Magazine Exclusive: The Art of Managing Your Regulator

Exams have gotten tougher, and prudential regulators are focusing intensely on bank funding, interest rate risk and liquidity management. This complimentary article from the first quarter issue of Bank Director magazine looks at how banks will need to respond as supervision becomes more intrusive.

Jack Milligan

The following feature appears in the first quarter 2024 edition of Bank Director magazine. It and other stories are available to magazine subscribers and members of Bank Director’s Bank Services Program. Learn more about subscribing here.

The Chinese general and philosopher Sun Tzu, author of the “Art of War,” once said it is important to “keep your friends close and your enemies closer.” A modern-day translation for bankers might be, “keep your customers close and your regulators closer.” In other words, stay closest to those who have the greatest impact on your fortunes.

Bankers and their regulators aren’t at war, of course, but there’s no question that state and federal prudential regulators exercise enormous control over the institutions under their supervision. Smart management teams and boards understand this and manage the regulatory relationship very carefully, emphasizing communication, transparency and responsiveness.

This is especially important now because the supervisory environment has changed significantly since the failures of Silicon Valley Bank and Signature Bank in March 2023, and First Republic Bank the following May. Regulatory examinations for safety and soundness have gotten tougher, according to bank CEOs, lawyers and consultants who focus on banking. Regulators are digging deeper into bank policies and procedures than they have in some time, while also focusing intensely on bank funding, interest rate risk and liquidity management. The three banks failed largely because depositors lost confidence in their stability and pulled their funds.

Less than a month after the demise of Silicon Valley Bank and Signature, Michael Barr, the vice chair for supervision at the Federal Reserve, and Martin Gruenberg, the chair of the Federal Deposit Insurance Corp., were summoned before Congress and grilled about the failures. In separate postmortem reports that examined the two failures in depth, the agencies pinned most of the blame on poor management while admitting that inaction by their examiners contributed to the banks’ demise. The banks were slow to respond to repeated concerns expressed by the agencies about their funding and risk management practices, according to reports, and the examiners did not press them hard enough to address their concerns.

According to a May 2023 report by the General Accounting Office, the Federal Reserve Bank of San Francisco, which supervised Silicon Valley Bank, downgraded the bank in June 2022 and began working on an enforcement action two months later, but did not finalize it prior to the bank’s failure. The GAO also said that the FDIC, which oversaw Signature Bank, “took multiple actions to address supervisory concerns related to [the bank’s] liquidity and management but did not substantially downgrade the bank until the day before it failed.” 

“In my experience, when regulators are burned or they’re embarrassed or they’re criticized — however you want to define it — their goal is to see that it doesn’t happen again,” says Gary Bronstein, who heads up the financial services practice at Kilpatrick Townsend & Stockton in Washington. “And therefore, they’re going to become more aggressive, more assertive, and they’re going to probably in some cases go too far and become too aggressive.”

Bronstein says the current exam cycle for banks has been “difficult,” and he believes the regulators’ goal “is to improve the speed in which things are resolved.” Indeed, the Office of the Comptroller of the Currency — which oversees banks with national charters— revised its Policies and Procedures Manual for bank enforcement actions in May 2023, even though none of the failed banks had a national charter. Under the revised guidelines, any bank that fails to correct persistent weaknesses in response to prior enforcement actions could be subject to a range of actions, including demands that it reduce its asset size or divest subsidiaries or business lines.

In fact, Bronstein says that one of his firm’s midsized bank clients was downgraded recently by its federal regulators without an exam. “That is very unusual,” he says. “Haven’t seen it in a long time … but they’re probably not alone. I just happen to know about it because it’s a client.”

None of the three federal prudential regulators agreed to comment publicly for this article.

But those who work with them say examiners have been especially focused on bank funding and liquidity management since the 2023 failures sent shock waves throughout the industry. Robert Azarow, who leads the financial services transactions practice at the law firm Arnold & Porter Kaye Scholer, says after the failures, “exam teams were walking into institutions of all sizes — not just the larger ones, but institutions of all sizes — and seeking information on levels of uninsured deposits and available liquidity that can cover 100% of the uninsured deposits.” Several of Azarow’s bank clients were required by their examiner to prove they could fully cover their uninsured deposits. What is so striking about these requests is that “we had not really seen that before as an exam priority,” he says. “And now, it certainly is an exam priority.”

John Asbury, the president and CEO at Atlantic Union Bankshares Corp., a $20.7 billion bank holding company headquartered in Richmond, Virginia, confirms that regulators are taking a deeper dive into bank funding since the failure of the three banks. “They’re looking at deposit concentrations and the granularity of the deposit base just like they do on the lending side of the bank,” he says. “They will examine the bank’s assets for industry concentrations, real estate concentrations, etc. Now they’re doing a similar thing on the depository side, which I’ve not seen before.”

Shortly after the March 2023 bank failures, the Federal Reserve Bank of Boston reached out to Anne Tangen, CEO of BankFive, a $1.8 billion mutual savings bank headquartered in Fall River, Massachusetts. “They were just asking questions,” Tangen says. “‘How are we doing? What’s the customer sentiment? What are we worried about?’ I would say they were concerned about our sources of liquidity and making sure we had plenty of cash on hand, making sure we had plenty or different sources of liquidity.” 

BankFive has an online division that has raised about $100 million in deposits, and the Boston Fed worried that this was hot money that might be at risk in a deposit crisis. “We were able to demonstrate over the last eight to 10 years that those deposits have been pretty sticky. I think more than 25% of those deposits are in checking accounts, so they’re not looking for high rates. It’s not hot money.”

BankFive did not lose a lot of deposit money despite the negative publicity surrounding the bank failures, according to Tangen. One BankFive customer with $14 million on deposit decided to disperse that money across numerous institutions, but overall, there were few defections. “It certainly doesn’t help when banks are being talked about on the nightly news and CNN,” Tangen says. “The media attention to it certainly had everybody nervous, but we didn’t see a ton of outflow.” In addition to coverage through the FDIC-managed Deposit Insurance Fund, Massachusetts banks are covered under a state-managed insurance fund that covers 100% of all deposits, and BankFive proactively reached out to many of its customers to assure them that all their deposits were safe.

Uninsured deposit levels throughout the industry have also been the subject of intense regulatory scrutiny since the bank failures. Silicon Valley Bank had 94% of its deposits over the FDIC’s $250,000 deposit cap at year-end 2022, mostly from venture capital firms and the startup companies they were invested in, compared to the average large banking organization’s 41% level, according to the Federal Reserve. Signature Bank had 90% of its deposits over the cap at the end of 2022, including funds from cryptocurrency companies that it was servicing. When concerns arose about the banks’ financial stability, many of their depositors fled.

There’s an old legal adage that hard cases make bad law because they often apply an extreme, across-the-board remedy to a wide array of less extreme cases. A similar dynamic exists with the uninsured deposit issue. It is not unusual for banks to have deposit levels above the $250,000 insurance cap — especially if they are big commercial lenders. It’s standard practice throughout the industry to ask for a business customer’s commercial deposits when lending them money. But relatively few community or smaller regional banks have uninsured deposit levels in the 90% to 94% range.

One bank whose uninsured deposit levels attracted its regulator’s attention soon after the Silicon Valley and Signature failures is Lake City Bank, the $6.4 billion commercial bank unit of Lakeland Financial Corp. in Warsaw, Indiana. In general, Lake City won’t lend money to companies unless it also gets their operating accounts, which adds to its deposit totals. “The uninsured deposit ratio at Lake City has effectively stayed somewhere between 54% and 56% since 2020,” says CEO David Findlay. “And if you go back to 2013, we were in the 45% to 55% range.” Lake City is a state-charted bank overseen by the Federal Reserve Bank of Chicago, and “that’s a number that clearly the regulators wanted to understand better,” says Findlay.

A large percentage of Lake City’s deposits come from public fund entities. “Those deposits are spread throughout the Lake City footprint, and [the Chicago Fed] wanted to better understand how our deposit relationships with those public fund entities were driven,” says Findlay. “Were they truly relationships or just opportunistic deposits that were priced aggressively?”

Deposits from public entities in Indiana are covered under a state-managed deposit insurance fund and when Lake City’s public entity deposits were excluded from the calculation, the bank’s uninsured deposit totals dropped to the 27% to 30% range. “When the regulators looked at our uninsured deposits excluding the public deposit funds, they saw that only one-third of our deposits were uninsured,” says Findlay. “They became less interested in having that discussion because of that low number.”

As the Lake City example shows, a high uninsured deposit total is not necessarily a cause for concern. “The regulators are understandably focusing on the level of uninsured deposits and effectively telling banks that you have to regard those deposits as involving far greater flight risk,” says H. Rodgin Cohen, the senior chair at Sullivan & Cromwell. “I and others worry that that is too undifferentiating an approach — that all uninsured deposits are not alike, and neither banks nor regulators should treat all uninsured deposits as representing the same flight risk.” Cohen offers two examples — municipal deposits, which are collateralized, and business operating accounts — both of which are likely to be stickier than other kinds of funding.

“Another aspect of uninsured deposits is concentration,” Cohen continues. “All things being equal, 10 deposits of $500,000 represent less risk than one $5 million deposit. A focus on concentration of uninsured deposits is understandable in view of [Silicon Valley Bank], but there is not a concentration by reason of uninsured status.”

When analyzing a bank’s ability to cover 100% of its uninsured deposit totals, Cohen says it’s important to analyze the asset side of the balance sheet. The crisis at Silicon Valley Bank started when it sold $21 billion worth of securities at a loss of $1.8 billion. That action spooked its customer base and led to a fatal deposit run. “What Silicon Valley demonstrated is that a high-quality asset may be liquid but, depending on interest rate movements, it may not be liquid at anything approximating the nominal value,” Cohen says. “Banks are being told by the regulators that they need to pay a lot of attention when doing their liquidity analysis that the assets they may need to liquidate can be liquidated without significant loss due to interest rate movements.”

But this creates a dilemma for banks with significant levels of uninsured deposits if they are expected to keep enough highly liquid assets on hand to cover those funds. “Let’s say what you have uninsured is 40% of total deposits,” Cohen says. “I don’t think any bank today holds a similar amount of its assets that can be immediately liquidated at no cost.” In fact, carrying a high volume of assets that can be sold on short notice without incurring a loss would punish a bank’s profitability. “Almost by definition, if assets are immediately liquefiable, they’re going to be carrying little spread to funding,” Cohen adds.

For most banks, liquidity planning focuses on having quick access to alternate sources of funds like collateralized borrowings from the Federal Home Loan Bank system, brokered deposits and overnight loans through the Federal Reserve’s discount window and the Bank Term Funding Program, which was created after the 2023 bank failures to provide liquidity to the industry. Banks can borrow from the program by pledging assets at their nominal, rather than market, value. Asbury at Atlantic Union says it’s important that banks be prepared to access alternate sources of funds as the need arises — and on short notice.

An industry-wide problem that impacts the liquidity issue is the high level of unrealized losses that have accumulated in bank securities portfolios over the past several quarters since the Federal Reserve began raising interest rates in the first quarter of 2022. A tidal wave of funding washed over the U.S. banking industry during the early days of the Covid-19 pandemic. The $2.2 trillion CARES Act passed during President Donald Trump’s administration included the Paycheck Protection Program, and the American Rescue Plan enacted during President Joe Biden’s administration offered another $1.9 trillion. The Federal Reserve also pumped additional money into the U.S. economy through its quantitative easing policy. A lot of that money ended up parked in bank deposit accounts — and many banks invested that idle cash in government and agency securities.

The value of these securities began to decline as interest rates climbed ever higher, and this has become a significant consideration for banks that are experiencing liquidity pressure. For accounting purposes, banks can place their securities in one of two buckets — held to maturity or available for sale. Securities in the latter bucket must be marked to market on a quarterly basis and public companies must report gains or losses through their accumulated other comprehensive income — or AOCI — line. Banks that find themselves in a liquidity crunch and have large unrealized losses in their available-for-sale accounts can only access that funding if they’re willing to sell securities at a loss.

The AOCI issue has capital ramifications that the regulators are beginning to pay attention to as well. Losses in the available-for-sale bucket are not deducted from regulatory capital like Tier 1 except at very large institutions, but they are charged against every bank’s tangible capital equity under generally accepted accounting principles. Tangible equity is real value. It is the capital that banks can most count on to cover losses that could threaten their survival.

Azarow says it’s wise to think that regulators might focus on the degradation of tangible capital levels throughout the industry as a potential safety and soundness issue. Well capitalized community banks with a solid earnings record that also have large unrealized losses in their available-for-sale securities bucket probably won’t receive undue regulatory scrutiny, he says. Weaker banks that are experiencing loan quality issues or a significant narrowing in their net interest margin might not be so lucky, and the regulators “will start evaluating the balance sheet and regulatory capital with the AOCI in mind,” says Azarow.

“Yes, they’re looking at that [tangible capital equity] number,” agrees Billy Carroll Jr., CEO at SmartBank, a $4.8 billion bank unit of Knoxville, Tennessee-based SmartFinancial. “I do think it is having some impact, especially on the [banks] that have been hit a little more severely. If rates stay up a little longer, and you do have any sort of credit event and have to tap into it, it’s not going to be there.”

While it’s always wise for banks to pay close attention to their prudential regulators, managing that relationship is more important now given how the regulators have reacted to the 2023 bank failures. 

A fourth federal agency — the Consumer Financial Protection Bureau — examines banks over $10 billion for compliance with various consumer protection laws. Historically, the bureau has generally relied more on formal enforcement actions than informal conversations and consultations. For an article on the agency, see “Learning to Live With the CFPB,” in the first quarter 2023 issue of Bank Director magazine.

Asbury says he communicates often with the bank’s two supervisory agencies — the Federal Reserve Bank of Richmond and Virginia’s Bureau of Financial Institutions. “Our philosophy has always been one of being communicative, being transparent and avoiding surprises,” he says. Asbury and the bank’s chief operating officer, Maria Tedesco, have a standing quarterly meeting with both regulators — often at the same time if the agencies can manage it. The regulators will also speak separately with other key leaders in the bank. And usually in December, “they will come before the board of directors and report out their perspective on the bank, examination results and areas of focus for the coming year,” he says.

Banks often chafe under the constraints of regulatory scrutiny, but it would be a mistake to think of the regulators as the enemy. “Those folks have a job to do, and we’re in a regulated business,” says Carroll. “We all knew that when we signed up to get in this business. Sometimes we think it’s maybe a little too one way and not enough the other way, but at the end of the day, those guys have a job to do.”

SmartBank’s regulators are the Federal Reserve Bank of Atlanta and the Tennessee Department of Financial Institutions. Carroll says he is dealing with many of the same people as when the bank was started 16 years ago, and the bank benefits from those relationships. “Having regulators with tenure helps a lot,” he says. “We’re very fortunate with [the] Atlanta [Fed] and the TDFI. We’ve got examiners who have been around for the last decade. [They] know us, and we know them. And so, it is nice to be able to have good, transparent communication.”

And while it has always been important to address regulatory concerns promptly, that is even more critical today given how the regulators were criticized after the Silicon Valley Bank and Signature Bank failures for being too lax in their supervision. “It’s really, really important that you promptly respond to any regulatory concerns that are presented,” says Asbury. “You do not ignore them; you do not drag your feet. I think it’s all about credibility.”

Bronstein at Kilpatrick Townsend & Stockton expects the prudential regulators to take action against banks that are slow to respond to their concerns. “I think we’re going to see more enforcement actions, and it’s going to be enforcement actions related to banks that are failing to timely and appropriately address their concerns,” he says. “It’s a new world, and this is just the beginning.”

Eugene Ludwig was comptroller of the currency from 1993 to 1998, and still actively advises banks on a range of business and regulatory issues. He doesn’t like what he sees in bank supervision today. “It has gotten a lot tougher, a lot more intrusive with a remarkable focus on thousands of details that I would say are almost so extensive that it feels like managing the bank,” he says.

Ludwig also believes this tougher regulatory environment could last well into 2024, especially if the U.S. economy goes into a slump that could result in widespread asset quality issues in sectors like commercial real estate and consumer credit. That will cause examiners to look even harder for problems “and with the way the supervisory pendulum is swinging now, that will just propel the pendulum even further,” he says.

The challenge for each bank is to make sure the relationship doesn’t suffer with the swing.


Jack Milligan


Jack Milligan is editor-at-large of Bank Director magazine, a position to which he brings over 40 years of experience in financial journalism organizations. Mr. Milligan directs Bank Director’s editorial coverage and leads its director training efforts. He has a master’s degree in Journalism from The Ohio State University.