The regulatory reforms that followed the financial crisis of 2007-09 created a financial system that is far more resilient than the one in place 15 years ago. Yet, the events of March 2023 make clear that the progress thus far is simply not enough. To ensure resilience, we need to do more.
To steer the process of further reform, we propose a set of 10 precepts that those who make the rules should keep in mind as they refine the prudential framework. These practical guidelines lead us to conclusions that mirror those in a recent post: regulation should be more rule-based (less reliant on supervisory insight or discretion); simpler and more transparent; stricter and more rigorous; and more efficient in its use of resources. Concretely, this approach means increasing capital and liquidity requirements; shifting to mark-to-market accounting; and improving the transparency, flexibility and severity of capital and liquidity stress tests.
The collapse of Silicon Valley Bank (SVB) revealed an extraordinary range of astonishing failures. There was the failure of the bank’s executives to manage the maturity and liquidity risks that are basic to the business of banking: they failed Money and Banking 101. There was the failure of market discipline by investors who either didn’t notice or didn’t care about the fact that the bank was severely undercapitalized for the better part of a year before it collapsed. There was the failure of the supervisors to compel the bank to manage the simplest and most obvious risks. And, there was the failure of the resolution authorities to act in mid-2022 when SVB’s true net worth had sunk far below the minimum threshold for “prompt corrective action.”
Waiting several quarters to act deepened the threat to the financial system, undermining confidence not only in many other banks but also in the competence of the supervisors. The extraordinary rescue actions last week by both the deposit insurer (FDIC) and the lender of last resort (Federal Reserve) are just a sign of the high costs associated with restoring financial stability when confidence plunges.
In this post we discuss each of these four failures, as well as the actions that authorities took to stabilize the financial system following the SVB failure. To anticipate our conclusions, we see an urgent need for officials to do at least five things:
Second, they should perform a speedy and focused stress test on each of these banks to assess the impact on their true net worth of a sizable further increase in interest rates. Any bank with a capital shortfall should be compelled either to issue new equity or shut down. (To ensure the availability of the necessary resources, authorities will need to have a pool of public funds available to recapitalize banks that cannot attract private investors.)
Third, to restore resilience, Congress must reverse the 2018-19 weakening of regulation that allowed medium-size banks to escape rigorous capital and liquidity requirements.
Fourth, the authorities must change accounting rules to ensure that reported capital more accurately reflects each bank’s true financial condition.
Finally, policymakers should assess the impact on the financial system and on the federal debt arising from the now-implicit promise to insure all deposits in a crisis. To limit risk taking, correspondingly greater fees and higher capital and liquidity requirements should accompany any explicit increase in the cap on deposit insurance.
