May 4, 2023
Anticipating tougher regulatory supervision and understanding what recent regulator reports mean for banks
By James C. Watkins and Edward Hida
Today’s banking crisis has now seen the failure of banks with combined assets approaching half a trillion dollars. With the latest failure of First Republic Bank following the closure and earlier failures of Silicon Valley Bank, Signature Bank and the winddown of Silvergate Bank through self-liquidation, the list now includes three of the four largest bank failures in US history. Banks should anticipate a new era of tougher bank regulatory oversight, examinations, regulatory frameworks and stress testing.
These bank failures were largely unexpected and the traditional red flags of rapid growth coupled with lagging risk management processes were not spotted, or at least not sufficiently followed up with robust regulatory reviews and action.
Importantly, uninsured depositors will no longer be viewed as stable or core sources of funding. This is a direct result of technology and smartphone’s revolutionary effects on banking: banking is now online, faster than ever, and largely virtual—this, combined with the rise of social media, has accelerated modern-day bank runs to lightning speed.
Therefore, we expect that banks with novel or concentrated business models and funding structures comprised of large uninsured deposits will be scrutinized intensely by investors and regulators and that they will need greater capital and liquidity buffers than in the past.
The self-assessment reports of the Federal Reserve Board and FDIC on the failures of Silicon Valley Bank and Signature Bank, respectively, are the first of likely several “lessons learned” reports. These reports provide an opportunity to examine the events and their root causes, but also, perhaps most importantly for banks to be aware of, they illustrate the anticipated future directions of regulators.
The Federal Reserve has called for reinvigorated regulatory oversight through stronger supervisory and regulatory frameworks. The FDIC has reinforced these same ideas. Notably, both regulators prominently cited delays in forcing bank action to address issues identified during examinations. So, banks can expect that regulators will work to strengthen regulatory oversight of banks by both immediately stepping up regulatory supervision and working towards longer-term revisions to beef up the regulatory framework.
Here’s our list of key takeaways that banks should monitor, make a plan for, and take action on.
Banking Regulatory Supervision
- Expect more examination focus on key risk areas. These include liquidity and balance sheet management, deposit concentrations and potential volatility, investment securities, incentive compensation, internal controls, internal audit, risk identification, risk modeling, risk governance including the role of the CRO, board oversight, narrow or novel business models and rapid growth. This increased focus may include both greater attention in regular ongoing examinations as well as increased horizontal examinations. As part of the increased focus, banks can expect higher regulator expectations, and should proactively review and enhance their capabilities across these areas accordingly.
- Expect more timely examination follow-ups. This will likely include quicker response on regulatory document requests and any management responses. Banks should strengthen their regulatory relations function, including staffing and responsiveness from relevant business units and senior management.
- Expect more timely and forceful examination findings follow-ups, regulatory rating changes and enforcement action escalations. This will likely include requests for documentation of management regulatory remediation plans, moves to track and request remediation and closure of regulatory findings so that they do not linger, and regulatory rating changes of the banks’ CAMELS ratings as well as RFI and LFI ratings. It may also include quicker escalation of findings, especially critical findings and overdue findings to enforcement actions. Again, this is because regulators will seek to carry out all of these processes on a timelier basis and more proactively force bank action on critical issues. Banks should strengthen their regulatory remediation capabilities as well as oversight both at the senior management and board oversight levels.
- Expect quicker regulatory oversight transition between regulatory portfolios as banks grow. This could be from the Community Banking Organization (“CBO”) portfolio to the Regional Banking Organization (“RBO”) portfolio, or from the RBO portfolio to the Large and Foreign Banking Organization (“LFBO”) portfolio. This will include more intensive oversight at each step through larger and more experienced regulator teams as well as greater coordination with the Federal Reserve Board, especially for LFBO’s. Banks should prepare their regulatory relations teams as well as their key functional and business areas for these changes to effectively work with regulators to meet their information and other needs.
Banking Regulatory Framework
- Expect proposed rules to rollback many of the regulatory exemptions granted mid-sized banks in the 2018/2019 era. This will likely include a lowering of current thresholds which establish a $250 billion threshold for many regulatory capital and liquidity requirements. The previous threshold for many of these provisions was $50 billion. Some aspects of revision to regulatory thresholds would require legislation while other aspects could be achieved by the regulators through the normal regulatory rulemaking process. While the exact threshold(s) to be proposed for different requirements are unclear at this time, it is clear that the view of key regulators is that these thresholds need to be revised and significantly lowered to include many mid-size and regional banks which escaped these requirements. Banks should closely monitor these changes as well as begin planning for potentially increased requirements.
- Expect tougher stress testing requirements. Revisions to applicability of stress testing requirements will likely come through proposed rules revising the thresholds applying enhanced prudential standards as noted above. More immediate changes in the next stress testing cycles could be made through actions such as potentially increasing the frequency of stress tests, requiring more stress test scenarios and including more severe stress test macroeconomic scenarios. Banks should closely monitor these developments as well as begin preparing for potential rule changes requiring broader applicability of stress testing as well as tweaks to stress tests such as increased frequency of the stress tests and more severe scenarios which could be implemented in upcoming stress test cycles.
- Expect increased requirements for regulatory capital and for liquidity. This will likely include requirements for increased capital as a result of the proposed TLAC rules to require an extra layer of loss absorbing capital and the Basel III End Game regulations currently under development of proposed rule-making. Banks should closely monitor these developments as well as begin planning for potentially increased requirements for those that may be impacted.
Through all of this turbulence, it’s crucial for banks to have trusted, experienced advisors that can ensure that their regulatory capabilities are keeping up with the changing times. Our team of former regulatory and banking executives at Secura/Isaac Group helps banks prepare for this period of increased regulatory oversight by conducting gap analyses of relevant areas and developing programs to strengthen the capabilities of banks’ relevant functional areas. Through our three service lines—advisory services, technology consulting, and executive search—we make sure our clients are covered from all angles.