event, the Federal Reserve’s decision to raise interest rates, triggered a shock to the value of equity of banks with significant maturity mismatches and unstable deposits,” write the researchers.

For each financial institution, regulators issue what’s known as a CAMELS rating. The acronym refers to the six categories that are assessed: capital adequacy, asset quality, management, earnings, liquidity, and sensitivity to risk. The researchers find that as rates rose, regulators adjusted the ratings they issued to the most-exposed banks, downgrading two of the six risk factors the most: liquidity and sensitivity to risk. A rate shock naturally draws more attention to these components than the others, so the downgrades suggest that supervisors “understood the consequences” of interest-rate risk, the researchers write.

Examiners were less likely to downgrade banks that had derivative contracts that protected them against rate movements, another indication that they understood the emerging risks.

Regulators might have been slow to scrutinize balance sheets because of an accounting tactic. According to other research by Granja, troubled banks were more likely to classify securities as being “held to maturity” rather than “available for sale,” perhaps to avoid marking down the value of those assets. (For more about this research, read “Are US Banks Hiding Their Losses?”) The stalling tactic might have worked, for a while. Starting in the second quarter of 2022, examiners were more likely to downgrade banks with larger unrealized losses in AFS securities, but only began to significantly downgrade banks with HTM portfolio losses during the first quarter of 2023.

Finally, regulators were not more likely to downgrade banks that relied more heavily on uninsured deposits, suggesting that they did not fully appreciate the risks associated with this type of deposit. Examiners, investors, and bank executives have long assumed that deposits are “sticky,” meaning that customers won’t pull their money out until they absolutely have to. But online banking makes it much easier to move funds, even just to pursue higher interest rates on deposits. (Read more in “Why Your Banking App Might Spell Trouble for Your Bank.”)

“This inaction of supervisors may be surprising,” Gopalan and Granja write. But, they say, it also may confirm supervisors’ own admissions in the wake of the fallout of SVB that current supervisory models don’t go far enough to capture the additional liquidity risks associated with an unstable deposit base, including uninsured deposits.

It’s clear that regulators did catch and contain some of the risks, saving money for taxpayers and bank customers alike, the researchers conclude. But considering the steep costs of delayed action, it’s fair to question whether the failure to detect a fairly straightforward risk—and move quickly to stop it—indicts the entire supervisory system and the $2 billion a year it costs taxpayers, Granja and Gopalan write.

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