Opinion: SVB's collapse exposes the Fed's massive failure to see the bank's warning signs

The San Francisco Federal Reserve Bank failed to act on red flags about now-defunct SVB's conduct.

Opinion: SVB's collapse exposes the Fed's massive failure to see the bank's warning signs

Failure of Silicon Valley Bank (SVB), SIVB, -60.41% was a failure in federal supervision and regulation.

Although they are often used interchangeably, the two terms are not identical. Regulation is about creating rules and supervision enforces them. The initial reactions to SVB's failure were focused on whether Trump-era deregulation was the cause. However, this ignores the essential question of whether rules that existed were being properly enforced.

They weren't and therefore the Federal Reserve was ineffective as a supervisor of banks.

SVB was under the supervision of the Fed from head to tail. The San Francisco Federal Reserve Bank was responsible for both the bank's larger parent holding company, SVB Financial Group, and the bank itself. SVB was the largest bank that the SF Fed supervised. SVB's CEO sat on SF Fed's Board of Directors until the bank collapsed.

There are at least four red flags that the bank's conduct should have raised alarm bells, but the Fed seems to not have heard them.

Explosive asset growth: SVB almost quadrupled its assets in just four years.

Hyper-reliance upon uninsured deposits. Nearly 90% of SVB’s deposits came from customers with more than FDIC’s limit ($250,000), which is often tech companies. Bank stability is affected by uninsured depositors.

SVB is at great risk of interest rates: In a period of rapid growth, SVB bought more than $ 100 million of mortgage-backed securities with low interest rates. In the event of rising interest rates, the bank did not purchase hedges to protect securities' value.

Cash to the Federal Home Loan Bank: SVB needed cash so it borrowed heavily from the Federal Home Loan Bank system. It was the top borrower of the San Francisco FHLB with $20 billion.

Lender of last resort

This is why the FHLB has been called the lender-of-next-to-last resort. The FHLB gets paid first before the FDIC if a bank goes under. The greater the bank's debt to the FHLB, it is the more taxpayers will suffer if it fails.

Each of these red flags ought to have been subject to greater scrutiny by the Federal Reserve. They all call for more scrutiny. SVB isn't a Main Street bank and has never been. SVB had 16 branches in its regional bank ($200B).

This doesn't even address questions about the relationship between SVB Venture Capital arm and bank customer base. This could be a red flag that the Fed should have investigated when regulating the bank holding company.

Although the Fed has launched an investigation into its own failures, it is unlikely that this inquiry will be sufficient. A Fed self-investigation by itself did not find any leaked information from the Richmond Bank president (the FBI discovered it, and the executive resigned in shame). Another Fed inquiry did not reveal dates of unethical trading between the Dallas and Boston Bank chiefs.

Congress is ultimately responsible for the Fed. Congress must investigate the events with its own investigation. It will not suffice to ask the Fed regional banks for their own fixes. One example: A law that required Fed regional banks to incorporate their boards was passed in 1970s, but was ignored widely; Kansas City Federal Reserve didn't integrate its all-white Board until 1992.

It is important to improve Fed governance, but it is not enough. The public is not allowed to see the supervisory reports of bank regulators. This means that we don't know how banks are doing or whether they are doing a good job. These reports, also known as 'CAMELS', should be made public by bank regulators so that Americans can assess how banks are doing and how well agencies are supervising them. It would be helpful to know what grade SVB was given by the SF Fed, for example.

Congress can either create specific rules for financial regulation or empower regulators to determine the details. Both cases, Congress depends on regulators for the enforcement of the rules. Congress cannot legislate judgment or competence. The U.S. financial regulator system has a lot of faith in the judgment and competence of bank regulators, especially the Federal Reserve. This was not the case with Silicon Valley Bank.

As a monetary policy maker, regulator, lender of last recourse, regulator of payment systems, producer of statistics and economic research, the Fed has been continually given more responsibility. It may be time to rethink the central bank's role.

One fact that is often forgotten is that the original proposal of Senator Christopher Dodd, in the Dodd-Frank law, envisioned taking control of banks like SVB from the Fed. This idea was defeated 91-9. Dodd-Frank eventually increased the Fed's power and authority over the country's banking system. SVB's case is an example of this failure.

Aaron Klein is the Miriam K. Carliner Chair, and a senior fellow at Brookings Institution. From 2009 to 2012, he was deputy assistant secretary of Treasury and chief economist for Senate Banking, Housing and Urban Affairs Committee, under both Chris Dodd and Paul Sarbanes. He was instrumental in drafting, securing passage, and implementing the Dodd-Frank Act.