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Welcome to Street Talk, S&P Global Market Intelligence podcast that offers listeners a deep dive into issues facing financial institutions and the investment community.

Nathan Stovall

I'm Nathan Stovall. And on this episode, we're talking about the lessons learned from the bank failures in the spring and whether or not new regulations are the answer to some of the problems that cropped up.

My guest today is going to cover some of the different ways that we think regulators could act to avoid or at least reduce the impact of bank failures without moving forward a whole host of new rules. Joining me on the show is a partner with Davis Polk in the Financial Institutions Group, David Portilla. David, thanks for coming on the show.

David Portilla

Thanks for having me. Great to be here.

Nathan Stovall

You had altered really good detailed post on the topic that I just laid out. And you made the case that some of the past regulatory proposals that we saw coming out of the financial crisis really could have been used or perhaps should have been used well before the turmoil that we saw beginning or opting in March and the liquidity crunch that followed. And one of the things that you talked about in detail were some of the early remediation triggers that the Fed had proposed, I believe it was about 2012, if I'm not mistaken. Maybe it makes sense like start there with you outlining with what those were and how you could have seen those kind of coming into place had they been implemented.

David Portilla

Yes, perfect. No, happy to. And maybe I'll start by saying, in this article I wrote, I think part of what motivated me was really 2 factors. One is some commentators or observers had said the fact of the March 2023 bank failures showed that the Dodd-Frank Act was structurally flawed and failed to achieve its purpose. And I think a part of what I thought was worth exploring was whether, in fact, that was true, meaning if the Dodd-Frank Act has not been fully implemented, can you say that it's structurally flawed or it failed.

And the other is sort of in the context of the larger debate around the regulatory response to the March 2023 bank failures. And in particular, I think the debate about the appropriate calibration of capital requirements and sort of thinking through whether there are alternative targeted responses that would be able to address the problems that were revealed with relative efficiency kind of going with the principle that when trying to design a policy response or regulatory response, it's always good to be as efficient as possible. Meaning the easiest policy response is to implement are really the bluntest ones, but they're also the least efficient. And is there a way that we could sort of be more efficient about addressing what was revealed?

And I think that led me to revisit Section 166 of the Dodd-Frank Act, which, as you mentioned, is the so-called early remediation requirements. And put simply, and I'll sort of unpack it a little bit more, what Section 166 and the early remediation requirements are, is sort of triggers that would require regulatory or supervisory action to remediate deficiencies at a financial institution when they occur, and they would be automatic.

And I think the idea was that to use, in the Fed's own words, was that their 2008, 2009 global financial crisis revealed fundamental weaknesses in the regulatory communities, tools to promptly deal with emerging issues. I think we saw that again in 2023. And tools that are in place didn't really provide supervisors. Well, I guess to say differently, this is from 2012, the Fed said, while supervisors had the discretion to act more quickly, they did not consistently do so. And Section 166 of the Dodd-Frank Act was designed to address these problems by directing the Fed to adopt regulations providing for the early remediation of financial weaknesses.

So in some ways, it's back to the future, right? Like this is the same -- the issue that was identified in 2008, 2009, meaning the regulators having the Discretion Act but not doing so is the same issue we saw in 2023. And the respond to that issue, Congress said in effect, you know what, maybe we need to take some of the discretion away and kind of force automatic actions based on triggers that the Fed would set.

Nathan Stovall

And for those -- just this past Friday, the FDIC came out with a review of First Republic. And I feel like they kind of said the same thing, right? They saw issues, but they didn't feel like they had confidence to act without pushback in terms of First Republic. So getting back to, again, that these -- as you had highlighted, these things were outlined back in '12 of what's set up hard thresholds where you will step up action. Is that right?

David Portilla

Yes, exactly. And more so in the early '90s, the Prompt Corrective Action regime was adopted. That's the regime that applies at the bank level, not the holding company level. And it really requires as the name suggests. Prompt Corrective Action taken by the regulators and the triggers there are capital levels.

And the other thing that Dodd-Frank Act did was require the Government Accountability Office, the GAO, to conduct a study on the Prompt Corrective Action framework and why it didn't work in 2008, 2009. And the GAO said at the time that bank regulators needed additional triggers that would require early and forceful regulatory action to address unsafe banking practices to improve the PCA. And so that's basically with DFA 166 then. But again, you have this really decades of finding the same problem, which is when supervisors have discretion to take prompt and forceful action they hadn't in the past, therefore, there should be automatic triggers to force them to take action.

But again, going back from the '90s to 2000s, 2010s, 2020s, the law was essentially not implemented. And I think the question is had it been implemented, would it have led to a different outcome? And maybe that's an unfair question because it's hard to go back in time and know what the answer would be. But another way to ask the question is, well, now that we've been through this experience again and given that the laws on the books, it doesn't make sense to revisit that as sort of a rifle-shot approach to address the problems we saw.

Nathan Stovall

Do you think -- so going through those triggers that were laid out, beginning with even just the first one. Looking back now with the benefit of hindsight, do you think -- I mean, maybe starting just with the SVB, which you talked about in detail on the post. Do you think there was enough stress there for that trigger to be hit? And if so, what comes with that trigger?

David Portilla

Yes. So the way the early remediation requirements were, as they were proposed in 2012, is there would have been 4 levels of remediation, and it's sort of like cold, a little bit warmer, a lot warmer and hot. And so Level 1 was what they called heightened supervisory review, which in the phrasing use the time would have been triggered when a firm first showed signs of financial distress. The remediation was pretty moderate for a Level 1 trigger.

And Level 2 is what they call initial remediation, and there would have been limits on capital distributions, acquisitions and asset growth. And interestingly, at least to me, looking back at Level 2, a firm's assets would have been limited to growing by no more than 5% quarter-over-quarter and year-over-year. And the reason I say that's interesting is because I think we all know, at least for SVB, it was essentially the fastest-growing bank, I think, in the industry or one of the fastest-growing banks in the industry.

And so you do ask yourself -- or at least I ask myself, I should say, imagine a world where Level 2 was triggered and the bank was limited to 5% quarter-over-quarter or year-over-year growth, do you ever end up in this situation? And you could ask yourself sort of an extension of the same question, do you ever end up at the next remediation level, which they call Level 3?

And Level 3 is really like serious stuff, Level 3, they called recovery level of remediation. And it would have required, among other things, a capital restoration plan, broad limits on BAU, business activities, a written agreement with the Fed, prohibiting capital distributions, asset growth, material acquisitions and restrictions on bonuses and pay increases and those types of things. Level 4 is basically closing the institution more or less.

But when you think of those consequences, it's a really interesting exercise to go back and think, well, imagine a world where SVB Financial Group, the bank holding company, was limited to 5% growth. And then the next question is, well, what are the triggers, right? I think one of the questions is like, that's the fundamental hard policy judgment is coming up with the right triggers. And one of the things that I was thinking through in the article was did the episodes of March 2023 provide lessons that can inform how triggers should be developed?

For example, I think we all now are very familiar with unrealized losses on investment securities portfolios and how that -- although it doesn't go through -- doesn't flow through the necessarily balance sheet equity and regulatory capital, what if you looked at that on a pro forma basis and thought of that as a trigger, for example.

I think the other thing I showed in the article, which I think is probably appreciated by a lot of your audience but maybe not appreciated by the public at large, is that the so-called deposit run at SVB -- well, not so called. I mean it was a deposit run of $40 billion in 1 day, and it's now been widely reported that they had a Q of $100 billion the next morning.

Nathan Stovall

Almost their entire deposit base between the 2 days.

David Portilla

Between the 2 days. But I think one of the things I pointed out in the article is there really have been a deposit outflow or a reduction in deposit funding for the basically 12 months prior to that. And so it's another question you could ask yourself is like, does -- would that be an appropriate trigger? You see that type of funding source steadily declining over a 12-month period of time, right, any extended period of time.

Nathan Stovall

Yes. And I thought that was a really interesting point, too, if I could jump in on that because in '22, yes, the industry lost 2% of the deposits. But as you outlined, SVB was about 4x that. Signature had outsized outflows too. So you could easily set it up where you say, okay, I don't know what the number should be. Is it 5%, is it 10% or is it 2%, if it's something like outflows? But what about 4x the industry?

David Portilla

Right.

Nathan Stovall

That sounds like a pretty good outsized marker to say we need to start kicking the tires on this thing a little bit more closely or at least trying to slow it down and figure out what's going on. And both of those would have screened on that or would have triggered, I should say, on that.

David Portilla

Both on the unrealized losses on the investment security portfolio and on the deposit outflows, I think SVB was an outline there on both. And I think that's a really interesting point, which is like, yes, it's very hard to pick an absolute number, but what about a relative measure? And that seems like, well, this institution doesn't look like the others. Maybe we need to go in and take a closer look and make sure that -- and then the whole point of early remediation is not maybe we have to go in and take a closer look. But now the law requires us to go in and take a closer look and take these actions.

But on the deposit outflow, just to focus on that for a moment, I think what's really interesting is as we show in the charts in the article from March 31, 2022, to December 31, 2022, so sort of the end of the first quarter through the end of the year prior to the failure, they lost $39 billion or 30% of noninterest-bearing deposits. And so essentially, funding costs went up and they weren't paying. So those deposits went elsewhere.

But to your point, presumably either others had stickier customers or we're willing to pay. I think there are lessons here about seeing, finding ways to identify outliers. And essentially, look, at the end of the day, I think what the policy imperative of early remediation is, is that it's kind of Congress saying, we're better off closing banks sooner and avoiding harm for these kind of outlier cases, because I think what Congress was saying in 2010 when it passed the Dodd-Frank Act is that when we wait is when we have these problems.

And so like -- I think the kind of question the article is asking is, if you go back to a world or if you imagine a world where SVB was closed in January 2022 with 6 months of preparation by the FDIC as the receiver to set up a data room and market the institution, is it as hectic as it was between March 10 and 12, 2023, when it failed?

The other point I would make, I think, is that I don't want to make it sound like I'm imagining -- where I'm imagining a world where CEOs say, oh, my God, my bank is going to be closed, like just because I have a bad financial quarter. I think the other point that Congress or that early remediation is trying to get at is that, let's say, those triggers existed in 2022. One of the interesting features of early remediation is that it's a rule. So it's public. All of your listeners who are analysts and market participants can look at the Qs and Ks and see when the triggers are hit, right?

And so they would know and they would know exactly what the consequences are, which can be really severe. What does that do? Well, it means bank management is really incentivized to make sure that those triggers are never hit.

Nathan Stovall

That's right. That's right.

David Portilla

So you have to ask yourself if there were -- again, I'm sort of -- this is hypothetical. But if you go back to 2022 and there was some trigger based on either unrealized losses on an investment security portfolio relative to balance sheet equity and regulatory capital or relative to the industry or deposit outflows relative to the industry, would bank management have said, "You know what, we can't let ourselves hit that level because -- and we can't even let ourselves be seen to becoming close to hitting that level because then the investors will know what's coming next. So we're either going to pay up for deposits to keep them or we're going to restructure our balance sheet quickly and swiftly, so we never hit that."

And so it's not like you get to a world where banks are being closed left and right by the government. You may actually be in a world where the incentives to manage the institution to avoid these triggers become much more stock.

Nathan Stovall

Certainly, I mean we see it a couple of ways, 2 points on that. I mean who runs at the minimum capital level? They don't, right?

David Portilla

Right.

Nathan Stovall

There's a cushion for exactly the reason you're talking about because what would that look like to everybody. Everybody -- you'd be a red flag to everybody. So you don't do that. So one, yes, they prepare on the front end.

The other one, too, we've kind of talked about, let's say it was either unrealized losses or outflows trigger coal in the middle of '22 that gets them looking more closely. They've probably kind of blown out the AFS portfolio like they eventually did and not call the bank on because the loss wouldn't be as big because rates weren't as high. So they would have had time whether it ended up where it ended up in terms of an orderly wind down. They might have been able to take time, though, to fix themselves because it wouldn't have been so far gone at that point.

David Portilla

And that's why -- and look, like I said, picking the triggers is the hard part, and I don't profess to have all of the answers there. But a part of -- I think a part of what the article is suggesting is, well, what if the Fed were to put out a proposal and like get ideas. It's the whole point of like the rule-making process, like let's see what the right -- Fed will have some ideas, commentators will have some ideas, put something in place. And like nothing is perfect and you adjust it over time, just like we do all other aspects of the Prudential framework.

But it just seems to me like a -- in some ways, it's almost regretful looking back that Congress said we have this problem and we're putting a provision in the law to fix it to make sure it doesn't happen again. Nothing ever happened with that provision of the law. And then you see the really adverse consequences of the problem materializing again.

Nathan Stovall

Sure, sure. Right. We had the playbook, and we just decided we weren't going to use it. We talked a bit about unrealized losses. A couple of things that have come down in terms of new proposals, at least for over $100 billion. How do you feel about the inclusion of unrealized losses and regulatory capital on AFS? And one of the things that we're talking more about is not saying proposing, but whether or not that the investment community is [indiscernible] on held to maturity as well and whether or not you'll see that come up in an examination framework. How do you think about sort of those 2 pieces?

David Portilla

On the AFS securities and the AOCI issue and just to level set for those who may not be following this as closely, AOCI or accumulated other comprehensive income is a balance sheet component, which takes into account losses and gains on available-for-sale securities. It does not, under the current framework except for a small handful of firms, flow through to regulatory capital, although it does affect your sort of balance sheet equity.

When the agency has proposed the current capital rules in 2012, they basically said, we think it should flow through the regulatory capital. And even when they adopted the current framework where it doesn't, they said the agencies believe that the proposed treatment of AOCI, meaning having it flow through the regulatory capital results in a regulatory capital measure that better reflects banking organizations actual losses or absorption capacity at a specific point in time. And then they said, but we're not going to adopt it because we understand that it can be difficult and costly to implement.

So I think what you see there, in some ways, this wasn't a new issue for the agencies. They probably wish they had done it originally in 2012. So they've now proposed as part of the Basel III endgame capital rule revamp to have AOCI flow through to regulatory capital for all firms with $100 billion or more in assets, as you said. I mean in some ways, in my mind, in my sort of observation of the scenario, it's then doing what they wish they probably had done in 2012.

I think HTM is another issue, right? Because they in some ways, it's conceptually different. Like AFS securities or securities and in theory, you might sell at any point in time where you'd have to take the marks. And so that's different than securities that you're firm is saying, no, it's actually going to hold to maturity.

And that, to me, like not -- I don't want to sound like a broken record, like early remediation is the only thing that -- which takes all these problems. But in some ways, it shows the promise of early remediation in the sense that early remediation allows you to find a middle ground, meaning you don't have to change the accounting classification of HTM. You don't have to change how HTM is capitalized from a regulatory capital perspective, but you can take into account the market value of HTM securities when you're supervising an institution through those early remediation requirements because I think the article also has some charts that were borrowed from the financial study.

The Oversight Council is showing the relative percentage of investment securities held as HTM among large banking organizations. And no surprise, those organizations that are required to flow AOCI through the regulatory capital held up between 60% and 70% of their investment securities as HTM, whereas those that were not required to flow AOCI through the regulatory capital held between 20% and 30% of the securities as HTM.

So if that would lead one to believe that as soon as the rule changes, that will just equalize, meaning like more firms will hold more securities as HTM. Okay. So if you solve the problem, I don't know, but it probably also suggests that maybe it makes sense to then evaluate how the performance of those HTM securities, what it means for the health of the institution overall.

Nathan Stovall

Sure. But to your point on early mediation, just focus on SVB. At the end of Q4, that HTM portfolio had a $12 billion hole in it. About half of the hole that they would have had -- the whole thing to market. So 45% of our TCE smoked. That should be a little bit of a warning sign to a regulator, and they would know that. They would have seen some of that starting in Q3. So you're right, you don't necessarily even have to put it there in order for it to show up and say, let's think about how you're positioning your balance sheet.

Well, in closing, the last thing I want to talk about -- we talked about a little bit Basel III endgame. One of the things that's been of interest to us is much more focused on granularity on their depositor base. And I know where this came from, SVB, top 10 depositors, $13.3 billion in deposits. That was a number that really struck a lot of people, including me. But talking about providing details on the top depositors. Do you think that, that is kind of like a fine-tune tool that almost falls in the early remediation bucket because it arms them with new information? Or I mean has that been other? I just wasn't aware of it.

David Portilla

Look, I think that the issue of concentration -- business model concentration has been a regulatory focus for a very long time. I think -- and a part of this is on maybe engaging in informed speculation. But certainly, the regulators have seen business model concentration as a risk for a long time. And that's why so-called niche banks are subject to greater regulatory scrutiny. That's the extreme example of that type of regulatory focus.

But when you pointed out that the deposit outflows that SVB experienced were markedly different than industry averages. That could lead one to think, well, is that because you're concentrated with one type of business, right? So you could see -- like I don't know that you could get early remediation requirements to be so finely tuned to say like this number of depositors that equal that percentage of your deposits, but you could see how having a very concentrated depositor base indirectly could flow through to metrics that are measured for sort of early remediation purposes.

Nathan Stovall

Former guests of the show pointed out, not long after their failure, how we have the corollary of the Texas banks in the '80s who were so heavily concentrated in oil and gas. And when oil plummeted, they had some problems as we now know. So -- and that was well documented to your point. So it's not necessarily new. It's more like it rhymes with a long-standing sort of regulatory focus in your mind.

David Portilla

Right, right. Yes. And look, to offer a couple of thoughts to wrap up, I think we can't prevent all bank failures, right, in the future. But we should have an effective resolution framework, which was really quoting FDIC Director, McKernan, who pointed that out. And I think what the spring taught us is there's some gaps in our resolution framework.

And I think fundamentally, if I had to sum up in like 5 seconds what my article is suggesting is we should make sure that we're preparing for resolution earlier and that if you -- like one of the things that the record regarding SVB has shown is, I think, it's Chairman Broomberg's testimony as they started preparing for the resolution on March 9, and the bank was closed on March 10. Well, preparing to do something the day before is a recipe probably for not the greatest chance of success.

So what could we do to make sure that in the future, we're increasing the odds that we're preparing earlier? You can't anticipate every situation, but what can you do to really make sure that you're trying to make -- you're positioned to start earlier. And that gets to early remediation, and that's sort of how I landed where I did with putting those thoughts together.

Nathan Stovall

Yes. And if you don't prevent it, you at least limit hits to the fund and probably don't let things get as bad. Well, that's an awesome place for us to leave it. Thank you so much for coming on the show. Really appreciate it.

David Portilla

It's my pleasure.