The failure of Silicon Valley Bank has sent shock waves through the U.S. and international banking system. One of the reasons, of course, was the bank’s shockingly weak financial condition. But it’s also likely that the widespread panic reflects a loss of faith in the Fed’s supervision of U.S. and foreign banks.
It’s now clear that there is a serious conflict between the Fed’s role as a monetary authority and its bank supervisory function. The Biden administration’s effort to allay the banking panic by guaranteeing all deposits in SVB will fail to return the US and the world’s banking system to boring normalcy until Congress makes major changes in the U.S. deposit protection and supervisory structure.
It’s not as though SVB deteriorated because it had made some risky loans—although it did. The main cause of its financial weakness was simply the failure to follow the most basic rule of banking: never support a portfolio of long term assets with short term deposits or other short term liabilities. This is particularly true when interest rates are rising, In that case, long term assets—even gold-plated bonds issued by the U.S. Treasury—will decline in value, and circumstances may one day require that you sell them or otherwise recognize the loss.
The fact that SVB’s failure was based on something so simple indicts the Fed’s regulatory system. An alert regulatory staff would have known that many banks within its jurisdiction were likely to have suffered asset value declines because of the Fed’s own policy of raising interest rates to stifle inflation. In many cases, these losses had not been recorded in their balance sheets (assets like Treasury bonds are not generally written down if they are intended to be held to maturity).
According to a recent article in the New York Times, The Fed was fully aware of SVB’s parlous condition, but its recommendations –which should have been directions—were not followed. The reasons for this, and the failure of the Fed’s supervisory staff to follow up with demands or even threats is inexplicable, except for the possibility that the Fed had conflicts of interest that interfered with tough supervision.
First, the chairman of SVB sat on the board of directors of the San Francisco Fed, the bank’s direct supervisor. How this was allowed is also inexplicable and reflects a blindness or arrogance at the Fed about its own susceptibility to conflicts.
Second, although we do not know what the Fed’s specific supervisory requests were, they came as the Fed itself was raising interest rates to curb inflation, putting greater pressure on all banks that were holding mortgage-backed or U.S. Government securities. While it was doing this, the Fed’s supervisory side knew that SVB would be especially adversely affected. Was the monetary side informed? Probably not, but once SVB failed, we saw the Fed change the policies on its monetary side. On Wednesday this week, the Fed raised interest rates 25 basis points, a small increment considering the continued high rate of inflation, and one unlikely to do much to slow prices, but it shows the Fed responding to its supervisory failure with a tepid effort on inflation. It is not sound policy either for monetary matters or bank supervision to have conflicted agency involved, but Congress only sees one solution.
Over the years, whenever there has been a significant banking problem, Congress has given increased power to regulators and supervisors—particularly the Fed—and has raised the FDIC’s insurance for bank deposits, now $250,000.
Both these measures will cause fewer and fewer depositors to care how carefully their bank is running its business, but Congress never questions whether the bank regulatory and supervisory system is effective. The recent failure or near-failure of many banks--together with the Fed’s conflict of interest between its monetary and bank supervisory responsibilities--is evidence that something is badly wrong with what Congress has constructed.
Many years ago, before the 2008 financial crisis, there was active private sector work on a nongovernmental system of bank supervision. The idea was that private sector groups would be formed to supervise banks for a fee, with a continuous right to inspect how the bank was being managed. Compensation for this work would be paid by the banks and would be commensurate with the size of the bank involved. The private supervisory groups would be required to make uninsured deposits in the banks they supervise. That would marry investment to a strong incentive for supervision. Governmental supervisory incentives are simply not strong or effective.
Nevertheless, when the 2008 financial crisis occurred, Congress turned immediately to giving more power to the Fed and the government’s regulatory and supervisory system. These “reforms” were put in place through the Dodd-Frank Act, before Congress or the Obama administration had done any serious study of the causes of the crisis or the performance of the financial supervisory system. “Never let a good crisis go to waste” was the motto.
The failure of SVB and others, and the quick recognition in the markets that something was badly wrong in the US bank supervisory system, should persuade Congress—this time—to look elsewhere for a more imaginative solution.
