Assembly Standing Committee on Banking and Finance

Good afternoon, and we are hosting an informational hearing on the collapse of Silicon Valley Bank, what happened, and what it means for banking regulation. Members are all spread out at Committee hearings, presenting bills of the Committee, but they will be coming in and out. But the most important thing is that we are being proactive. We are moving forward with this hearing, and that Members will be able to go back and observe the hearing in its full entirety and hear all of testimony.

So with that, again, good afternoon and welcome, everyone, to our first hearing regarding the collapse of Silicon Valley Bank, often called SVB. Please note that there is a background paper published on the Committee's website, and there are copies here in the room. And today's materials from our presenters will also be published on the website. The purpose of this hearing is to learn about SVB's failure and what next steps the Legislature should consider as we think through ways to shore up California's banks.

As a state chartered bank, SVB was supervised by our regulator, the Department of Financial Protection and Innovation, along with the Federal Reserve. DFPI has announced it will release its own report in early May about the SVB collapse and DFPI's supervision of the bank. This Committee will also reconvene after the release of that report. Therefore, I consider today's hearing more of a prologue to a deeper dive into the policy issues raised by the March 2023 events.

But this will be a very substantive prologue because--well, there's a lot to discuss, and we look forward to hearing from our presenters. The SVB failure was a major event in banking and finance, and in just one day, roughly 40 billion was withdrawn from the bank due to the fears of the bank's financial health. This was one of the largest bank failures in history. And this wasn't just any bank.

SVB was essential to the tech sector, one of the most important engines of economic growth in California. Since the bank's failure in early March, we have learned a lot about what happened. We have learned that SVB was exposed to what is called interest rate risk, which is a type of risk we will learn more about today. And SVB management did not address this risk despite numerous warnings.

We have learned that SVB relied heavily on venture capitalists, tech companies, and startups for its business, and these companies and investors have been struggling in the current economic environment. This made SVB uniquely vulnerable. We have learned that SVB had significant deposits well above the federally insured level of 250,000 dollars. By the end of 2022, around 88 percent of the bank's deposits were uninsured. We have learned that important federal banking rules were modified in 2019 and may have laid the foundation for SVB's failure.

We have learned that in today's social media climate, it is remarkably easy to spread concern among a bank's customers. And we have learned that federal supervisors identified the risk and problems in SVB's business model and warned the bank's management of these risks, but it does appear that SVB ignored those warnings and that regulators did not take the next step in compelling a change in the bank's practices.

The more we learn about SVB collapse, the more I am certain that there are no easy answers or convenient explanations. For an event like this, many things have to go wrong, and they have to go wrong at the same time. Today is about identifying what went wrong so that we can identify what has to happen or must happen next. A few other notes before we begin. First, SVB is not only a California bank that has struggled this year.

Silvergate, a bank that catered to cryptocurrency companies, wound down last month, and First Republic Bank was the target of significant industry-led interventions to help stabilize it. And though our focus today is primarily on SVB, the experiences of these banks are also relevant to our discussion, and we will hear more about them as well.

Second, this Committee will need to take a serious look at DFPI supervision of SVB, and it's important to explore what tools DFPI has at its disposal when it identifies problems in a bank, and whether DFPI is empowered to use those tools. I have tremendous respect for Commissioner Hewlett and her team, and I am hopeful that DFPI and the Legislature can have an honest and productive conversation about what is working and what isn't with its supervision of state chartered banks.

If there are shortcomings, then yes, we should address them. Once DFPI has released its report, we will invite the DFPI team to present that report before this Committee. An announcement will be forthcoming very soon.

Thanks again to everyone who has joined us today, and I want to open it up to anyone, as far as Members as they come in, so we might interrupt if they have a comment or wait between presenters to allow certain ones to come in and accommodate the schedule to be able to make comments before they have to again leave. So with that, opening it up to other Members as they come in, just be prepared for that if we have to interrupt you at the last second.

Other than that, I do want to turn to our first panelist, and that would be Todd Baker, who is a financial services executive whose career has led him from corporate law to leadership roles at several of the largest domestic and international banks, and roles as an academic, consultant, writer, speaker, and commentator on banking, financial technology, consumer financial access, and regulation issues.

He is currently, if I understand it correctly, Senior Fellow at the Richard Paul Richman Center for Business, also Law and Public Policy at Columbia Business School and Columbia Law School. And with that, Mr. Baker, we are excited to be able to hear your testimony today. Please.

Thank you, Chairman Grayson. I appreciate your opening comments, and I just want to point out to people that I do live in Berkeley, California. So I'm a Californian for many years. So in line with your introduction, I'm going to talk about causes, effects, and some of the consequences of what happened at Silicon Valley Bank. So if we can advance the slides to slide two. So I'm going to run through the causes here. I'm going to do it in more detail.

So I'm not going to go through this slide. Next slide. The effects of those and what actually happened at Silicon Valley Bank. Next slide, please. Then we're going to look at some unanswered questions. And finally, the next slide, some key policy issues. Next slide, please.

So it's worth noting that this all happened within a period of about three weeks, from the initial indication of problems at the time on March 8th, through the sale of the remaining Silicon Valley Bank assets and liabilities to First Citizens Bank on March 27th. So a very quick timeline. Okay, could you move two slides forward?

So what we're really talking about here is the background. What happened to Silicon Valley Bank was in part the result of a long period of very low interest rates and high growth in the technology business. So this slide eight here shows the growth of the digital economy over the last ten or 15 years. Steady growth, and then a very enormous increase in the years leading up to this past year, 2002. Next slide.

At the same time, and this was principally a result of the 2008 financial crisis and the interventions of the Fed, interest rates were very low for very long, and for a long period, essentially effective interest rates were close to zero. Next slide. As a result of that, bank deposit rates, the rates that banks paid on deposits were zero to extremely low, again, until quite recently when the Fed started raising rates. Next slide. Two other things made this last period sort of a Goldilocks period.

Credit performance was as good as it's been in my career and for as long as it's been in my career. So no credit problems in the economy. And the--next slide--equity markets boomed for an extended period. Stock prices, particularly for technology companies rose through this entire period. Next slide. Okay, all good things have to come to an end. And inflation reared its head as a result of Covid and various other factors.

And the Fed, for the first time in a very long time, started to raise interest rates. Next slide. So short-term interest rates began to spike as what was called 'quantitative easing' ended. And--next slide--and you'll see that this rate rise, the one that's circled there, the arrow to the left, was the fastest and steepest of all the rate actions by the Fed over the last 30 or 40 years. So exceptionally fast and exceptionally high interest rates over a very short time. Next slide.

This coincided, and there was some cause and effect relationship here for sure, with a decline in the tech economy. The tech economy peaked about the same time that interest rates started to rise, and the stock prices of all the tech companies dropped very rapidly. 2002 was particularly difficult in that regard, and the tech economy, which had been booming for an extended period, really ten years, suddenly ground to a halt and started reversing. Next page.

New venture investment in technology also began to decline very rapidly, at the same time as stock prices for established tech companies dropped. This is highly relevant because Silicon Valley's major business was providing assistance to venture-backed companies and more late stage technology companies. Next page. As rates rose, deposits started to leave the banking system. This is only through the first couple of quarters of 2002, but if we extended this chart out, you would see very substantial reductions in deposit balances in the banks.

And this is because while interest rates were zero, essentially there was no cost to leaving money in deposit accounts that didn't pay interest. Silicon Valley had a very large number of those accounts. But as interest rates rose and yield became important again, investors started looking for places to put their money where they would earn more interest and started pulling money out of the banking system. Next slide.

Okay. So that's sort of the environmental situation, which was a cycle was happening in technology at the same time as a cycle was happening in interest rates, and the impact that had on the banking industry was significant in terms of deposit flows. Deposits started to leave the banking industry. Okay. Silicon Valley Bank had a unique business model. It was founded back in the 1980s. At the time of its failure, it was the largest California state chartered bank.

The Federal Reserve, as you noted, was its primary federal regulator, and the DFPI was its state regulator. It had a unique focus on the global tech industry. It provided support for startups, venture capitalists, established technology companies, and it's important to note that its activities were international in scope, not just in California or in the U.S., but also in Europe and Asia.

It also, interestingly, was a prime sponsor of the wine industry in California, a small business for Silicon Valley Bank, but a very big impact business for the wineries. And it had a largely undiversified risk profile. What I mean by that is, unlike, for example, Bank of America, which is nationwide in scope, banks' consumers, banks, all different kinds of businesses is not highly concentrated in one area. Silicon Valley Bank was very concentrated in loans and activities associated with tech and tech fundraising.

As a result of that, its deposit base, as compared to other banks, was more volatile, tied to the tech industry cycle. If you look back at its history, you'll see that deposit balances rose and fell with tech industry cycles over the last 30 or 40 years. This time because we had an exceptionally long tech cycle and an exceptionally long period of low interest rates, really unprecedented in my long career, the assets and deposits of Silicon Valley Bank grew enormously.

During the last eight or nine years, deposits and assets grew from about 50 billion to about 200 billion or over 200 billion. Because Silicon Valley Bank--although it was a lender--was not able to fill its balance sheet and match those deposits with loans, it had an exceptionally large percentage of securities on its balance sheet. So it had plenty of loans, as we'll see on the chart in the next page, but it also had--

There you go. And almost all of its deposits were from corporations and businesses that had very few individual deposits. And my number is slightly different from yours, but 94% exceeded the $250,000 cap. Next slide. This bank was very important to the California innovation economy. About 50% of us venture backed companies used Silicon Valley bank. It funded businesses in all types of technology and biotechnology, to Internet companies, to life sciences of various types. Really deeply involved in anything that started with venture capital. Next slide.

As I mentioned, it had operations around the world. Next slide. It was, by US terms, a large but not giant bank. So 212,000,000,000 in assets. I think made it about 25th, if I recall correctly, in size, and 74 billion in total loans. Next slide. As I mentioned, it had recently very accelerated deposit growth. You can see that the period end assets rose very substantially over the last five or six years. Next page.

Unlike many banks, the stock of Silicon Valley Bank tracked the tech markets rather than other banks. In other words, it was most closely correlated with the Nasdaq. It rose and fell with the tech cycle rather than with banking. And this reflected the fact that its business did very well in times when the tech business was doing very well and less well in times when it was in decline. Next page.

Now we'll move to some of the things that accelerated the crisis, and particularly the management questions that the Chairman mentioned at Silicon Valley Bank. Next page. So, as Fed Governor Michael Barr said in hearings two weeks ago, Silicon Valley Bank's failure is a textbook case of mismanagement. And for a bank observer, that is very clear.

They failed in the most basic way to manage the liquidity risk, that is to say, the risk that their funding sources through deposits, would be more volatile than expected, and that they would have to then use cash and securities that they had on their balance sheet to pay off deposits as they left the bank. They had a history of, shall we say, not following best practices in the liquidity management space.

I think it will be very interesting as we learn more about what exactly happened or what didn't happen. But I think we'll find a variety of circumstances where they made wrong decisions around that risk. It's basic to the banking industry that you do not want to be taking interest rate risk, because interest rate risk is essentially a bet. You don't know which way interest rates are going.

And what you try to do is hedge your exposure so that if interest rates go up or down, your business is relatively little impacted. You can make it not impacted, but you try to restrain that. The worst thing to do is to make directional bets on interest rates and put your bank and your earnings at risk by being wrong about which way interest rates are going. So, next slide. So, looking their risk, in a nutshell, they had volatile deposits.

As we said, those technology deposits moved fast, primarily matched against interest rate sensitive securities and other assets. So a high risk deposit base and assets that were significantly interest rate sensitive. Next. As we mentioned, they probably had just about the highest level of uninsured deposits in the industry. If you look down here, you can see us bank, for example, at about 50% uninsured deposits.

That would be typical for a very large commercial bank, because uninsured deposits are a characteristic of a bank that deals with large corporate clients. Right, because most of them have more than $250,000 invested in the bank. But Silicon Valley Bank, even in that context, was an outlier. You can see the number two was signature bank, the New York bank that also failed that same weekend. And that First Republic Bank, I'll note, is significantly lower, but still higher than these other banks. Next slide.

And then, most significantly, the balance sheet assets of Silicon Valley bank were primarily securities. They had $100 billion of securities as opposed to $74 billion of loans. Next slide. Now, those securities, the interest rate risk of a security is largely dependent on its duration or how long the obligation is. So a five year security is much more subject to changes in interest rates than a three month security.

And so Silicon Valley Bank had a combination of a very large securities portfolio and an interest rate risk profile, which was not adequately controlled. They had too long assets being supported by liabilities, in this case, deposits that were likely to be highly volatile. And you see on this chart the impact of the unrealized, that is to say, the market losses, were they to have to sell all their securities, which normally would not be the case.

You can see that their risk profile up here was way out of line with the rest of the banking industry. So they had the largest risk associated with their securities portfolio. Next slide. As I mentioned, their deposits started to tail off quite significantly by the end of 2022, and that accelerated into the first quarter. So they were losing deposits very quickly. And next slide, we move into why? What did they do here? Well, first, they.

They failed to diversify their risk away from the tech exposure, right. So they had a very concentrated set of risks associated with the test cycle, which tech cycle, which should, in most circumstances, have alerted them. The fact that the deposits associated with the tech business were likely to be volatile and leave more quickly than a more diversified deposit base. Secondly, the board quite noticeably lacked any expertise in bank risk management.

The seven board Members assigned to the risk Committee, only one had any background even remotely related to risk management, and most of them were from businesses that don't have to deal with these types of risks. More concerningly, it appears that management apparently tried to what we call play the yield curve.

And what that means is, if we think of that long period when interest rates were zero, it was a good idea from an earnings standpoint to have longer, higher, because longer securities typically have a higher interest rate. You earn more on securities that are longer term, and that works fine as long as you don't have to sell those securities. And in a period that long period of Low interest rates, that worked just fine. They earned more on the securities, right? They never had to redeem them.

So they never took the market loss if rates changed. And they were unprepared for rates moving up that strategy to become highly toxic. And they did not prepare in any way for the prospect that rates would put their securities portfolio deeply underwater, and they would at the same time as their deposit balances were dropping. Second. Next page. In addition, we've all read the reports. They had no chief risk officer for many critical months as this crisis was building.

Apparently, they essentially sold a crucial interest rate hedge they had on the securities portfolio to generate earnings, presumably to meet earnings targets. And this would have been quite unusual. The rest of the banking industry has hedged their securities portfolios. Apparently, a decision was made here to take the hedge off that typically would mean that they believed that rates were going to drop. And, of course, as I mentioned, it's not a good idea to make bets on whether rates are going to drop or not.

And it looks like they did. Apparently, they replaced the liquidity risk model, which would have warned them about the possibility that deposit drops would put the securities portfolio in trouble when it gave an answer they didn't like and change it to a new model that I only know from press reports.

And they clearly were not prepared for a liquidity run, as they, again from press reporting, had an extremely difficult time pledging securities to the Federal Reserve under the emergency tloc facility that was put in place, and to the federal home loan bank, and just were unable to deal with the extent of the risk. And I guess my last speculation is that they lived on opium, that things were going to be okay, rates would come down, it would all work out. No one would do that.

And 99 times out of 100, that probably is what happens, but every once in a while, it doesn't. And in the banking industry, you have to prepare for that circumstance. Next slide. So back to timing and messaging. Apparently, Moody's investor services was going to downgrade their debt and deposit ratings because of this risk, which, by the way, was fully disclosed in the 10 k. And bank analysts saw the extent of the mismatch between asset liabilities.

And as a result, the bank hired Goldman Sachs, and Goldman came up with the idea of selling a large portion, actually a relatively small portion, but the most volatile portion of the securities portfolio, and at the same time, raising capital to cover the loss. Two things went wrong with that. One I'll talk about in a minute, that had to do with Silvergate bank. And the other was that it was probably too little, too small a solution.

When you have a $75 billion securities portfolio problem, or 100 $1.0 billion securities portfolio problem, selling 2 billion doesn't really solve it. Next page. As the Chairman mentioned, Silvergate played a role here because the Silvergate bank failure happened just at the same time as Silicon Valley announced that it was going to sell capital uncommitted. By the way, it was a plan to sell capital, not an actual sale of capital, and sell securities.

Silvergate's collapse essentially forced attention on the same problem, because Silvergate's problem was an exaggerated version of Silicon Valley's problem. It had, all of its deposits were with crypto companies. The crypto crash led those deposits to leave the bank very rapidly. The bank had a securities portfolio that it thought was adequate to deal with. That turned out it wasn't. It was too long again.

And as a result, Silicon Valley, sorry, Silvergate, went out of business, and that focused everyone's attention on other banks that had that issue, and in particular, Silicon Valley Banks. Next. Yeah, this is just a thing that shows you what happened with Silvergate. Bank's deposits grew very rapidly during the crypto boom and fell off. So something similar was happening at Silicon Valley Bank. Next. And as the Chairman also mentioned, something new happened.

The $42 billion withdrawals that you mentioned on that one day was about, well, the statistic I use when Washington Mutual failed in 2008, during the last eight business days, they lost a total of $18 billion of deposits. And that was a bank that was larger than Silicon Valley bank. So this $42 billion number was huge. Plus, as Fed Member Barr said, there were $100 billion more getting ready to come out the next day.

So the size and speed of this was unprecedented, and it had something to do with the makeup of the Silicon Valley bank deposit portfolio, all uninsured, all in a very tight knit industry where information passed quickly, but also due to the fact that to move your money, all you need to do is pick up your cell phone and do something on your app.

Very different from our vision of a bank run from it's a wonderful life or pictures of the 30s where people are standing in the lobby and yelling, you don't need to do that anymore. And it can move very, very fast. Next page. And I point out, for those who are critical, that bank runs are a form of what we call a prisoner's dilemma.

It's never a good idea for anyone to start a bank run, but once a bank run starts, you really have to participate in it or else you're going to be left holding the bag. Next. So all these things came together on the left that we discUssed, and what happened was the worst bank run in Us history. With that $42 billion leaving in an afternoon, 100 billion headed out the door.

They were unable to secure liquidity from the Fed and the FHLB sufficient to pay off deposits, and they were seized by the FDIC at the request of the Department of Financial Protection and Innovation. Next slide. What happened next? Well, shareholders were effectively wiped out. I should point out that the holding company shareholders still have an interest in a couple of subsidiaries, and there's going to be a dispute with the FDIC over who gets those. Initially, the insured depositors were fully protected. The uninsured. Not now.

Look, think of our slide. That means 6% of the depositors were protected and everyone else was not. They used a type of receivership which assumes that they're going to liquidate rather than sell the whole bank. And the FDIC's communications, in my view, were very poor. They were accurate in terms of the legalities, but they did not make clear that about a third of the uninsured deposits were going to be distributed as soon as the next Monday.

And I think it was a fairly bureaucratic statement that did not do much to calm concerns of depositors and others in other banks. So there was a lot of confusion over the weekend. There was talk of selling the franchise or selling parts of the franchise. That didn't happen. Next slide. And by the next day, the contagion run was happening on basically all regional banks that had high levels of uninsured deposits, many of whom were in California. First Republic Pacific, western Silicon Valley.

I'm sorry I mentioned signature bank failed. Over the same weekend, western alliance, Zion's all suffered significant deposit runs. Next slide. And then we saw the massive effects that a true failure of Silicon Valley bank would have on California because of its critical role in the technology industry and great concern about how a variety of companies were going to meet payroll and what the impacts would be on the state. Next slide.

Preaching to the choir here, but California dominates in tech and relies very much on tech, so I'll just move on. So things were not going well. Other banks were being threatened, and the procedure was followed by the Treasury Department, the Federal Reserve, the FDIC, which called for what's known as a systemic risk exception, which is an extraordinary action taken to allow the FDIC to do more than just pay off insured deposits.

And so the conclusion was reached with respect to both Silicon Valley bank and signature, that this was a systemic risk moment, and that the FDIC would, in fact, guarantee all deposits and set up what are known as bridge banks to market the franchises in an early way. The banks started normal operations again on Monday. The holding companies declared bankruptcy, and then ultimately. Next slide. The franchise was sold to a company out of the Midwest called First Citizens Bank shares. The assets and liabilities were transferred.

Next slide. I won't go through the details of how this was done, but basically all of the assets, loan assets and securities and all of the relevant liabilities were transferred at an extremely large cost to the FDIC. About $20 billion is the estimate. That would be the largest failure in history or largest cost failure in history. Next slide. Next slide. One more? Yeah. Okay. So what are the questions that we don't know, obviously. What did management there know and when did they know it?

There are many indications that outside risk advisors had advised them to do things that they chose not to do. How were they thinking about the expected growth and shrinkage of the company in the tech cycle? What was going on with that securities hedge? A reversal, the change in the risk models, the not having a chief risk officer at the same time as they were scheduled, insider sales. So all that requires looking into what did the board know and when?

One thing that's very significant is the risk Committee had 18 meetings during 2022. That's very, very unusual. You would think maybe six, if that. So the risk Committee was deeply involved in something, probably in responding to the regulatory actions that the Fed and the DFPI were taking at that time. What did the regulators know?

The regulators have indicated in testimony so far that they intensified supervision very actively in 2022, cited the bank with what are known as MRAs and MRIAs, matters requiring attention and matters requiring immediate attention. The question everyone seems to ask is, should they have done more? Should they have ordered change that they did not. And we'll be learning more about that when the Fed does its report and when the DFPI does its report to know what was done and what wasn't.

Clearly the thinking around the moody's downgrade and the capital raise is worth looking at. It was a very unsuccessful strategy. And then there'll be some discussion about whether any of the holding company assets end up for the benefit of the bank. Last thing, policy issues. So it's raised a number of issues, starting with how should management be treated given these risk management failures. There are provisions that allow for so called clawbacks, which is pulling back compensation that's previously been granted.

Should individuals be banned from further involvement in the industry? That's another power that the regulators have. Here's one that I think the state could actually do something meaningful on is: should bank boards be required to have expert Members? As I mentioned, the Silicon Valley Risk Committee and the board of General had very few people with any banking experience. And California could certainly change this requirement for at least its larger regulated banks.

The fundamental question is, did the regulators have the right powers or could they have used their existing powers more effectively? Is new legislation required? Or is just empowerment of the regulators to use powers they already have? And again, we'll learn more about that when we learn what was actually done during those days. And then the whole question of systemic risk needs to be rethought, because the prior view of what institutions could cause systemic risk was the very biggest ones, the too big to fail.

So called GSIPs, the Bank of Americas, the Morgan's, the Citibanks. Well, this is a much smaller bank. And yet because of its impact on a particularly critical industry for the country, its failure caused a systemic event. And so we need to think much more carefully about which banks are systemic. And to the point that the Chairman made about changes that were made to the regulatory structure.

Maybe we need to impose the same requirements on those smaller but still systemically important banks that we impose on the larger banks. And I think that'll be a source of major discussion at the federal level. And then very specifically on the question of liquidity, do we need to think about the question that I think Michelle will talk about, which is this bank was well capitalized, capital was not the issue. And most of our regulation focus very heavily on capital.

We do have liquidity requirements, but they would not apparently have captured this risk. Even had the liquidity requirements applied, the bank probably still would have met them, because the liquidity requirements, again, are tied to models which assume how fast deposits are going to leave, and valuation changes in securities portfolios. And so, at least as far as the research I've seen from Yale so far, it appears that Silicon Valley bank would not have been cited for failure to meet those requirements.

So the requirements need to be looked at again. Okay, so that's the end of my thing here. When you're ready, I can talk about First Republic Bank. Maybe you want to go first and finish the Silicon Valley thing.

Mr. Baker, thank you for your presentation. Very insightful. And we do have Members that are present here with us. I think at this time, we will move to our next presenter and then open it up for Members to be able to make comments and ask questions at the very end. So with that, we have with us Ms. Michele Alt, a partner at Klaros Group, a strategic advisory and investment firm.

Ms. Alt is a regulatory professional and attorney with both private and public sector experience, including as a senior legal official in the office of the Comptroller of Currency. So, with that, we would like to hear your presentation and insight as well.

Thank you very much for having me, Chairman Grayson. And Members, what I'd like to start with is to really emphasize that the SBB failure is really a paradox, right. Because it's incredibly shocking that the speed with which it failed, the enormity of it, the costs of its failure, the profound risk management failures that are becoming obvious, that is all very shocking. But at the same time, as Todd just walked you through, there were many predictable.

Well, this was the predictable outcome, and it was well known what the risks were. Right. So now we're on to kind of the fun part, which is the search for the guilty. Right. That inevitably happens after a failure. And I'm kidding, of course, this isn't fun, but there will be not just a search for a guilty, but a mad scramble for the exits. Right? It was his fault. It was their fault. Right.

So let's just start with a little bit of a level set as to who does what before we say who did what wrong. Okay, so I'm just going to give you a quick overview of the dual banking system, and please forgive the 101 if you'd like me to run past. It is fine. May I have the next slide, please? Okay, I should some disclaimers. I am not speaking with any inside knowledge about SBB, and those are my own views today. All right, next slide, please.

All right, so the dual banking system, it's a parallel system, right. And I will say it's unusual. I think probably the only example, as far as I know, in the world that we have both a federal and state banking system. We have an extraordinarily complex, as you know, financial regulatory system, and we have a system of both state and federal banks. As you all know, SBB, state chartered.

So the thing to remember about the difference between a state bank is essentially a federally chartered bank, which would be the national bank, is characterized by its national charter and oversight by federal supervisors. A state bank is characterized by a state charter, but supervisioned by both the state and federal supervisors. And that's the thing to keep in mind. That's truly the parallel dual banking system we're talking about. May I have the next slide, please? All right, so this is the dual banking system.

As I mentioned, on the left side are national banks, the federally overseen national banks. The supervisor is the OCC, my Alma mater, as it were. The OCC does not take kindly to any kind of intrusions or attempted intrusions by states in the affairs of national banks. But that's another story and an old story. State banks, there are two types, state Member and state non Member banks, right? So when we speak of Member, we're talking membership in the Federal Reserve system, right?

So a state Member bank, like SBB and Silvergate, is regulated in California by the DFPI and the FRB. Dual regulation there. A state non Member Bank, right, like First Republic, will be regulated by the DFPI and the FDIC. So I can tell you that the FDIC is thanking its lucky stars that SBB was a federally regulated bank. Next slide, please. All right, quick note on bank holding company regulations. So, Todd, you mentioned the role of the shareholders in Silicon Valley Financial, the holding company of SBB.

So the Fed regulates bank holding companies like Silicon Valley Financial. It's oftentimes a bank holding company is just a shell under which sits one or more subsidiaries, including a bank subsidiary. One or more bank subsidiaries. The bank holding company itself does not offer banking services. They do so through their subsidiary banks. So in this case, it would have been Silicon Valley financial on top, and the sub would have been SBB. Simple. Okay, next slide, please. All right, I won't read this to you.

What I will say is that the DFPI rightly notes that it has understanding with both the FRB and the FDIC, by which they share supervisory oversight of state banks of California. State banks. They have cooperative agreements around the examination cycle for these banks and good, positive working relationships. The next slide, please. All right, I think what you should look at is the last bullet here. Generally, federal regulators will consult with a state banking supervisor, as to remedies. Right? That's a little bit different. Right.

That's signaling, frankly, that the DFPI, in this case, and this quote, is not in the context of SBV, but is that the DFPI is not in the driver's seat when it comes to fashioning remedies like this.

Yeah, it's the junior partner, you might say.

Yeah, you might say that. All right, next slide, please. All right, so here's what I want. When you're thinking about who is responsible, right. And a lot of questions will be, what did the DFPI know? When did it know it, right? So when it comes to the dual banking system, one of the difficulties that state banking supervisors face, not just DFPI, right, is they have a broader mission and jurisdiction than the federal banking agencies. The federal banking agencies supervise banks, right?

For the most part, and nothing else. The DFPI and other state banking regulators are also responsible for the non bank financial services providers in the state. They can range from pawn shops to funeral homes to sophisticated fintechs. They are responsible for quite a broad swath of financial services providers, and that's a big plate that they have. The DFPI, as you can see here, has more than 20 different types of licenses for which it is responsible. Right?

Compared to the Fed in San Francisco, which would have been the primary supervisor of SBB. Right? The San Francisco Fed has 200 more employees than the DFPI. And remember, only focused on banks, none of the non banks. Right? And they have the ability to draw on resources from other Federal Reserve banks within the Federal Reserve system and from DC headquarters. So they have significantly larger resources, both in terms of funding and people, than the DFPI.

This provides the federal regulators with significant advantages when dealing with complex banking institutions. A state banking supervisor such as the DFPI is going to be challenged in its ability to supervise a bank like SBB, as Todd noted, that has operations in multiple states or has very specialized business models like Silvergate. Right. The DFPI is just spread a little bit thinner. And so Todd called them the junior partner of the DFPI.

But yes, you might consider the federal banking agencies as the senior partner in that relationship when it comes to complex multi state banking organizations. So I don't say all of this to judge who the fingers should be pointed at. I say it to provide context, right? So when you say, what did the DFPI know? Well, did they know it firsthand? Were they getting it from the Fed? And how was this? When was this situation apparent to them? That's the sort of thing I would be asking.

Right. And when thinking about the sorts of problems that Todd noted towards the end of his presentation, one was really just a complete debacle when it came to messaging by the regulators around the SBB failure. I am sure all of you here got lots of calls over the weekend that SBB failed. Right? I did. Right. Absolute panic. I've never seen release anything like it. Right. And that was attributable to two things. Right. Was SBB's CEO on Wednesday saying, don't panic. Right.

Which is always a sign you always should panic.

If somebody says, don't panic, you're in bad shape. And the FDIC saying, we'll let you, we're, we're concerned and we're trying to figure this out. Very unsettling. Further over the weekend, a lot of the calls I got, and we can go down this rabbit hole in a few minutes. I'm not going to spend too much time on this, but SBB had a number of account holders, large fintech companies that held enormous deposits in FBO accounts for the benefit of accounts.

So say I heard from a particular company that we have 400 million in an FBO account, all of which should be eligible for pass through insurance. What that means is that they had a big omnibus account with many, many account holders underneath it. Right. All of which had less than 250,000. Right.

So they were like, we're sure that it should be insured, but the FDIC won't confirm that and won't tell us what data they need, where to send it, and how soon they will sort this out. So this problem was eliminated when the FDIC and the Fed said, ok, everything's going to be covered, we're going to have a liquidity facility. It's all going to be fine.

But there was such bungled messaging, and I think that the DFPI could significantly help in coordinating and getting the message out to the citizens of California if another such event transpired. Next slide, please. Okay, so I stole this one from Todd. It'll probably look familiar, but I want to just touch on one thing that we haven't gotten to, and it's another role that DFPI can play here. So this, very quickly, is what first citizens wound up with. Right?

So, okay, they bought the bank, essentially, but you know what they didn't buy. Next slide, the SBB community benefits plan. I don't know if you're familiar with this. This is an $11 billion commitment on the part of SBB to Fund small business loans, community development loans, residential mortgages to make donations, 9 billion of which was slated for California. Right. And this was hailed as a great success, this plan, when it was released, gosh, just in 22.

Yeah. It was associated with. They bought an operation called Boston Private Bank, and this was part of the negotiation with community groups at the time.

So what happens? Well, first citizens made no commitment with regard to the SBB community benefits plan. Remember, First Citizens is not located in California. They may not be super keen on committing 9 billion to California. I don't have any inside knowledge of this, but they might be thinking maybe not. And first citizens is not in the same financial position as SBB was at the time SBB made that commitment. Right. As Todd mentioned in his remarks. Right.

By the time SBB failed from a prior high of 174,000,000,000 in deposits, it was less than 57 billion. Right. So that $11 billion commitment looks a lot harder to swallow when you've only got 57 billion in deposits. So that said. Right. I think that first citizens is likely to negotiate at least some sort of partial compliance or renegotiate that commitment. I think that's the sort of thing that is perfect for the DFPI to have a say in and a role in.

But I know that'll be the next issue of great concern to many in California. But with that, I'm happy to expand the discussion or take questions.

Thank you very much, Ms. Holt, for that presentation. Very insightful, especially when it came to being able to distinguish the roles that each agency has and the types of banks that actually exist, and especially here on the state level, what our role will be moving forward, where we understand our parameters and where we're effective and what we can do as far as giving direction, even legislation and policy, to a regulatory body like DFEI.

And so for us today, this is really accomplishing what we were looking for in this session, and that is to learn what should we be looking for? What should we be listening for? And when these reports come out, what should we be looking to glean and actually launch into some policy making, if that's necessary, or giving direction to our regulatory body to be able to either fit them with more tools or to empower them to use tools that they may have already had.

Right. And I'd like to emphasize, kidding aside, when Todd or I say junior partner, that does not mean that the state's interests are junior. Right. There's every reason for the state to have an equal seat at the table when it comes to understanding the condition of the banks in its state. Right. And the impact that that condition might have on its citizens. So certainly I would recommend that you really look into what information was available and when to the DSPI.

And I also emphasize the point I made earlier, that this bank went from being a relatively not small, but not large bank to a very large bank over a very short period of time. And even at the Federal Reserve, they were behind the ball in realizing this. They just moved it into the larger bank category for their own internal work. Because again, the Fed will spend less time with smaller banks, the DFPI will spend more, and that tends to reverse when they get larger.

You know, this was a fast moving target.

Thank you very much, Mr. Baker. And we do have Members of the Committee here would be more than welcome to entertain your comments and then also any questions you might have.

Thank you, chair, and excellent presentations.

Where do we begin? But you have started to define the boundaries here and what we can or cannot mean. All I know is now what you've presented and then just reading in the public papers. Two comments in your presentation, sir, you mentioned that we all were watching the interest rate situation with the Federal Reserve and watching him slowly eke up there. That was over maybe a six to nine or 12 month period.

Assembly Member Dixon, please.

So even that period of awareness is surprising to me that both agencies were not focused on that, because it wasn't like it happened overnight. It was happening with some consistency.

Right. And the well run banks were spending more time trying to protect themselves from that. And this bank was clearly an outlier. That became evident to all of us when they filed their 10 k. And the size of this problem was evident, but the regulators would have seen it considerably earlier. There's a bit of a generational problem here because there's a whole generation of bankers who've never seen interest rates above effectively zero. So that can give you a small amount of justification.

But basically, if we look at them compared to the activities of other similarly situated banks, they're an outlier.

Well, and then one other question, just.

If I may, before you ask your question, I'm going to step out and go to another Committee real quick. Ms. Dixon, please continue on. And if you want to ask some questions, I will be right back.

Okay, one of your more. Well, they were all substantial observations, but two things in terms of the composition of the bank's management. They did not have a risk officer for a long period of time. And I think I read that the CEO or the President was performing in that function and he did not have any experience in that regard. And then also the composition of the board of directors, wouldn't that have been a deficiency that one of the two regulatory agencies would have flagged?

They certainly would have. That makes me think of two things, Ms. Dixon. Typically, regulators expect three lines of defense risk management framework at a large institution. And the second line being the risk function should be independent of the business function. Right. Should provide independent assurance of the management of the risk of the business function. So when you do have the CEO, if that's the case, I don't know this, but if you have the CEO running risk, that's going to raise concerns.

Certainly a bank of that size would be expected to have a CRO on duty.

Well, so just to begs the next question, since they didn't, is this something that could be one of a long list of regulatory enhancements or revisions?

Well, yes, but again, it would have been an expectation that they have a CRO. The question is why was it allowed to go along for so long with that one? And the point you made around the board is also, I think, significant. For instance, audit committees are required to be chaired by someone with auditing responsibility. Right. Risk committees should, in fact, contain Members who have professional experience managing risks in a financial institution. That is not a statutory requirement.

It is something that California could impose on state banks of a certain size. And I think it would be good practice and probably most bank regulators would expect to see that.

And I wouldn't be surprised if in the MRAs and MRIAs there were concerns raised about the lack of a CRO or some blurring in the three lines of defense. I don't know if there were, that's confidential supervisory information. But it wouldn't surprise me. Again, I would be curious to know what the DFPI knew. When did they know, who knew and when did they it.

All right, Mr. Fong, did you have any questions?

Thank you so much, Madam Chair, and thank you so much to both our presenters for.

Robust presentation, super insightful. You kind of touched upon it earlier, but I want to do some follow up on the Federal Reserve and DFPI. We know that in 2021, the Federal Reserve found serious weaknesses in how the bank was handling chief of key risks. And you mentioned the CRO. Why didn't they have one? But why didn't the Federal Reserve or DFPI who shared supervision of SVB step in after issuing six citations?

And second question would be, once a certain number of citations have been issued, should the Federal Reserve or DFPI step in to resolve those issues occurring within the bank?

Those are excellent questions, Mr. Fong. There isn't a magic number of MRAs or MRIAs before an alarm bell rings. Certainly, though, the range of enforcement actions increases, right, from confidential--just, you really need to fix this--to public enforcement actions that might include cease and desist or civil money penalties.

I'm not aware that there were any such enforcement actions, and in fact, again, when I say that SVB was shocking, the failure, incredibly shocking, I would say. Unprecedented. For a bank that has no pending public enforcement actions to fail, that is really unusual, right? So again, to your point: what was going on? I don't know.

Michele is entirely correct on that. There's a paradigm issue here a little bit because people are always fighting the last war, and the last war in 2008 was about capital and credit risk. And as a result, as capital was declining, banks were issued regulatory orders to raise capital or to take other actions. In this case, credit was not an issue at all. It was entirely this other beast, interest rate risk.

And I have the sense that the lack of immediacy of interest rate risk--because interest rate risk, if that securities book I told you, if there hadn't been a run on the bank, right, it would all have ended up just fine. Those securities would have paid off when they were matured. Everyone would have got their money. Credit risk will take down a bank on its own. Interest rate risk requires an outside event or circumstance that causes the interest rate risk to be crystallized into losses, otherwise it doesn't happen. So there's a certain respect in which I honestly think everyone in the industry kind of forgot about interest rate risk.

And this is something I've been harping on. Pay attention to how often you hear statements, particularly at the federal level, that our banks are well capitalized, right? Well, so was SVB, right?

But there are other factors in there--

That, to Todd's point, right, that capital, while capitalized, doesn't tell the whole story, right?

Well, the Chair is back. We've been going back and forth asking questions.

Did we answer both of your questions?

Yes. Thank you so much for that insight. I really appreciate it.

Assembly Member Fong. Go for it.

Thank you, Mr. Grayson. I asked a couple of questions. I really appreciate the responses back, and thank you so much for this insightful presentation. Thank you, Mr. Chair.

Assembly Member Soria.

Yeah, I just have one quick question. So if DFPI wanted to more assertively demand changes in the risk management practices--as you guys mentioned, right; that was one of the factors that was noted as an issue--what type of authority do they have? Since they're the chartering authority, I'm thinking.

I don't know the answer to that question. I apologize. But typically, it would not be the chartering provision that would provide necessarily the supervisory authority that you're talking about. And so the supervisory, the enforcement actions that we just discussed, the range with Mr. Fong, those are found in federal law. Do you have any-

Yeah. There are parallel state laws in California around safety and soundness. There's a less robust regulatory scheme. A lot of the federal law has been turned into detailed regulations. That's less common at the state level, but there's generally a residual authority to the extent that violations are identified to take more aggressive action. It's very rarely done. It tends to be bank regulation over a long period of time has gotten heavily proceduralized.

So it's typically some--what we call writing you up, like an MRA or an MRIA, and then there is an assessment about whether the person has or the bank has satisfied those things. And there might be an additional criticism if they hadn't. And then eventually it leads to either an agreement, a written agreement, or in the worst case, a cease and desist order. But they rarely use their sort of plenary authority to try to force action without going through all those steps. And that tends to be very counterproductive in an emergency environment.

And if I may, just ask you to engage in a thought experiment. SVB, well capitalized, profitable, growing fast, darling of the venture capital community, beloved by its fintech depositors, a week before it failed, if the DFPI had tried to independently come down on the bank, you would have gotten a lot of calls, right? And there, I'm not saying it wouldn't have been appropriate, but it would have been--

Pushback, you mean.

Again, because the bank wasn't subject to any public enforcement actions; by all outside appearances, was really very financially sound. So they're in a difficult position.

Assembly Member Dixon.

I just kind of have one follow up question to clarify in my mind. You talked about the dual system. Is this typical in all states or is it California?

All states. All states.

Is that a potential area for us to look at? And is there redundancy? Are both the Federal Reserve and the Deposit Insurance Board and the--whatever it's called-- DFPI?

The definition of U.S. financial regulation is redundancy. But because there are crossover--

Does that make--breed confusion and misunderstanding?

Oh my goodness. Yes. But this, as I mentioned, it's been in place for 200 years, and the subject of frequent battles, jurisdictional spats. The complexity of our system in the U.S. is, as I said, sort of unparalleled in the country. And we never seem to solve that because nobody wants, given jurisdiction, wants to give it up. And once agencies like--I mean, for example, the OCC has been around since it was created under Lincoln, you know. And every time there's a big crisis, there's talk about should we simplify the system? And I don't know about you, but the last crisis we wound up with another regulator.

No one wants to give it up.

Yeah, exactly.

Okay.

And actually, as a general matter, state, federal bank supervision has worked fine, largely because interests are aligned. There no longer is the type of regional interest that you might have had with an agricultural bank in Iowa not wanting Wall Streeters messing with it. Banking regulation is fairly standardized at both state and federal level, so usually cooperation works effectively.

We only think about it when something goes wrong, and it's worth thinking about it insofar as you want to make sure that the state is appropriately protecting interests of state residents. And I think that we'll learn a lot from the investigations, both at the Fed and the DFPI, about whether this cooperation was really working and whether the DFPI was getting the information it needed to be as effective as it could be.

Okay. I just have one other final question related to risk, which I talked about earlier. But as I understand it, when all the depositors were made equal, if I understand that correctly, which means there's no more risk for a bank, they're going to always be bailed out or always be covered. Their depositors will be covered. And risk management is so fundamental to any organization. So if you take the risk out, what are we doing?

One point of clarification is no one has announced that henceforth all deposits in the system will be insured. But it's a reasonable enough precedent to assume would be cited in a future precedent. Yeah.

Certainly depositors may begin to rely on it.

Yeah. So that is definitely a frequently cited sort of counter. If you take the risk away, what's to stop the bankers from really swinging for the fences, right? And I would say there are all sorts of rules in place that govern their behavior and require effective risk management. I think that books will be written and movies will be made about why those measures in this case didn't work. But I welcome you.

No, I think that's right. In my academic role, this particular topic is of intense fascination to the bank, regulatory, and academic world. Very differing views as to whether increased deposit insurance or what's known as moral hazard, which is the idea that people should monitor uninsured amounts they have in banks, it's rather impractical for people to do that, but the theory is that they should be doing that.

Yeah. Because, I think, Ms. Dixon, you're asking, and I get it, you're asking like, 'well, gosh, if there's no limit to deposit insurance, what's to kind of control the bad behavior of the banks?' The moral hazard argument puts the burden on the individual depositor to say, 'where's my money being effectively managed?' The problem with that, right, is that the individual depositor really doesn't have access to the information they would need to make an informed judgment.

Just seeing like call reports are public, but most depositors wouldn't know how to read one or what to make of it or really what it's telling them. You know, your point is well taken.

And if you look at the point Michele made earlier, this was a well capitalized bank. Stock market loved it. It was very popular. You know, how much do we really expect people to monitor that? It's a hard question.

If I could put a little plug in, I would also be thinking about the incentives for the executives.

Yes.

Right? So what's to stop them, right? What's to stop them from swinging from the fences? Pay attention to how they're paid. Not how much, but how, right? So what portion is an incentive? What does their arrangement require in terms of vesting deferral? What are the measures against which their performance will be assessed? Is it all reward or is it also risk management performance?

Right. For example, it would be very common to compensate an executive in another industry on growth, and banking growth can be highly dangerous or effectively managed. Maximizing shareholder return. Well, to the extent that you're doing that at the cost of taking risks in the short-term, that may be more challenging.

So we've set up a system where we have standard capitalist incentives for the executives of organizations, where society is actually covering the downside. And so one needs to look at compensation in this type of industry differently than you would look at a company in the milk production business.

I agree. Thank you very much.

Which is also a different way of looking at how we address consumer protections.

Correct.

But normally it's bottom thinking of the consumer, but going to the top and looking downward as well and providing those protections.

Yes, because incentives work the same way around consumer products, which is, it's possible that a banking product is highly profitable and yet quite damaging to customers.

Correct. I think one of the big issues that we'll be dealing with here in Sacramento when it comes to SVB's failure is what it does mean about--or in reference to our state charter. And are there changes that need to be made to the charter in addressing competitiveness? And also, if maybe not speaking specifically to SVB itself, but are there appropriate thresholds or markers to where it's no longer appropriate to be a state charter or something of that set? Do we explore something like that, or is that something that is already in a good place?

Well, I think that there has always been great value provided in the state charter, but there are lots of ways you could look at how complex an institution under any charter would be and therefore what sort of supervision regime it should be subject to, right?

That's very common, for example, with regard to very large institutions, the G-SIBs, right? They are--wow, are they regulated, right? So there may be a discussion, as you said, about thresholds. I would leave that obviously to your wisdom, but that's certainly something you could consider.

New York, for example, which for a long time had very large Wall Street and foreign banks supervised in New York, has actually done a quite good job of doing that, but they focused resources on it and in many ways the lead regulators for some of the institutions in a way that would be surprising in other circumstances. That's particularly with foreign banks, who tend to base their U.S. operations in New York.

In your estimation, we do hear about the need for the state charter, which I just heard from you again. We do hear about that, but we also hear about promoting bank innovation. Do you see that actually in practice?

Ah. Yes. I'm glad you asked that. You know, I think it's really interesting that the DFPI changed its name to DFPI, right, to really emphasize the role that it has in fostering innovation. I recently had the pleasure of appearing on a panel with the head of the innovation office, the California DFPI Innovation Office, and she talked about how they foster innovation here at the state.

And the state regulators have long made the point in arguing about--in presenting the argument for the value of the state charter about the better touch that a state regulator has with the businesses in its state, with the needs of the consumers in the state, and therefore, the unique positioning they have in supporting innovative business models.

I would like to say that SVB was not actually very innovative. They apparently had innovative interest rate risk management practices. But no, they were a traditional bank, right, that served a lot of innovative tech communities, but they themselves were a traditional bank.

They took deposits, they lent money, they did fee businesses. Very typical.

So I don't think it's like a failure of innovation that contributed to SVB's failure. I do think, given tech's incredibly important role in California and in the economy, it's appropriate, in my view, to make sure that the DFPI continues to foster that within financial services in the state.

And, in looking more broadly, I mean, there are specific businesses in California that exist largely here, technology being one of them. But let's not forget the wine industry, which was highly dependent on this business. And there are other banks in the state and the Central Valley particularly, that are very involved in the agricultural lending and other things. And the knowledge that the State Regulator has about the importance of those industries is important, particularly when those companies are small.

The challenge, as we've seen, is when they get large, and then naturally, regulatory supervision tends to gravitate toward the federal regular at that point. But it's still important to have that voice, particularly given the importance of the particular businesses that are being supported by those banks in the California economy.

Especially because just because it became large doesn't mean it no longer was a state charter.

Absolutely.

It still was a state charter.

It had a huge impact on the state.

Right.

And if anything, requires--

More state involvement. Yeah.

Yes.

Could I ask just a follow up question?

A final to the final?

A final to the final?

Pardon me?

Final to the question? Well, you keep asking good questions.

Go ahead, Assembly Member Dixon, and then we'll wrap up after this question.

Well, what does innovation mean in the banking industry, whether it's California or federal? And what are we looking for when we have that name? And is that kind of a red flag to be careful?

Gosh, I love that question. Nobody asks that. So I would say, when one of my clients says, 'I have an innovative business model,' usually they mean they have a new way of delivering a product or supporting the identification of customers or their needs. So it's typically around the technology that is being used to solve problems in the legacy banking system.

So a better way of gathering data, a faster way of providing a service, a product that meets the needs of a particular group not well served currently by existing banks, for whatever reason. I wouldn't say that innovation is a red flag. What I often say to my clients is bring the receipts.

When you're saying you're innovative and that you're solving this problem, show us, right? Sometimes innovation gets confused with the Field of Dreams approach, which is just, if we do this, it's going to solve problems, right? So it's always worth asking, 'are you solving the problem you set out to solve?'

Good answer. Thank you.

Very good. This was incredibly insightful, very educating. Thank you very much for the presentations, Mr. Baker, Ms. Alt, and we do need to open it up for public comment. Do we have folks that are here that would like to come and make a comment? All I ask is that you give your name, your affiliation, and please keep your comments brief. Seeing nobody moving, I think we did put glue down on the seat before they said--you have stunned them with your presentation. Thank you very, very much.

Seeing no one for public comment, thank you very much for your presentations, and we look forward to the reports that are coming out at the beginning of May. Thank you. This hearing is closed.