The recent turmoil in the banking sector has led to calls for tougher rules to prevent failures like Silicon Valley Bank (SVB), and Signature Bank, as well as the eleventh-hour rescue of First Republic by JPMorgan and UBS’s takeover of stricken rival Credit Suisse.
However, any moves to avert further banking shocks should be weighed against the wider implications for the US economy: a pullback in bank lending could ratchet up the cost of funding for businesses and households, potentially worsening the economic slowdown just as higher interest rates begin to bite.
There are five crucial steps to strengthen bank supervision while keeping credit flowing into the economy.
Toughen capital and liquidity requirements for mid-sized banks
First, supervisors should toughen rules for mid-sized banks, especially those with between $100 billion and $250 billion in assets, to ensure they can withstand a negative economic shock. But instead of strengthening supervision for smaller lenders, lawmakers and regulators have only made them weaker in recent years.
This was because of the belief that such rules curtailed bank lending, hurting the US economy, or that smaller institutions did not pose a systemic risk – a view that has been proven devastatingly wrong by the recent collapse of several such lenders.
In 2018, the US Congress watered down parts of the Dodd-Frank Act, laws implemented after the 2007-08 financial crisis, to exempt some lenders with assets of up to $250 billion from the strictest safeguards. Those include stress tests (an analysis to determine if a bank has enough capital to withstand a crisis) as well as capital and liquidity requirements.
In 2019 the Federal Reserve, the US central bank, took similar steps to weaken supervision for all but the largest lenders. The result was that many banks have loaded up on risky assets to boost their profits, ultimately sowing the seeds of their demise, and threatening the US economy.