The Federal Reserve’s plan to expand oversight of lenders after the collapse of SVB Financial Group and Signature Bank is a move in the right direction. While it will likely be a laborious process, there is also an easy fix.
The Fed is considering tougher rules for midsize banks after last week’s events, the Wall Street Journal reported. They could target lenders with between $100 billion to $250 billion in assets. In 2018, lawmakers rolled back some of the restrictions imposed after the global financial crisis. They raised a threshold so that those with less than $250 billion in assets — instead of $50 billion previously — could escape the toughest regulatory scrutiny. SVB, the 16th largest lender with about $210 billion assets, was a big beneficiary.
Extending the government’s radar will be time-consuming, however. Instead of monitoring just a dozen big banks, such as JPMorgan Chase & Co. and Bank of America Corp., the regulators will keep their eyes on more than 30. This perhaps explains why, in the past, officials had talked openly about spending less time policing the balance sheet of smaller institutions.
There is another way. Currently, the Fed gives smaller lenders more leeway in their accounting of available-for-sale securities. Remove that opt-out.
To meet redemptions, banks routinely put some of their customers’ deposits in seemingly safe assets, such as Treasuries or agency-backed securities. Banks can designate them as being “available-for-sale” or “held-to-maturity.”
With available-for-sale assets, mega banks are required to reflect unrealized gains and losses in their reported capital ratios. But smaller institutions do not need to.
Meanwhile, selling held-to-maturity securities can be tricky. If more than a small portion is sold, the whole portfolio is impacted, and lenders would be required to mark to market for up to two years. It’s not a decision lenders take lightly.
This is exactly what happened to SVB. With little cash on hand and deposits dwindling, the bank scrambled to dispose of almost its entire available-for-sale portfolio, resulting in a loss of around $1.8 billion. As such, SVB raced to seek fresh capital, thereby spooking its clients and causing a bank run. This would not have happened at mega banks.
Indeed, once we adjust for unrealized losses, we find that smaller banks have more modest capital buffers than the big ones. And the culprit is the opt-out they get for their available-for-sale asset holdings.
It does seem like the Fed is attempting to do the right thing. According to the Journal, over the next few months, the central bank is expected to propose changes that could require more banks to “show unrealized gains and losses on some securities in their regulatory capital.” It did not give further details.
Removing this leniency for small banks would force them to either hold more cash, or raise capital gradually over time.
Since the global financial crisis, most scrutiny was placed on the so-called systemically important mega banks. But as we are finding out with SVB and Signature, the regulators used a “systemic risk exception” to fully protect their depositors anyhow. These midsized lenders are too important to be ignored.
Shuli Ren is a Bloomberg Opinion columnist covering Asian markets. A former investment banker, she was a markets reporter for Barron’s. She is a CFA charterholder.
