Quarles issues stark warnings to Fed in wake of bank failures

Randal Quarles
Randal Quarles, former vice chair for supervision at the Federal Reserve, pushed back against his successor's report on the failure of Silicon Valley Bank.
Zach Gibson/Bloomberg

As the Federal Reserve weighs changes to regulation and supervision policies amid the ongoing banking crisis, its former chief regulator shared some words of caution.

Former Fed Vice Chair for Supervision Randal Quarles said the Fed must be sure any changes made are clear, consistent and measured, or else they will be stricken down in court.

"The reason that it's important that we get this right is that if bank supervision can't develop a way of being effective, while also being transparent, consistent and sensitive to due process, it will not survive a coming conflict with the modern judiciary," Quarles said. "It will be found to be a farrago of impermissible delegation of congressional action and unauthorized resolution of major questions."

Quarles issued this and other stark warnings on Friday during a conference hosted by Stanford University's Hoover Institution. 

His anticipation of a potential judicial clash comes at a time when some federal courts have shown a willingness to entertain challenges to regulatory authority. Last fall, the U.S. Court of Appeals for the Fifth Circuit ruled that the Consumer Financial Protection Bureau's funding mechanism was unconstitutional. Meanwhile, the Supreme Court has also shown less deference toward regulators in some recent decisions. 

Quarles also cautioned that the Fed's current capital and liquidity regime, which does not allow banks to count reserves held at the Fed toward their liquidity requirement, is making it unnecessarily difficult for banks to prepare themselves for periods of stress. He said one reason Silicon Valley Bank was so ill-prepared for the run on its deposits in March was because it was disincentivized from keeping assets at the discount window — the Fed's primary mechanism for emergency lending. Such an arrangement, Quarles said, undermines the Fed's ability to serve as lender of last resort.

"That is the main lesson of SVB, not a more restrictive capital regime, or more self-insured liquidity regime, or a more unfocused and assertive supervisory regime," Quarles said, "but a rethinking of the misguided undermining of the Fed's core liquidity mission that we've been engaging in for decades."

Friday's event was Quarles' first public appearance since current Vice Chair for Supervision Michael Barr released his report on the failure of Silicon Valley Bank two weeks ago. Quarles seized the opportunity to refute his successor's conclusions, many of which blamed Quarles' own policies and priorities for contributing to the poor oversight of the collapsed bank.

Quarles called Barr's findings "not just loopy but obviously loopy." In particular, he took issue with the conclusion that the tiering system for capital requirements implemented on his watch contributed to Silicon Valley Bank's demise. He noted that the bank was primarily deposit-funded, had a relatively small loan book and was "awash in liquid assets." Because of this, he said, the pre-2019 capital regime would not have made the bank any more stable than it already was.

"It is perfectly possible to have a coherent and well reasoned belief that those tailoring changes should have been calibrated differently or not done at all. I think you'd have the worse of the argument, but that's a reasonable position," Quarles said. "SVB, however, is not evidence for your case. It's not evidence that you would be right. It is, so far as it is evidence of anything, evidence that you were wrong."

Similarly, Quarles said the report mischaracterizes the changes to bank oversight that he pursued as the Fed's chief supervisor. Barr's report stated that his predecessor oversaw a "shift" in supervisory culture, but Quarles said if there was such a change, it did not move in the direction he intended.

"My message to the supervisors was not that they were to be less assertive, but that they were to be more focused on the things that really mattered, and more assertive on those things," Quarles said, adding that staff seems to have taken a much different tack with Silicon Valley Bank. He noted that of the 31 supervisory findings at the bank, none were focused on the core issues in the bank's ultimate failure: unhedged interest rate exposures and a reliance on uninsured deposits.

Quarles said the report was part of an "unseemly orgy of recrimination and political maneuvering," from government officials, one that overcomplicated a simple narrative. Like the savings and loan crisis of the 1980s, he sees the issue as the result of excessive fiscal stimulus leading to inflation and an aggressive monetary policy response, in turn wreaking havoc on interest-sensitive sectors and their banking partners. 

He also said the lion's share of blame for Silicon Valley Bank's failure belongs to its executives, who took the risks that led to its demise.

"When we come across a building in flames, we may have issues around the margin with the firefighters," he said. "But our first instinct should be to blame the arsonist, not the firefighter."

Quarles said the scale and speed of Silicon Valley Bank's failure was unique and a "sea change" moment emblematic of how advancements in technology have exacerbated the historic risks of panics. As a result, regulators should reflect on how to respond to these issues more effectively going forward. 

He also emphasized that the current crisis is not yet over and work remains to be done to minimize its impact on the stability of the financial system.

"Interest rates will stay higher than many are currently expecting them to stay and for longer, and the consequence of that will be that this pressure will remain on this category of institutions and a broader category of institutions than we are currently expecting," he said. "So, the question of what should we be doing is not a purely prospective one for what should we do over the next several years, it is a question of what should we be doing right now, because it's not over."

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Banking Crisis 2023 Regulation and compliance Politics and policy Federal Reserve
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