In a recent speech before the Brookings Institution in Washington, D.C., Federal Deposit Insurance Corp. (FDIC) Chairman Martin Gruenberg reviewed the lessons learned from the bank failures this spring, calling for “important changes to capital regulation” of large regional banks to prevent future financial stability risks.
He pointed out that four years ago, he spoke about the resolution of large regional banks in the U.S.
“The key point made in that speech was that, while regional banks may not be as large, complex, and internationally active as the Global Systemically Important Banks … they would pose distinct and significant challenges in resolution that could raise serious financial stability risks,” Gruenberg said. “In particular, the speech pointed out the heavy reliance of regional banks on uninsured deposits for funding. That reliance has the potential to create a destabilizing contagion effect on other banks if one regional bank were to fail and uninsured depositors took losses.”
If there were any doubts about resolving regional banks, he said, they were dispelled by the failures of Silicon Valley Bank, Signature Bank and First Republic Bank earlier this year.
The Federal Reserve and FDIC found the three banks all had something in common, he said: poor management, they were unresponsive to supervisory feedback, and “their supervisors were not forceful enough in requiring them to take corrective measures.” Also, most of their funding relied on uninsured deposits.
“These characteristics proved to be a toxic combination when each bank faced stress,” Gruenberg said. “That experience should focus our attention on the need for meaningful action to improve the likelihood of an orderly resolution of large regional banks under the FDI Act.”
Proposed regulation changes
One of those actions includes the notice of proposed rulemaking to implement the Basel III capital rule, issued in late July.
“Under the proposal, unrealized losses on available for sale securities would flow through regulatory capital for all banks with more than $100 billion in assets,” Gruenberg said. “This means that these banks, in order to maintain their capital levels, would need to retain or raise more capital as these unrealized losses occur.”
That likely would have made a difference in Silicon Valley Bank’s failure.
“Had Silicon Valley Bank been required to hold capital against the unrealized losses on its available for sale securities, as the proposed Basel III framework would require, the bank might have averted the loss of market confidence and the liquidity run. That is because there would have been more capital held against these assets,” he said.
The FDIC, Federal Reserve, and Office of the Comptroller of the Currency are working on another change, proposing a long-term debt requirement for banks with $100 billion or more in assets. The advance notice of proposed rulemaking on Resolution-Related Resource Requirements for Large Banking Organizations was introduced in October 2022, and the three agencies expect to act on that proposal soon, Gruenberg said.
The proposal includes requiring covered banks to issue long-term debt sufficient to recapitalize the bank in resolution.
“Such a long-term debt requirement bolsters financial stability in several ways. It absorbs losses before the depositor class – the FDIC and uninsured depositors – take losses. This lowers the incentive for uninsured depositors to run,” he said. “Further, it creates additional options in resolution, such as recapitalizing the failed bank under new ownership or breaking up the bank and selling portions of it to different acquirers, as an alternative to a merger with another large institution.”
The FDIC is getting ready to propose changes to the IDI Plan Rule to make its requirements “significantly more effective,” Gruenberg said.
The IDI Plan Rule, adopted in 2011, requires banks with over $50 billion in total assets to submit resolution plans to the FDIC detailing how the bank could be resolved if it is placed in receivership. The FDIC plans to issue a notice of proposed rulemaking “that will be a comprehensive restatement of the rule for notice and comment,” he said.
Among other things, the proposed rule would require banks to provide a strategy that explains how it could be placed into a bridge, how to stabilize a bridge, how operations could continue separate from its parent company and affiliates, and to identify franchise components that could be sold to reduce the size of a remaining bank.
“The importance of this work was underscored this spring. While Silicon Valley Bank and First Republic had been required to file resolution plans which provided basic information that was useful, far more robust plans would have been helpful in dealing with the failure of these institutions,” Gruenberg said. “Signature Bank failed before it would have been required to file its first resolution plan in June.”
Finally, the FDIC is reviewing whether its supervisory instructions on funding concentrations need to be strengthened, including establishing a threshold for concentrations of uninsured deposits and requiring more frequent reporting of deposits.
“The failure of three large regional banks this spring, and the need to exercise a systemic risk exception to protect uninsured depositors at two of them, demonstrated clearly the risk to financial stability that large regional banks can pose,” Gruenberg concluded. “It makes a compelling case for action by the federal bank regulatory agencies to address the underlying vulnerabilities that made the failure of these institutions possible.
“These are perhaps lessons we should have learned from the 2008 financial crisis. The events of earlier this year provide us with another opportunity. This time I don’t think we’ll miss.”