After the failure of Silicon Valley Bank, the Federal Reserve conducted an internal investigation, led by Vice Chair for Supervision Michael Barr, into the bank's supervision and the impact regulation might have played in its failure. The report was released on April 28 and contained explicit criticism of deficiencies in the management of Silicon Valley and the regulatory oversight of the bank. In addition, it explored the potential impact of the Economic Growth, Regulatory Relief, and Consumer Protection Act (EGRRCPA, otherwise known as the tailoring rules) on the effectiveness of supervision.

We believe the report provides a road map for possible changes to come for both supervisory oversight and enhanced regulation, particularly for regional banks with more than $100 billion in assets. While the report does not specify the timing of potential rule changes, we believe any such rulemaking would go through normal notice and comment periods and include transition rules with a runway period.

The Fed also pointed out in its report that certain regulatory changes are already in progress, including the implementation of the Basel III endgame rules, the use of multiple scenarios in capital stress testing, and a long-term debt rule to improve the resilience and resolvability of large banks. It said it plans to seek comment on these proposals soon.

Overall, S&P Global Ratings believes enhancements to regulation and supervision could be positive for U.S. banks' credit quality, though stricter regulation sometimes can lead to strategic and profitability challenges. We consider the strength of a country's regulatory framework as part of our U.S. Banking Industry Country Risk Assessment (BICRA), which helps to determine the starting point of a bank rating (see "Banking Industry Country Risk Assessment Methodology And Assumptions," Dec. 9, 2021). Whether enhancements to regulation eventually lead to any upward rating actions will depend on the specifics of the rules and the impact on banks' business models and operating conditions at the time of implementation. Although we may view certain enhancements as broadly supporting the creditworthiness of banks, whether they are enough to spur positive rating actions will depend on our view of the materiality of the changes with respect to specific companies.

Supervision Is In Immediate Focus

The Fed said its first area of focus will be "to improve the speed, force, and agility of supervision." Accordingly, we expect oversight of banks, especially those with greater than $100 billion in assets, to increase, and we expect supervisors will take quicker action on banks with observed deficiencies. Such actions could also accelerate the volume of "matters requiring attention" that regulators issue to banks' management, which, if not addressed in a timely manner, could lead to enforcement actions.

We expect more rapid action if supervisors deem a bank to have inadequate capital planning, liquidity risk management, or governance and controls. Although each bank's supervisory record on these matters is typically not disclosed publicly, regulators may shine more light on a bank's deficiency by requiring it through enforcement action to hold capital or liquidity beyond regulatory minimums or by limiting incentive compensation and capital distributions until the problem is remedied.

We also believe the regulators' supervisory approach to models and modeling tools used by banks' management for capital, liquidity, or interest rate risk may evolve in several ways. For instance, the Fed could make its modeling assumptions more stringent for banks' liquidity risk from uninsured depositors. Moreover, changes to internal model assumptions by banks' management could face greater supervisory scrutiny, especially in cases when they appear to soften the severity of stress.

All of these actions could help support to some degree the safety and soundness of the U.S. banking system, which we consider in our BICRA analysis. They could also help flag deficiencies in individual banks' risk management practices at earlier stages of development, which in turn could bolster our credit analysis in terms of areas of focus.

How Regulation Could Evolve

In one of its four key takeaways from the report, the Fed said its tailoring approach and a shift in supervisory policy "impeded effective supervision by reducing standards, increasing complexity, and promoting a less assertive supervisory approach."

The 2018 passage of the EGRRCPA raised the minimum asset threshold for banks under enhanced prudential standards (EPS) to $250 billion from $50 billion while giving the Fed ample discretion to apply EPS to banks with at least $100 billion in assets. The Fed responded with the tailoring framework and established four categories of banks, based mostly on asset size, for determining the application of EPS (see the appendix for a diagram of the four categories of banks and their regulatory requirements under the tailoring rules).

We believe the report suggests that under Michael Barr's leadership, the Fed could "revisit the tailoring framework." Based on the Fed's recent review of Silicon Valley Bank, key regulatory measures we believe the Fed could consider include the following:

Potential Rating Implications Will Emerge In The Details Of New Regulation

We believe it is premature to predict which of the areas identified in the table above, if any, will translate into actual regulation. More certainty exists about the rule expanding banks' requirement to hold a set amount of long-term debt for resolution purposes, given a proposal was already in motion before the bank turmoil in March (see "Potential Rating Implications Of The Proposed Rules To Resolve Large U.S. Regional Banks," Oct. 24, 2022). However, it is unclear whether the Fed will consider increasing the number of banks under this rule's scope and specifically add Category IV banks.

From a ratings standpoint, strengthening the regulatory framework could support how we assess industry risk as part of our U.S. BICRA but may not necessarily lead us to revise upward the anchor, or starting point, for our ratings on banks in the U.S. That would likely depend in part on the extent and impact of regulatory tightening, some demonstration of the effectiveness of such tightening over time, and a host of other factors that can affect other parts of the BICRA analysis.

For individual banks, more stringent regulation could increase the amount of capital and liquidity they hold, which could lead to higher ratings, depending on operating conditions and peer rating relativities and assuming it does not significantly weaken profitability.

More stringent regulation could also lead, over time, to a pickup in industry consolidation because it may become more cost effective for banks of greater scale to implement and absorb the cost of regulation.

Finally, more stringent regulation could raise the cost banks need to charge to issue loans, which in turn could push more lending activity outside of the banking industry. This could affect bank profitability and add to financial instability if significant volume were to be pushed to the unregulated financial sector.

We will monitor these issues as we gauge the progression of bank regulation in the coming months and years.

Appendix

Related Research

• Credit FAQ: A Closer Look At Unrealized Losses' Effect On U.S. Bank Ratings, June 8, 2023
• Potential Rating Implications Of The Proposed Rules To Resolve Large U.S. Regional Banks, Oct. 24, 2022
• The U.S. Banking Sector Should Remain Stable Despite Easing Regulatory Oversight, Oct. 22, 2019
• Farewell (Regional Bank) LCR, We Hardly Knew Ye: What The Liquidity Coverage Ratio Tells Us And What Could Be Lost, June 17, 2019
• U.S. Regulators' Plan To Ease Bank Rules Is Largely In Line With Our Expectations, Nov. 7, 2018
• Reform--Rather Than Overhaul--Of U.S. Banking Regulation Has No Immediate Impact On Ratings, June 14, 2018