The Fed has been criticized for failing to warn of bank failures

WASHINGTON (AP) – The Federal Reserve has faced criticism for missing clear signs that the Silicon Valley bank was at high risk of collapsing into the second largest banking collapse in U.S. history, observers said.

Critics point to many red flags surrounding the bank, including its rapid growth since the pandemic, its unusually high level of uninsured deposits, and its many investments in long-term government bonds and mortgage-backed securities, which have fallen in value as interest rates rise.

“It is inexplicable why Federal Reserve regulators failed to recognize this clear threat to bank safety and soundness and financial stability,” said Dennis Kelleher, chief executive of Better Markets, an advocacy group.

Wall Street traders and industry analysts “have been publicly shouting about these very issues for many, many months since last fall,” Kelleher added.

The Fed was the primary federal regulator of the Santa Clara, California-based bank that went bust last week. The bank was also regulated by the California Department of Financial Protection and Innovation.

Now the fallout from the collapse of Silicon Valley Bank and New York’s Signature Bank, which went bust over the weekend, is complicating the Fed’s upcoming decisions on how much to raise interest rates to combat chronically high inflation.

Many economists say the central bank is likely to have raised rates aggressively by a half-point at next week’s meeting, which would mean stepping up its inflation fight after the Fed hiked a quarter-point in February. Its rate is currently around 4.6%, its highest level in 15 years.

Last week, many economists suggested that Fed policymakers would raise their forecast for future rates to 5.6% next week. Now it’s suddenly unclear how many more rate hikes the Fed is forecasting.

With the collapse of the two big banks raising concerns about other regional banks, the Fed may focus more on boosting confidence in the financial system than its long-term attempt to tame inflation.

The latest government inflation report, released Tuesday, shows inflation rates remain far higher than the Fed prefers, putting Chair Jerome Powell in a more difficult position. Core prices, which exclude volatile food and energy costs and are considered a better predictor of longer-term inflation, rose 0.5% in January-February – the sharpest since September. That’s well above the Fed’s annual target of 2%.

“Maybe it would have been close aside from the aftermath of the bank collapse, but I think it would have gotten them halfway point (rate hike) at this meeting,” said Kathy Bostjancic, chief economist at Nationwide.

On Monday, Powell announced the Fed would review its oversight of Silicon Valley to understand how it could have better managed the bank’s regulation. The review will be conducted by Michael Barr, the Fed’s vice chairman who oversees banking supervision, and will be released on May 1st.

A Federal Reserve spokesman declined to comment further.

Elizabeth Smith, a spokeswoman for the California Department of Financial Protection and Innovation, said, “We are actively investigating the situation and conducting a thorough review to ensure the Department is doing everything in its power to protect Californians.”

By all accounts, Silicon Valley was an unusual bank. Its management took excessive risks by buying billions of dollars in mortgage-backed securities and government bonds when interest rates were low. As the Fed steadily hiked interest rates to combat inflation, resulting in higher interest rates on government bonds, the value of Silicon Valley Bank’s bonds steadily declined.

Most banks would have tried to make other investments to offset this risk. The Fed could also have forced the bank to raise additional capital.

The bank had grown rapidly. Its assets quadrupled to $209 billion in five years, making it the 16th largest bank in the country. And about 94% of deposits were uninsured because they exceeded the Federal Deposit Insurance Corporation’s $250,000 insurance limit.

That percentage was the second-highest among banks with more than $50 billion in assets, according to rating agency S&P. Signature had the fourth highest percentage of uninsured deposits.

Such an unusually high proportion made Silicon Valley Bank very vulnerable to the risk that depositors would rush to withdraw their money at the first sign of trouble – a classic bank run – which they did.

“I’m at a loss for words to understand how this business model was found acceptable by their regulators,” said Aaron Klein, a former congressional aide now at the Brookings Institution who worked on what was then the Dodd-Frank Banking Regulation Act in the wake of the 2008 financial crisis past.

The bank failures are likely to influence an upcoming Fed review of rules governing how much money large banks must hold in reserve. Barr said last year that he wanted to conduct a “holistic” review of these requirements, raising concerns in the banking industry that the review would result in rules that would force banks to hold more reserves, limiting their ability to lend would.

Many critics also point to a 2018 law that loosens banking regulation in ways that contributed to Silicon Valley’s failure. Pushed by the Trump administration with bipartisan support in Congress, the law exempted banks with assets ranging from $100 billion to $250 billion — the size of Silicon Valley — from requirements for regular audits, such as those encountered during tough economic times would hit, so-called “stress tests” were the exception. ”

Silicon Valley CEO Greg Becker had lobbied Congress to roll back the regulations and was a member of the board of directors of the Federal Reserve Bank of San Francisco until the day of the collapse.

Sen. Elizabeth Warren, a Massachusetts Democrat, asked him about his lobbying work in a letter released Tuesday.

“These rules were designed to protect our banking system and economy from the negligence of bank managers like you – and their retraction, along with your bank’s cruel risk management measures, have been questioned as the main causes of their failure,” Warren’s letter said.

The 2018 law also gave the Fed more discretion in its banking supervision. The central bank then voted to further reduce regulation for Silicon Valley-sized banks.

In October 2019, the Fed voted to effectively reduce the capital these banks had to hold in reserve.

Kelleher said the Fed could still have pressured the Silicon Valley bank to take steps to protect itself.

“Nothing in this law in any way prevented Federal Reserve regulators from doing their jobs,” Kelleher said.


AP business writer Paul Wiseman contributed to this report.

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