(Bloomberg Opinion) -- The banking havoc of the past few weeks has focused attention on regulators: What should they learn, and what should they do about it?
I see five lessons, and five prescriptions.
First, banking rests on confidence. For uninsured depositors, running at the first sign of trouble is a perfectly rational response. The cost of doing so is often negligible, while the consequences of dawdling can be vast, because no bank can pay everyone at once. This means that banks are stable only until their viability is called into question, as Silicon Valley Bank’s demise demonstrated.
Second, systemic importance isn’t solely a matter of size. Even a small bank can cause big problems if other banks look like it. When Silicon Valley Bank got into difficulty, panic immediately spread to institutions with similar profiles, in terms of the prevalence of uninsured deposits or unrealized losses on loan and securities portfolios.
Third, panic is difficult to stop once it starts. When uncertainty and risk climb, people often act based on what they expect others to do, rather than on their assessments of fundamental value. Once that dynamic takes hold, reversing it requires overwhelming force.
Fourth, a bank’s prospects depend on more than just the credit quality of its assets. Interest-rate risk, and the composition of assets and liabilities, also are important. Silicon Valley Bank failed not only because it had mark-to-market losses on otherwise safe long-term bonds, but also because its depositors were mostly concentrated in start-up ventures in a tight network, and thus more likely to flee en masse.
Fifth, incentives matter. When bank executives’ compensation is tied to earnings and to the bank’s stock, they’ll be motivated to take more risk. Silicon Valley Bank didn’t really need to invest in long-term Treasuries to have a viable business. It was stretching for yield, to boost earnings and the stock price.
What to do?
First, address the issue of uninsured depositors. Forget the notion that they can monitor banks and provide market discipline. In practice, they do so only in a binary way: not at all, or suddenly and completely. Insuring them ex-post on a case-by-case basis, as happened with Silicon Valley Bank, is unfair, discriminatory and won’t prevent future runs. Insuring them ahead of time would enable banks to take bigger risks at greater scale, requiring draconian regulation. The right balance might be more selective – focused, say, on banks that adequately diversify risks and stay within reasonable growth limits.
Second, restore systemic-risk supervision of mid-sized banks. Back in 2018, Congress raised the asset threshold for tougher capital and liquidity regulation, from $50 billion to $250 billion. This should be reversed. Barring that, the Fed has the power to extend the enhanced regime, which includes regular stress tests, down to banks with more than $100 billion in assets. It should do so.
Third, head off panics by making central bank lender-of-last resort facilities always available and easier to access. Standing facilities that are not stigmatized would help. One can imagine a regime in which banks purchased liquidity insurance from the Fed. This would mitigate moral hazard concerns, as the central bank would be compensated upfront as opposed to providing something ex post for free. Also, a credible backstop would reduce depositors’ incentives to run at the first sign of trouble.
Fourth, pay more attention to interest-rate risk, and the fundamental mismatch between banks’ long-term assets and short-term liabilities. Assessing the flightiness of deposits will be tricky, but certainly they should be evaluated differently if they far exceed customers’ typical business needs. Beyond that, the analysis must be holistic: Rising interest rates can entail mark-to-market losses on long-term bonds, but can also boost banks’ net interest margins and the value of their retail deposits (Silicon Valley Bank being a notable exception).
Finally, adjust incentives. If, for example, bank executives’ compensation shifted away from cash and equity toward subordinated debt that they had to hold for several years, they would be less inclined to take the kinds of risks that could lead to failure and the write-off of that subordinated debt. The CEO of Silicon Valley Bank might not have taken on added interest-rate risk to boost shareholder returns if his compensation was more dependent on the outcome.
To contact the author of this story:
Bill Dudley at [email protected]
