Bank failure fallout spells tougher regulation for regional banks ahead

In the wake of recent bank failures, regional banks are once again at risk of facing tougher regulations that impose major burdens.

Following the collapses of Silicon Valley Bank and Signature Bank and an ongoing industry liquidity crunch, pressure is growing on the Hill and among regulators to impose more stringent liquidity, capital and stress testing requirements on regional banks.

In a new bill supported by dozens of Democrats in both the House and Senate, lawmakers are seeking to repeal 2018 legislation that eased regulations for banks with between $50 billion and $250 billion in assets, which were initially established in 2010 under the Dodd-Frank Act. If passed, banks with assets above $50 billion would once again be considered and regulated as "systemically important" after lawmakers raised that threshold to $250 billion under the Trump administration.

However, the bill is likely to face a tough path in Congress, meaning that regulators will potentially lead the crackdown on increased supervision of regional banks.

Stress tests and capital and liquidity requirements

Under anticipated increased regulation, financial institutions with assets between $50 billion and $250 billion would fall subject to regular annual stress testing and enhanced liquidity, capital and resolution plan, or "living will," requirements.

"We believe that regulation will disproportionately burden midsize and smaller banks," Piper Sandler analyst Mark Fitzgibbon wrote in a March 22 note.

If Congress is successful in its effort to lower the threshold back to $50 billion, a number of banks would be subject to that stricter regulation. According to data from S&P Global Market Intelligence, 39 US banks had between $50 billion and $250 billion in assets as of Dec. 31, 2022.

The annual stress testing requirement would be particularly burdensome for regional banks, said James Stevens, co-leader of the financial services industry group at Troutman Pepper. Currently, banks with more than $250 billion in assets are subject to annual stress testing, while banks with between $100 billion and $250 billion are subject to stress testing every two years. Banks with below $100 billion in assets are generally not subject to stress testing.

"Providing information to your regulator to enable them to do the stress test is a big project," Stevens said in an interview. "Having a regulator review something that you do yourself, versus giving them information and then having them do it are different."

Among other requirements, banks would also have to meet a ratio designed to measure assets that are available to meet their near-term liquidity needs, known as the liquidity coverage ratio, Stevens said.

"That's a ratio that is complicated to calculate and it requires a great deal of liquidity," the Troutman Pepper attorney said.

Regulators will likely lead the charge

Exactly who will impose those tougher regulations on regional banks is up in the air.

Congress' effort to lower the "systemically important" threshold back down to $50 billion "could struggle in the Senate and is highly unlikely to clear a GOP-controlled House," said Isaac Boltansky, managing director and director of policy research at BTIG.

Boltansky believes it is inevitable that regional banks will find themselves subject to more onerous supervisory stress testing and tightened liquidity coverage ratios over the next 12 to 14 months, but those changes will likely come from regulators rather than Congress.

"Ultimately, we believe that the [Silicon Valley Bank]-induced liquidity crisis will lead to policy changes, but we believe those changes will be advanced in the regulatory sphere," Boltansky wrote in a note. "We are bearish on Congress acting in the near term, but if this crisis worsens materially then it will be forced into action. Our sense is that we need to see more bank failures and/or forced M&A in the regional bank sphere before Congress is forced into action."

With a tough road ahead for legislation, Congress is still putting the banking industry under a microscope.

Both the Senate Banking Committee and the House Financial Services Committee will soon hold hearings to examine the bank collapses, with top financial regulators testifying. The Senate committee will hold its first hearing March 28, while the House panel will meet March 29.

Would more regulation have prevented recent bank failures?

As banks are confronted with potential new burdens, questions have been raised about whether Silicon Valley Bank and Signature Bank would have failed had they been subject to the tougher restrictions originally enacted under the Dodd-Frank Act. However, industry observers are unsure those increased regulations would have picked up on the banks' unique situations.

"I think that it's just hard to say that exposing [Silicon Valley Bank and Signature Bank] to the liquidity coverage ratio or to supervisory stress tests or more frequent reporting as to capital levels and things of that nature would have been dispositive and prevented this failure," Troutman Pepper's Stevens said.

"I think we're going to find, in hindsight, that it's much more complicated, with lots of contributing factors," Stevens added.

One such factor that contributed to the collapse of Silicon Valley Bank was liquidity stress. Days before regulators took possession of the bank, its parent company SVB Financial Group announced capital raise plans, which included selling $21 billion of available-for-sale securities for a loss of $1.8 billion.

It is unlikely the regulations imposed on the nation's largest banks would have picked up on the liquidity stress.

Silicon Valley Bank "probably would have received a passing score" on the liquidity coverage ratio requirement, Bank Policy Institute Chief Economist Bill Nelson said in a recent analysis.

The bank's problem "was not that it did not hold liquid securities like Treasuries and agency-guaranteed mortgage-backed securities," Nelson said. "Its problem was that those securities were long term and paid low interest rates, and thus suffered extraordinary losses when interest rates rose. That's not a problem that the LCR is designed to catch."