The Fed Should Be Fired as Bank Regulator. Powell’s Discussion of Silicon Valley Bank & Regulatory Failure Shows Why

The Fed is structurally too conflicted to regulate banks. The FDIC is not, but it needs tiger teeth to bite CEOs’ heads off.

By Wolf Richter for WOLF STREET.

The collapse of Silicon Valley Bank laid bare how inept and conflicted the Federal Reserve is as banking regulator, and why it can never be deconflicted the way the Federal Reserve System is structured, and why it will always be inept – willfully inept.

The structural problem with the Fed as top-dog banking supervisor is that the Federal Reserve System consists of the Board of Governors, which is a federal agency that Powell chairs; and 12 regional Federal Reserve Banks (FRBs), such as the San Francisco FRB, whose shareholders are the financial institutions in their districts, such as SVB Financial, whose CEOs sit on the board of directors of the FRBs, such as SVB CEO Greg Becker, and that the bank examiners employed by the FRB of San Francisco were examining Silicon Valley Bank. They were squealing about the risks at SVB for a few years, as we now know, and they escalated, and they tried, but it was all muffled.

The Fed should never be a bank regulator because it cannot be an effective bank regulator because it’s too conflicted: The regional FRBs are governed by the CEOs of the banks in their districts, whose primary objective is their own wealth, not effective regulation that could cut into their own wealth. And this came out big time in the wake of the collapse of Silicon Valley Bank.

Powell alluded to these issues during the post-meeting press conference, when he was being pushed by reporters about Silicon Valley Bank and the Fed’s regulatory failure.

Everyone knew about it, from bank examiners to the public, but the Fed let it go:

“At a basic level, Silicon Valley Bank management failed badly,” Powell said. “They grew the bank very quickly. They exposed the bank to significant liquidity risk and interest rate risk, didn’t hedge that risk,” he said. This bank “was an outlier in terms of its percentage of uninsured deposits and in terms of its holdings of duration risk,” he said.

“We now know that supervisors saw these risks and intervened,” he said. “Supervisors did get in there and were on this issue,” he said. “The supervisory team was apparently very much engaged with the bank, repeatedly and was escalating. Nonetheless, what happened, happened.”

“There have been presentations about interest rate risks. I mean, it’s been in all the newspapers,” he said.

“It’s not a surprise that there are institutions that have had unhedged long positions in long-duration securities that have lost value as longer-term rates have gone up due to our rate increases. So that’s not a surprise,” he said.

When asked if he could confirm whether or not the Fed’s Board of Governors (which Powell chairs) knew about these escalations by the bank supervisors at the FRB of San Francisco, Powell said: “We’ll have to come back to you on that. I don’t know.”

And when he was asked how the Fed would ensure that banks comply with these citations, how the Fed would enforce them, Powell said: “That is a great question.”

Reviews & investigations to find out “what went wrong.”

“We’re doing a review of supervision and regulation,” Powell said. “My only interest is that we identify what went wrong here. How did this happen is the question. What went wrong. Try to find that. We will find that. And then make an assessment of what are the right policies to put in place so it doesn’t happen again. Then implement those policies.”

“We’re undertaking a thorough internal review that will identify where we can strengthen supervision and regulation,” he said.

“It is clear we do need to strengthen supervision and regulation. And I assume that there will be recommendations coming out of the report,” he said.

“It’s 100% certainty that there will be independent investigations, and outside investigations, and all of that. When a bank fails, there are investigations. And, of course, we welcome that.”

“The question we’re all asking ourselves over the first weekend was how did this happen?”

But wait… we know “what went wrong.”

We already know “how this happened,” we know “what went wrong,” we don’t need any more reviews and investigations and reports and recommendations. What went wrong is that an FRB regulates the banks that own it. That’s structural. You cannot fix that with a report. The FRB of San Francisco regulated one of its shareholders, SVB Financial, whose CEO was on the board of directors of the FRB of San Francisco. This is a form of voluntary self-regulation.

The Fed should be fired as banking supervisor and regulator; the FDIC should get that top job along with tiger teeth to bite CEOs’ heads off.

No review and investigation can fix the regulatory setup. The Fed will never be an effective bank regulator and supervisor. It’s structurally too conflicted.

Congress should restructure banking supervision. The Fed should remain lender of last resort for the banks, and focus on monetary policy. But it should be fired as bank supervisor and regulator. It had its chance and blew it. Over and over again.

The full regulatory and supervisory power should be given to the FDIC, which has long been one of the three bank regulators, but junior to the Fed. And it should be given some real teeth.

The FDIC’s priority has been to minimize the losses to the deposit insurance fund. Effective and tough-love supervision that reduces the magnitude of the fallout if a bank fails, and that prevents many bank failures in the first place, is in line with the FDIC’s priority of minimizing the losses to the deposit insurance fund. The FDIC is not structurally conflicted – unlike the Fed.

Enjoy reading WOLF STREET and want to support it? You can donate. I appreciate it immensely. Click on the beer and iced-tea mug to find out how:

Would you like to be notified via email when WOLF STREET publishes a new article? Sign up here.