By guaranteeing the safety of all depositors (not just those below the current federal guarantee of $250,000) at Silicon Valley Bank and Signature Bank, have we unwittingly begun to nationalize our banking system? Perhaps so, but it could be that what the Biden administration is doing is even worse.
Treasury Secretary Yellen first said under oath in Senate testimony that the new policy would apply to other failing banks in the future only if the FDIC board, the Fed board, she and the President agreed that it was the proper action. In saying this, she was suggesting a new American banking system. This new banking system would create both moral hazard where bank executives are encouraged to take on more risk than they would without the unlimited federal guarantee, and crony nationalization where a depositor is protected only if what? If the bank is too big to fail? If the bank is in a region or an industry thought to be vitally important to the nation? If the depositors are influential political donors? If the board of the failing bank includes former members of Congress with eponymous banking regulation? Such socialization of risk and privatization of profit (moral hazard) for what will be perceived to be allies of the administration is antithetical to capitalism and to democracy. It cannot be allowed to stand as policy.
Then, one week later, the Secretary reversed her position by saying that the administration was not planning to extend the deposit guarantee to all depositors. Her peripatetic policy announcements are inviting more runs that will destroy the remaining trust that depositors have in the banking system. In fact, depositors are already lowering the level of their bank deposits by fleeing to money market funds and shadow banking alternatives, thus trading one set of risks for another and setting the stage for the next round of crisis, emergency stopgaps and new regulation.
Senator Warren and others are calling for more regulation and blaming relaxation of some Dodd-Frank provisions for the current crisis. Targeted additional laws might help, but more laws will never replace sound judgment. Dodd-Frank focused on credit risk, a big contributor to the 2008 bank crisis. It did not address certain axiomatic banking principles like duration risk and industry concentration risk that apparently are not as axiomatic as some presumed.
Trying to address such fundamentals through more laws, however, will never replace competent oversight by regulators and governing boards. Any Banking 101 student should have seen the danger of the asset liability duration mismatch in a rising rate environment. Any competent regulator would view one of the fastest growing banks in the country not having a Chief Risk Officer in place for 8 months as a huge red flag. There were ample signs that could have averted the current crisis under existing regulation had we had in place more competent and more courageous regulators and governing boards. Legislating intelligence and courage into those responsible for overseeing our banks will be a huge challenge.
Equally challenging is the passivity that large index-based institutions represent among the largest shareholders at many publicly traded corporations. For 90% of the companies comprising the S&P 500, Black Rock, State Street or Vanguard (the 3 biggest index fund managers) are the single largest shareholder. Estimates of the percentage of the American equity markets now owned by index funds range as high as 30%. These funds by definition (passive) tend not to challenge management. Not having the beneficial owners of these index funds (pensions, endowments and individuals) appropriately represented on the governing boards of public companies potentially creates lax oversight and misaligned fiduciary responsibility that can be particularly worrisome on the compensation and risk committees.
Having said all of the above, as is said about generals who are always fighting the last war, and not the next war, the same can be said of legislators. Inevitably, rightly or wrongly, legislators will write new laws. There will be legislation that addresses some of the causes of the banking crisis of 2023 and by doing so could reduce the chances of a future banking crisis.
When in the 20th Century Carter Glass of Virginia led the passage of two laws that stood the test of time. The first established the Federal Reserve in 1913 and later the Banking Act of 1933, which created the Federal Deposit Insurance Corporation (FDIC) that still federally guarantees depositors today. Glass was looking forward, not just backwards at the causes of proximate banking crises. Like Glass, today’s legislators would be better served by addressing the potential causes of the next crisis, such as the relatively unregulated esoteric money market funds and shadow banking vehicles into which much of the deposit base is now fleeing, as well as the potentially misaligned fiduciary responsibilities created by the size of the index- based shareholders.
