Can the SVB crisis be solved in the longer run?

The failure and closure of Silicon Valley Bank (SVB) raise immediate issues as to how policymakers should react. I’d like to step back and consider what this implies for banking regulation more generally in the longer run. The main lesson is that successful bank regulation is an ongoing, dynamic problem, unintended secondary consequences are rife, and neither more regulation or less regulation can be guaranteed to succeed.

If you think of the FDIC/Fed/Treasury as a consolidated entity, the broader question is how many financial institution liabilities they should guarantee, whether explicitly or implicitly. Let us consider why in fact the government felt compelled to guarantee all of the deposits.

An unwillingness to guarantee all the deposits would satisfy the desire to penalize businesses and banks for their mistakes, limit moral hazard, and limit the fiscal liabilities of the public sector. Those are common goals in these debates. Nonetheless unintended secondary consequences kick in, and the final results of that policy may not be as intended.

Once depositors are allowed to take losses, both individuals and institutions will adjust their deposit behavior, and they probably would do so relatively quickly. Smaller banks would receive many fewer deposits, and the giant “too big to fail” banks, such as JP Morgan, would receive many more deposits. Many people know that if depositors at an institution such as JP Morgan were allowed to take losses above 250k, the economy would come crashing down. The federal government would in some manner intervene – whether we like it or not – and depositors at the biggest banks would be protected.

In essence, we would end up centralizing much of our American and foreign capital in our “too big to fail” banks. That would make them all the more too big to fail. It also might boost financial sector concentration in undesirable ways.

To see the perversity of the actual result, we started off wanting to punish banks and depositors for their mistakes. We end up in a world where it is much harder to punish banks and depositors for their mistakes.

Another unintended secondary consequence is that lots of funds would flow out of the banking system and into U.S. Treasuries. In other words, our private businesses would find it harder to borrow and our government would find it easier to borrow and thus government would command more resources. That hardly seems like a desirable outcome for a policy decision that had some initially libertarian motives.

Alternatively, you might think it is a simple way out for the government to guarantee all those deposits, as indeed was done last evening.

That decision too will prove to have unintended secondary consequences. Raising the FDIC protection limit from $250,000 to ??? raises political eyebrows in a dramatic manner. For one thing, the FDIC would then be seen as guaranteeing a much larger part of the financial system. Over time, the pressures for the government to protect yet additional parts of the financial system will grow, just as they did after the bailouts from the 2008-2009 financial crisis. Furthermore, if the FDIC keeps on increasing its protections in the quest for financial stability, that means a larger FDIC, a larger regulatory apparatus, perhaps higher capital requirements, and over time higher premia for banks to pay to the FDIC.  (As a side note, worthy of another post, we are also hearing calls that somehow VCs need to be regulated now, if they are going to “receive bailouts”.)

As that scenario unfolds, there will be all the more incentives to supply more lending and also deposit-taking services outside the formal and more heavily regulated banking sector. Rather than pushing more resources into the larger banks, this policy would push additional resources outside the formal banking system altogether. That would mean less power, oversight and scrutiny from the Fed and also from other regulatory bodies. Typically American banks are more tightly regulated and monitored than are non-bank financial entities.

This kind of problem is likely to unfold slowly, but it is no less real. The initial policy was an expansion of FDIC regulatory authority, but the end result could well be less total regulation of lending and depository functions. Once again, the policy decision may fail at achieving its initially intended goals.

The core problem is this: regulators can only protect so much of the financial system. Yet in a wealthy, peaceful economy the financial system often grows more rapidly than does gdp, if only because the financial system is based on the intermediation of wealth, not income. Simple accumulation boosts the ratio of wealth to income over time, thereby creating regulatory dilemmas for finance. Neither “regulating more and more of it” nor “letting more and more of it continue in a less regulated manner” are entirely satisfactory solutions.

But those of course are the only options available to us.


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