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banking system, banks, Elizabeth Warren, executive compensation, Federal Reserve, finance, financial reform, inflation, interest rates, Michael S. Barr, monetary policy, regulation, risk management, Silicon Valley Bank, stress tests, SVB, {What's Left of) Our Economy
So much analysis and commentary has been prompted by the recent outbreak of turmoil in the U.S. banking system (including Congressional hearings with testimony from system supervisors themselves) that it’s hard to believe that any major points have been badly neglected. Except they have been – at least according to my own efforts to follow the situation. Here are three of the biggest:
First, there’s been a flood of claims from progressive American legislators – led by Massachusetts Democratic Senator Elizabeth Warren – that the banking woes have stemmed largely from a Trump-era rollback of the regulatory reforms that were put in place after the 2007-08 global financial crisis to prevent the crackpot schemes that were the immediate cause of that near-meltdown.
In particular, Warren argued, the 2018 law that eased some of those early regulations exempted all but the nation’s biggest “systemically important” banks from mandatory, independent stress tests that aim to gauge their vulnerability to sudden economic shocks.
But what these critics either don’t know, or don’t want you to know, is that the stress tests that were designed for those biggest banks never included the kind of steep – indeed historic – rise in interest rates pushed through by the Federal Reserve to fight multi-decade high inflation. So even had the mandated stress tests been conducted for banks like the now-collapsed Silicon Valley Bank (SVB), they would have missed the very danger that touched off the current banking jitters.
Second, even though the above criticisms of the rollback are offbase in the above key respect, regulatory failures clearly occurred. And based on what’s known, the most puzzling has to do with the Federal Reserve. Here’s a description of the Fed’s performance in regulating SVB provided to Congress this week by the central bank’s Vice Chair for Supervision Michael S. Barr – who is heading the Fed’s deeper investigation of its procedures and practices. It’s worth quoting in full (footnotes have been removed):
“Near the end of 2021, supervisors found deficiencies in the bank’s liquidity risk management, resulting in six supervisory findings related to the bank’s liquidity stress testing, contingency funding, and liquidity risk management.In May, 2022, supervisors issued three findings related ineffective board oversight, risk management weaknesses, and the bank’s internal audit function. In the summer of 2022, supervisors lowered the bank’s management rating to ‘fair’ and rated the bank’s enterprise-wide governance and controls as ‘deficient.’ These ratings mean that the bank was not ‘well managed’ and was subject to growth restrictions under section 4(m) of the Bank Holding Company Act. In October 2022, supervisors met with the bank’s senior management to express concerns with the bank’s interest rate risk profile and in November 2022, supervisors delivered a supervisory finding on interest rate risk management to the bank.
“In mid-February 2023, staff presented to the Federal Reserve’s Board of Governors on the impact of rising interest rates on some banks’ financial condition and staff’s approach to address issues at banks. Staff discussed the issues broadly, and highlighted SVB’s interest rate and liquidity risk in particular. Staff relayed that they were actively engaged with SVB but, as it turned out, the full extent of the bank’s vulnerability was not apparent until the unexpected bank run on March 9.”
What’s astonishing about this testimony – and what’s been largely overlooked in banking crisis commentary so far – is that it states that between “the end of 2021” and last November, supervisors from the Fed and from its San Francisco branch told Silicon Valley Bank repeatedly of major actual and potential problems in its management practices no fewer than five times, The bank did…apparently nothing. And Fed officials at more than one level responded by…wringing their hands?
The big question: If banks are so free to ignore these warnings and ratings downgrades for so long, why bother with them in the first place? And a question almost as big: Once it’s clear that a bank is acting so negligently and arguably illegally, why doesn’t the Fed start making this information public in some way? Don’t depositors have the right to know that they’re likely doing business with a scofflaw?
(This report by the non-profit financial reform advocacy group Better Markets blames the Trump-era rollback for this seemingly gaping hole in supervisory and regulatory policy, in particular by in most cases preventing supervisers from communicating their findings to bank boards of directors, meaning that the senior managers who presumably had something to do with a bank’s problems could keep this information to themselves. The subject definitely needs further investigation – and correction if this account is accurate.)
Third, the torrents of easy money with which the Fed has flooded the economy for so long played a role in SVB’s failure that’s only been fleetingly mentioned. For not only, as widely noted, did this ocean of resources encourage overly risky lending (by greatly reducing the cost of guessing wrong). Not only did it give investors and businesses enormous, skyrocketing amounts of cash to deposit in banks like SVB. Not only did the rock-bottom interest rates generated by super-easy money lead the flush banks to park more and more of it in longer-term instruments – which offered higher yields and therefore more revenue.
But these revenues, and the higher stock prices they usually produced, were central to the compensation paid to senior executives – the more so since new lending opportunities weren’t remotely great enough to keep up with the hugely increased supply of assets. So bank management had at best modest incentives to manage better the risks of such extensive long borrowing – because salaries and bonuses would suffer. And because even (or especially?) the cleverest among us too often get addicted to hopium, it’s easy to understand how reckless risk management persisted even after it became obvious that interest rates were going up and depressing the face value of these long-dated assets.
This dynamic (described more completely in these Financial Times and Wall Street Journal pieces) seems to have been particularly prominent at SVB and the few other institutions that have either failed or are on the ropes. But it’s likely unnervingly widespread at lots of other less-than-systemically important banks that have been operating in the same abnormally low interest rate environment.
Of course, these three issues don’t exhaust the list of banking turmoil subjects that need much more examining. But deeper dives into them seem like a more than good enough place to start.