As Banks Fail, Some are Demanding Tighter Regulation. Sure, But…

The bailout of depositors at the Silicon Valley Bank has prompted a call for better bank regulations. It is noted, for example, that a few years back, Silicon Valley Bank lobbied for a change in the banking law that exempted mid-sized banks, such as itself, from Federal Reserve stress tests — and that Donald Trump signed the law. And now the bank fails

Republicans come to the aid of corporate greed: It makes a zingy cartoon.

The stress test was a regulatory child of the last recession. It’s a simulation: Take the bank’s balance sheet and put it through a hypothetical crisis. The idea is good. To be useful, though, the test needs to anticipate the sort of crisis that actually happens. And according to Will Diamond, assistant professor of finance at the Wharton School, the actual test the Fed used didn’t do that. He writes, “To me, the biggest culprit in SVB’s failure is that the Fed’s most severe stress test scenario in 2022 didn’t even consider the possibility of rising interest rates.”

Rising rates are what pushed Silicon Valley Bank over the edge. In banking history, the classic way banks were wrecked was quite different: bad loans. Often it was loans that bank executives made to themselves. In the Great Depression, the biggest banking disaster in Seattle was of two savings-and-loan associations. In one, the CEO lent millions to his personal mortgage company. In the other, the CEO pumped the depositors’ money into his personal network of radio stations. Both were legally under the thumb of a state regulator who let it happen.

Americans have learned a lot about regulating banks in the past century. But it cannot be perfect.

When Washington Mutual failed, I was a newspaper reporter, so I talked to an executive there I had known for a long time. He had been a federal regulator before he was a Seattle banker. He was a smart guy — and he had misjudged the risks in subprime mortgage bonds. “We all drank the Kool-Aid,” he told me. 

Those who call for more regulation assume that of course, the government people will see the problem and do what’s right. But seeing it is not enough. Before the last crisis, in 2008, a handful of regulators raised an alarm about the bonds backed by sub-prime mortgages. Sheila Bair, head of the Federal Deposit Insurance Corp., was famously one of them. But Henry Paulson, secretary of the Treasury, was not — nor was Alan Greenspan, the previous chairman of the Fed. In hindsight, the progressives pilloried Greenspan, a Republican, for believing in the “gospel” of the market. (They like to sneer at economics by comparing it to religion.) To his credit, Greenspan allowed that he had been wrong. But the Fed chairman had a long record of being right.

Regulators are past-oriented and risk-averse. Risk-takers are the ones who make the future, even in the regulated world of banking. Silicon Valley Bank was set up in 1983 by a venture capitalist to serve the start-ups in California’s hothouse of innovation around Santa Clara. That the bank grew to $200 billion in assets implies that the managers made many years of good decisions. Then they made some really bad ones.

According to press reports — and we don’t have the full story yet — what brought down the Silicon Valley Bank wasn’t its loans, but how it used its excess funds. At the end of 2022, the bank’s balance sheet showed that it held $91 billion in U.S. government and agency bonds, which it intended to hold until maturity. Held that long, government bonds are the safest investments there are. But the bank had bought long-maturity bonds, which were vulnerable to a drop in value if interest rates in the market went up. The Financial Times reported that at the end of last year, the bank’s bond portfolio was $15 billion under water. That would be important if the bank’s depositors wanted their money. 

The Silicon Valley bankers could have insured against that by hedging against an interest-rate drop. But they didn’t. Hedges are insurance. They cost money, and the bankers didn’t want to spend it. “Essentially, to juice its [profit] in the short term,” wrote the Financial Times, “SVB ambled into 2023 almost completely unhedged — in effect, a massive multibillion-dollar bet that interest rates were approaching their peak.” 

Where were the regulators? According to the New York Times, the regulators just down the road at the San Francisco Fed were aware of the risk, and had been watching the bank for more than a year. By June 2022, they had put Silicon Valley Bank into “full supervisory review.”  And it wasn’t enough.

Those who call for stricter regulation have a point. Stricter regulation might have saved the bank. But regulators can make mistakes, too.

The obvious case is the Federal Reserve’s monetary policy of the past 15 years. Under Ben Bernanke, the Fed dropped interest rates nearly to zero to promote recovery from the 2008 recession. Under Janet Yellen and then Jerome Powell, the Fed kept interest rates at near-zero for almost 15 years. That was a huge mistake, because it encouraged people to think that zero interest was normal. (For the story of that mistake, see PBS-TV’s new Frontline piece, Age of Easy Money.)

When bankers make big mistakes, their bank fails. When government regulators make big mistakes, the whole country feels it.

Regulators pronounced the failure of Silicon Valley Bank a threat to the entire system. Was it? In hindsight, maybe that was a mistake. Economist Paul Krugman writes in the New York Times, “There is a reasonable argument, one that I largely agree with, to the effect that the failure of SVB didn’t pose a systemic threat in the way that the failures of financial institutions beginning with Lehman Brothers did in 2008.” Sebastian Mallaby at the Council on Foreign Relations argues in the Washington Post that it wasn’t a systemic threat: “Silicon Valley Bank was a medium-sized lender with almost no linkages to the wider financial system. Its collapse occurred at a time of full employment.”

At the moment of crisis, it’s hard for regulators to say, “Let the depositors take the loss. The system will hold.” At Silicon Valley Bank, where most of the deposits were owned by corporations, the $250,000 limit covered only 3 percent of the deposits. In that respect, this was like a bank a century ago, when there was no deposit insurance. (System-wide, deposit insurance covers about 57 percent of deposits.) As it had done several times before, the government ended up guaranteeing all the deposits, even ones in the tens of millions.

Now come voices saying: The FDIC’s $250,000 cap is “window dressing.” Nobody takes it seriously anymore. Let’s be honest and have the government openly guarantee all deposits, all of the time. So say law professors Lev Minard and Morgan Ricks in the Washington Post. “The time has therefore come for Congress to scrap the $250,000 cap on deposit insurance coverage, strengthen regulatory oversight accordingly and charge banks much more for operating a government-backed deposit business.”

The rejoinder is that this would amount to “a nationwide no-risk banking system,” writes Marc Thiessen of the American Enterprise Institute in the Washington Post. That we are already on the road toward such a system is not sufficient reason to go all the way. The government would be on the hook for an enormous new liability. To minimize that risk, government would have to take away the remainder of bankers’ commercial freedom. At the extreme, you can imagine the banking system run by the Post Office. An institution like Silicon Valley Bank, which served tech start-ups, might never come into existence.

Some people are willing to risk that. “It is time to give up on the convenient fiction that the checks and balances of the market can contribute to the policing of irresponsible bankers,” Mallaby writes in the Washington Post. But is it a fiction that market forces contribute to policing bankers? Even at Silicon Valley Bank, the bankers have not been bailed out. Their bank stock has gone to zero, they have lost their jobs, and their resumes exude an odor of failure. And that is a good thing. Their pain, and the knowledge of their pain, makes the system stronger.

So, too, would the enforcement of the $250,000 cap, or some other limit that leaves big depositors with some skin in the game. To be uninsured doesn’t mean you lose everything. In the time before deposit insurance, when a bank failed, money for the depositors was raised by collecting the loans (which were not forgotten) and by selling off the assets. During a depression, the loans were usually hard to collect and the assets weren’t worth a lot. The depositors might have to wait several years and get 50 cents on the dollar. But we’re not currently in a depression. The bank’s assets are mainly government bonds, which are easy to sell. It’s a fair bet that without the emergency coverage, the depositors at Silicon Valley Bank could have gotten most of their money, after a wait.

We’re not going back to the world before deposit insurance, but there needs to be a limit to the government’s liability if banking is to remain a private-sector activity. Treasurers of high-tech companies may not want the responsibility of selecting safe banks for company funds, and there may be some uncertainty to it, but that’s their job.

Perhaps $250,000 is the wrong ceiling for insurance coverage, or the coverage should be defined another way. Imagine a system that would offer 100 percent coverage up to one amount, 85 percent to a second amount, 70 percent to a third amount, and so on. Almost every country has commercial banks, and they all face the same problem. Nobody in America seems to ask what other countries do, and how well it works. Deposit insurance is not an all-or-nothing question.

Whatever rules Americans choose for dealing with banks that fail, they should be ones we’re willing to follow.