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Finance
Five steps to avert further banking turmoil, without triggering a credit crunch
Failures at First Republic and others could have been avoided with tougher supervision and treasury management, as well as targeted deposit insurance and “fair value”accounting.
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.
Trust is essential to stability in the banking sector
More broadly, this highlights the “agency problem”: the interests of lenders are not fully aligned with that of their customers. Such problems can be reduced, though, if lawmakers and regulators reverse the deregulation drive.
That’s because, if mid-sized banks were subjected to the same rules as their bigger peers, the warning signs at SVB and others could have been highlighted much sooner (or avoided altogether).
Expand targeted deposit insurance for businesses
Second, deposit insurance should be revamped to prevent the kind of bank runs that brought down SVB and First Republic. But rather than scrapping the $250,000 cap set by the Federal Deposit Insurance Corporation (FDIC), as some lawmakers have called for, I recommend expanding targeted coverage for business accounts. This is needed because the value of uninsured US deposits has risen significantly since 2009 and last year, from $2.3 trillion to $7.7 trillion, the FDIC said in a report. In the case of SVB, many small and medium-sized companies used mostly unbacked deposits parked at the Californian lender to pay wages and other basic expenses.
“Banks have loaded up on risky assets to boost their profits, ultimately sowing the seeds of their demise, and threatening the US economy”
When SVB collapsed, these businesses faced insecurity over the fate of their cash, which sparked runs on other mid-sized banks across the US – deposit flight that was hastened by the ubiquity of social media and digital banking. This underlines how trust is essential to stability in the banking sector.
Raising the insurance threshold to $2.5 million for businesses would restore some of that trust, and cover what most companies need for payroll. Avoiding a blanket increase for all accounts, meanwhile, would help deposits maintain financial prudence while reducing the “moral hazard” problem of banks increasing exposure to risk because they don’t bear the full costs.
That problem can be further reduced by making lenders guarantee a portion of deposits themselves – the third step to balanced supervision.
That will require a significant increase in their equity funding, such as by reducing the share of profits paid out in dividends, or through a rights issue -offering more equity to existing shareholders at a discount. Such a move is likely to be deeply unpopular among banks, given that any capital raise will be costly. But it would give them skin in the game, and discourage them from taking excessive risks.
Reform US accounting rules
Fourth, we need to rethink “hold-to-maturity” accounting. This approach means that banks do not need to book any changes in the value of securities they own, so long as they have both the intent and ability to hold them to maturity.
The stock of securities designated as hold-to-maturity has ballooned since the Fed began raising interest rates in mid-2021 from near zero to just over 5% today. That’s because this cycle of monetary tightening caused a dramatic fall in the price of usually-safe government bonds and other long-duration securities (because newly issued bonds have higher yields).
But the losses were not realized on the balance sheets of many banks because their executives certified they would hold them to maturity.
However, lenders can run into serious trouble when they are forced to sell those assets at a massive loss to cover deposit withdrawals, which is what happened to SVB. It eroded the bank’s capital cushion, leading to insolvency. I believe, therefore, that accounting rule-makers should force banks to recognize those unrealized losses on securities.
That can be achieved via “fair value” accounting when banks calculate the value of securities based on their current market value. This approach would have illuminated the huge paper losses that SVB racked up on its bond portfolio much sooner, thereby giving investors and supervisors the chance to force the bank to take action and bolster its financial position, before it was too late.
Companies: strengthen treasury management
Fifth, we cannot expect regulators nor lawmakers to be solely responsible for maintaining financial stability; we need better risk management on the part of depositors themselves. Many of SVB’s customers entrusted the bank with all of their capital, despite only $250,000 of it being insured – meaning their immediate and long-term funding needs were at the mercy of just one institution. The risk of concentration was brutally exposed when SVB collapsed, leaving these companies scrambling to secure funds to meet even basic needs. Companies should, therefore, diversify their banking relationships, and consider keeping accounts with multiple lenders – ideally four – and holding at least three months’ worth of cash in each account. Better treasury management could be the difference between death or survival at a time of ongoing bank sector turmoil and wider economic pressures.Authors
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