The Silicon Valley Bank debacle was especially shocking for two reasons.
First, regulatory agencies and commentators had been telling us that the great debate on regulation and supervision that followed the numerous financial crises between 2007 and 2012 had absorbed these experiences into strengthened regulatory and supervisory regimes. Central banks and both domestic and international regulatory agencies, were reassuring about the resilience of advanced-country banking systems (while raising concerns about nonbank financial intermediaries and finances in developing countries).
For example, the International Monetary Fund’s January World Economic Outlook Update informed us: “Financial sector regulations introduced after the global financial crisis have contributed to the resilience of banking sectors throughout the pandemic, but there is a need for address data and supervisory gaps in the less-regulated non-bank financial sector.” Needless to say, the banking troubles that emerged with Silicon Valley Bank’s failure were located squarely within that supposedly resilient, more-regulated financial sector.
Second, supervisory stress tests and assessments seem to have missed not the most remote contingencies—seemingly hidden potential shocks—but the most obvious monetary policy shock in plain sight.
Let’s start with some background.
As the IMF informs us, regulatory regimes were strengthened following the financial crisis. The post-crisis discussions under the auspices of the Basel Committee on Banking Supervision focused clearly on strengthening three possible balance-sheet fragilities.
First, capital efficiency. Financial institutions were required to have an adequate equity buffer to protect depositors and senior creditors against an unexpected impairment of assets, for example a spate of defaults. This was to be ensured through a higher ratio of capital to risk-weighted assets, a leverage ratio for which assets were not weighted, more rigorous definitions of capital, broader coverage of exposures, a capital conservation buffer, a possible countercyclical buffer, and a surcharge on large banks.
Second, adequate liquidity. Banks were supposed to comply with a liquidity coverage ratio to ensure they would have sufficient liquid assets to cover potential outflows under stressed conditions for a month for large banks (and three weeks for medium-size banks).
And, third, a net stable funding ratio was supposed to be imposed to guard against excessive reliance on unstable sources of funding. The concern had been highlighted by the crisis of banks in Ireland where extremely rapid growth—with a dangerous concentration of assets in real estate—had been financed by volatile wholesale funding from abroad. While the growth of SVB was financed via a different type of volatile funding, the underlying logic (one would have thought) would surely have informed supervision.
Besides all this, there was much handwringing about the missed signs of impending turbulence in 2007 and early 2008, and also renewed focus on possible problems of regulatory arbitrage, for example shifting assets from trading book (where they are marked to market) to banking book (where they are carried at cost).
Fast forward 15 years. As noted, prior to the SVB implosion, the mantra among central banks and both domestic and international regulatory agencies, was entirely reassuring about prudential regulation and the resilience of banks in advanced countries.
This seemed plausible. Surely, in this new world of rigorous regulation and supervision, obvious warning signs would be heeded. Even if capital looked adequate in general, rapid growth based on large uninsured deposits, concentrated in one volatile sector, would surely elicit questions about the stability of funding even if the circumstances were not precisely those initially envisaged under the net stable funding regulation. Given these questions, liquidity coverage should have been a focus of attention. Yet these issues seem to have surprised the supervisors.
The recent experience is even more shocking in light of the obvious implications of the biggest, most unmissable financial sector story of the past year—the rapid tightening of monetary policy.
Banks are in the business of maturity transformation—that is, their assets are generally less liquid than their deposit base. This means they always face duration risk. As interest rates rise, the market value of their assets drops; the longer the duration of the assets the greater the fall in value. Similar implications for the balance sheet of the Fed—”Tightening Monetary Policy will Put a hole in the Fed’s Balance Sheet”—were spelled out in one Barron’s article in October of last year. And, even though the Fed had no need to realize losses on its bond holdings, the inevitable rise in rates on liabilities would undermine its earnings. Wouldn’t the Fed just take a cue from its own balance sheet to focus on analogous vulnerabilities in banks’ balance sheets? How much more dire would it be for banks to cope with rising interest rates and a volatile deposit base?
Are central banks and bank supervisors impervious to experience? Or will they now learn that stable funding is critical, that even medium-sized banks are important, especially if the whole system is being subjected to a common stress, and that adequate liquidity under stress needs to be frequently re-evaluated, and by exacting scenarios not merely mechanical ratios and predictable stress tests? If so, perhaps we can avoid another similar crisis—or, at least, foisting the cost of irresponsible banking on better-behaved banks or taxpayers. If not, we will be stuck in a perpetual Groundhog Day loop.
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