Battling bank failures: A feature – not a bug – of the system: Paul J. Davies

In the wake of Silicon Valley Bank and Signature Bank’s failures a year ago, regulatory responses, such as the Federal Reserve’s proposed rule changes and the Recoup Act, aim to hold executives accountable for bank failures. However, historical banking bargains, shaped by political pressures, economic shifts, and technological advances, reveal a complex interplay. While calls for higher capital requirements echo, the challenge lies in depoliticising banking regulation and reconsidering the sector’s role in achieving political and social objectives. The road to financial stability remains fraught with political intricacies.

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By Paul J. Davies

It’s a year since the failures of Silicon Valley Bank and Signature Bank – and the renewed cries of “never again.” Almost instantly began inquiries to work out who to blame, as well as hurried efforts to tighten banking rules, raise capital demands and enact laws to make executives pay.

Within months, the Federal Reserve issued a highly technical proposal for rule changes that runs to nearly 1,100 pages. Some updates were due but SVB’s collapse inspired a much heavier rewrite. The Senate Banking Committee has come up with the Recoup Act, to make executives accountable for bank failures and to pay back more of their rewards.

These restart familiar battles, which are pitched as specific economic tradeoffs. Curb bank profits with higher capital demands and they’ll have to cut lending to ordinary people and companies. Give unelected bureaucrats excessive powers to claw back pay and to kick executives out of their jobs, then talented people will work elsewhere.

The truth is neither of these efforts will fundamentally fix banking, or starve the economy of credit. They are mere tweaks to deeper, long-term political and social bargains that last for decades, or more. A country’s banking system is forged in the balance between the powers of interest groups to demand access to credit, the ability of bankers to lobby for their own protections and profits, and the borrowing needs of governments themselves, among other things.

For example, the first great modern bargain was made through the development of the Bank of England in the late 17th and 18th centuries. In return for lending to the state to fund Britain’s wars, the then-privately owned bank was given strong protections from competitors in literally printing money and given strong protections in other commercial activities.

In the US, leaders of the early republic tried a similar thing several times but were undone by the need of individual states to finance themselves and the tensions between local and national government, according to a seminal comparative history of bank regulation by Charles Calomiris and Stephen Haber. To cut their long and fascinating story absurdly short, those conditions produced an explosion of small unit banks that ran limited local monopolies and formed an enduring political alliance with farmers. That dynamic helped shape American banking for more than 150 years.

More relevant to today’s battles is what happened in the 1980s and 1990s when economic and political pressures along with advances in technology spurred a wave of regulatory changes and created much larger banks that did business nationally. The process of approving mergers gave political activists the chance to extract concessions, particularly around increasing the availability and affordability of credit for homebuyers, as Calomiris tells it.

Governments in the US (and UK) loved the idea of selling voters the dream of wealth and property without spending taxpayer money directly. However, the upshot (again to simplify drastically) was a systematic lowering of mortgage standards, a long credit expansion and eventually a massive financial crisis, for which taxpayers had to foot the bill.

This great banking bargain and the expansion of home ownership since the 1980s always involved taxpayer subsidies, they just weren’t obviously visible. They were paid through minimal interest rates on deposits, government sponsorship of Fannie Mae and Freddie Mac and ultimately the implicit state support for the banking system because of its critical role in the economy. These subsidies evolved over the 20th century and were exploited by banks, interest groups, politicians and, really, everyone else.

True, a lot has changed since 2008 in how much capital banks have to issue, how risks on their balance sheets are measured and the defenses they are meant to have against a sudden need to let customers shift their deposits. SVB still happened, but the system is probably much safer than it was. However, it’s also easy to be complacent about the short life of last March’s problems. Don’t forget how quickly the Treasury pledged to look after uninsured deposits, or that the Fed immediately opened a program for cash-strapped banks to swap government bonds for funding at face value. These prevented other potential bank runs.

What hasn’t changed is how and where bargains over banking are struck, or the democratic and political involvement in regulation. The US has suffered regular banking crises over the centuries and more than 560 banks have failed just since 2000. In contrast, Canada hasn’t seen a systemic crisis in more than a century and fewer than 50 banks have folded since the late 1960s, according to the Canada Deposit Insurance Corporation.

The US system is highly responsive to democratic, political and often populist demands. SVB arguably got into so much trouble in part because in 2018, lobbying efforts by smaller banks allowed them to escape the tougher rules created only a few years earlier – with bipartisan support. Politics deemed these banks weren’t systemically risky. But then they were. Now the Fed is trying to reverse that change again.

Canada has always had fewer, larger, better diversified banks that cooperated more. They are all overseen by a single national regulator. That means more financial stability, but it might also mean less dynamic banks that don’t innovate as much and could maintain higher margins on some products.

Some think the answer in the US is obvious: much higher capital requirements calculated against simpler common measures. I don’t fully buy that because any guardrail can be moved or weakened in a more reactive political system – and often in hard-to-see ways. For example, use ordinary GAAP accounting to measure balance sheets and the fight could move to change rules over what counts as an asset or liability. The US and Europe already have different measures for derivatives exposure, for example.

A possible answer for financial stability is to lessen the influence of politics on rule-setting and supervision. The US, UK and others have done this with monetary policy, for instance. But that’s no panacea: Independent central banks may be good at inflation targeting, but they struggle to help economic growth and have been blamed for rising inequality. If you’re solving only for financial stability, you might lose track of fair pricing for consumers or helpful innovations.

Another possible answer is to simply not use the banking system for political or social aims: Those are best and most democratically achieved through taxation or legislation that has been openly debated.

The regulatory response to SVB, the Fed’s proposed rule changes, is already in deep trouble politically. Chair Jerome Powell now suggests they could be withdrawn. The Recoup Act, too, might well be neutered, just like previous similar attempts. We will learn things from the last crisis and some guardrails might improve, but it’s hard to see the US waving farewell to financial crises.