By Pete Schroeder and Hannah Lang

WASHINGTON (Reuters) -A top U.S. regulator told a Senate panel on Tuesday that Silicon Valley Bank did a “terrible” job of managing risk before its collapse, fending off criticism from lawmakers who blamed bank watchdogs for missing warning signs.

In the first congressional hearing into the sudden collapse of two U.S. regional lenders and the ensuing chaos in markets, both Democratic and Republican lawmakers pressed the Federal Reserve’s top banking regulator on whether the central bank should have been more aggressive in its oversight of SVB.

“It looks like regulators knew the problem, but no one dropped the hammer,” said Senator Jon Tester, a Democrat.

Michael Barr, the Fed’s vice chairman for supervision, criticized SVB for going months without a chief risk officer and how it modeled interest rate risk, which he said “was not at all aligned with reality.” Fed supervisors had flagged such issues with bank management, but they went unaddressed, he added.

“The risks were there, the regulators were pointing them out and the bank didn’t take action,” he said.

The failures of SVB, and days later, Signature Bank, set off a broader loss of investor confidence in the banking sector that pummeled stocks and stoked fears of a full-blown financial crisis. A deal to rescue Swiss giant Credit Suisse last week and a sale of SVB’s assets to First Citizens Bancshares this week has helped restore some calm to markets, but investors remain wary of more troubles lurking in the financial system.

Senior members of the Senate Banking Committee agreed with Barr that the banks had been mismanaged and former executives should be held responsible, but also questioned how the banks could collapse so quickly with regulators on the case.

Barr told the committee he first became aware of the interest rate risk issues at SVB in mid-February, while Fed supervisors had been raising issues with the bank directly in months prior to that.

“The failure of Silicon Valley Bank, Signature Bank and the general turmoil in the banking sector are the direct result of the failure of regulators, including the agencies we have before us today,” said Senator Steve Daines, a Republican.

Barr was challenged on whether the Fed’s annual “stress test” of large banks would have identified risks at SVB, given that recent tests have not explored how banks could weather rapidly rising interest rates, even as the Fed aggressively hiked borrowing costs in a bid to stem inflation.

“It was like somebody going in for a test for COVID and getting a test for cholera,” said Sen. John Kennedy, a Louisiana Republican.

Barr agreed it would be “useful” to test for higher rates as well, and said he was looking to expand the breadth of the test in the future.

Regulators have vowed to review their rules and procedures after the twin failures while insisting the overall system remains sound. Barr added he welcomed external reviews of regulators’ work and expects the Fed to be “accountable” for any shortcomings that are unearthed.

Barr and FDIC Chairman Martin Gruenberg both stressed in their remarks that depositor funds are safe and sound.

Both indicated they are looking into tightening rules for banks and applying stricter oversight for firms similar to SVB.

Some Democrats, including major bank critic Senator Elizabeth Warren of Massachusetts, have also argued a 2018 bank deregulation law is to blame. That law, mostly backed by Republicans but also some moderate Democrats, relaxed the strictest oversight for firms holding between $100 billion and $250 billion in assets, which included SVB and Signature.

Barr said he anticipated the Fed would need to strengthen capital and liquidity standards for firms with more than $100 billion in assets.

The hearing is the first of what is expected to be several examining the banking tumult. The House Financial Services Committee will hear from the same regulators Wednesday, and congressional leaders have already said they want to question the former CEOs of the two banks on what went wrong.

(Reporting by Pete Schroeder and Hannah Lang; editing by Deepa Babington and Anna Driver)

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