The Federal Reserve Board (“FRB”) Inspector General (the “OIG”) has issued a highly critical report regarding FRB supervision of Silicon Valley Bank (“SVB”) in the years preceding the bank’s failure in March 2023. The oft-told tale of the demise of Silicon Valley Bank is included in the OIG report and will not be repeated here. Suffice it to say that that SVB’s failure was the result of unchecked growth in an operating environment that lacked adequate risk management and governance guardrails. But the most interesting takeaways from the OIG report relate to the agency watchdog’s critique of the FRB’s supervision of SVB and the OIG’s recommended changes to the supervisory process for large financial institutions.

Many findings in the OIG report echo conclusions reached in the FRB’s own April 2023 assessment of the circumstances that contributed to SVB’s failure. Both the OIG and FRB reports cite the poorly coordinated handoff of SVB from a Regional Banking Organization (“RBO”) supervisory team, which was appropriate when SVB had $50 billion in assets, to the more robust team that supervised SVB as a Large and Foreign Banking Organization (“LFBO”) when the bank crossed the $100 billion in assets mark and, eventually, $200 billion in assets. But a few new considerations emerge from the OIG report:

• The OIG report is critical of the supervisory focus on risk management over financial results.The report notes that the LFBO supervision team did not push SVB to mitigate the effects of interest rate changes, which were the proximate cause of SVB’s failure.“Further emphasis on assessing the effect of rising interest rates,” the OIG report notes, “could have helped reveal the vulnerabilities inherent in the bank’s financial condition.”
• The OIG report also highlights the FRB’s reliance on a possibly flawed internal model to staff supervisory teams, determine the frequency and intensity of examinations or continuous monitoring, and allocate examination hours.Specifically, OIG is critical of the use of the “Banks Exams Tailored to Risk” (“BETR”) process, authorized by FRB Supervision and Regulation Letter 19-9, which combines surveillance metrics with examiner judgment to classify the level of risk at a particular bank and, based on that assessment, to establish an appropriate frequency and intensity of the bank’s continuous monitoring and point-in-time examinations.However, the BETR system, which was principally developed for supervision of community banks, was used, at least in part, to establish the supervisory parameters for SVB, thereby, resulting in the allocation of insufficient supervisory resources as the bank continued to grow.
• The OIG report identifies the pause in on-site examinations during the early phases of the COVID-19 pandemic as a factor in the deterioration of the supervision of SVB.At the start of the pandemic, FRB staff conducted a “prioritization exercise” to the scheduling of supervisory activities that resulted in a “low risk” classification for SVB.Among factors cited in support of the “low risk” classification was the concentration of SVB’s customer base in technology and private equity firms which were considered not directly impacted by the pandemic.Consequently, five examinations for SVB were cancelled at time when SVB was growing rapidly.
• The OIG report calls out an internal governance dilemma for the Federal Reserve Banks.SVB CEO Gary Becker was elected to the board of directors of the San Francisco Federal “because of his knowledge of the technology and venture capital sectors.”Although Reserve Bank board members are not provided with confidential supervisory information and may not participate in supervisory matters, the OIG concluded that Mr. Becker’s presence on the Board created the appearance of a conflict of interest.It is noteworthy that FRB San Francisco staff interviewed by the OIG acknowledged that senior officials had considered whether Mr. Becker should be removed from the board after SVB’s supervisory ratings were downgraded.However, these discussions were tabled as concerns developed about the interpretation of his removal as signal to the market of the bank’s deterioration.The OIG recommended that FRB requirements for Reserve Bank directors be revised to encourage service by retired. rather than active, bank executives.

We have certainly not heard the last word on the SVB, Signature Bank and First Republic Bank failures. It is likely that ongoing investigations by the bank regulatory agencies, the Securities and Exchange Commission, and Congress will provide an even fuller picture of the circumstances that led to the failure of three institutions that were not on any short list of potentially troubled institutions.