The abrupt bankruptcies of Silicon Valley Bank and Signature Bank and subsequent concerns about the stability of other banks have a violent combustion debate among legislatorsthe financial industrythe Biden administration And former government officials on a series of banking reforms and regulatory changes.
The ideas floated within a month The collapse of the Silicon Valley Bank on March 10, 2023 range from calls to overhaul banking regulations to a major overhaul of government oversight of the banking system.
I’m a professor of finance who previously worked for two major banks and was an economist at the Federal Reserve. Based on what I’ve learned from the banking crises that have unfolded over the last 40 years, I would divide all banking reform proposals into five categories.
1. Stronger supervision
Silicon Valley Bank reportedly ignored six separate warnings from the Federal Reserve Bank of San Francisco that it was short on cash and engaged in risky practices. The call for stricter banking supervision and regulation should therefore come as no surprise.
Such reforms would improve the changes of a law Congress passed in 2018 which relaxed some banking rules.
Previously, the government had to watch out for banks with at least $50 billion in assets. It had to subject them, among other things stress tests – in which the authorities assess whether banks are able to respond to hypothetical economic shocks – by having sufficient cash on hand to meet relatively strict capital requirements.
The 2018 law increased the limit on what counts as a “systemically important” bank to $250 billion in assets, allowing many banks, including SVB, to circumvent these stricter regulations.
The White House has already called for new rules similar to what’s listed above for medium-sized banks — those with $100 billion to $250 billion in assets. SVB, which had approximately $210 billion in assetsfell into this category before its demise.
Senator Elizabeth Warren of Massachusetts and Representative Katie Porter of California have introduced legislation in the Senate and House of Representatives that would simply repeal the 2018 lawbringing the threshold back to $50 billion.
Large banking trading groups, such as the Bank Policy Institutearguing on behalf of its major bank members have argued that the 2018 law was not a major factor in the bankruptcy of SVB and Signature Bank.
Patrick T. Fallon/AFP via Getty Images
2. Higher deposit insurance threshold
The role of deposit guarantee schemes in averting and alleviating banking crises could also change.
The Federal Deposit Insurance Corp. should have just done that insure bills up to $100,000 during the 2008 financial crisis. But instead, the almost all depositors coveredboth uninsured and insured, in most of the bank failures that occurred at the time.
Then the government raised that limit to $250,000 in October 2008. But the FDIC again broke with its official mandate when it protected depositors from losses above that cap during the March 2023 bank failures.
Some lawmakers have proposed raising the $250,000 limit on deposit insurance.
Representative Maxine Waters, the top Democrat on the House Financial Services Committee, says she supports the move. And Warren has suggested she might support new limits running into the millions of dollars instead of hundreds of thousands.
“Is it $2 million? Is it $5 million? Is it 10 million?” she said in a television interview.
But those lawmakers have so far failed to call on the FDIC to commit to always covering all losses of customers who take losses when bank failures cause their deposits to disappear — rather than doing so on a case-by-case basis.
FDIC Chairman Martin J. Gruenberg told the Senate Banking Committee at a recent hearing that the insurer intends publishes its own proposals on May 1.
3. “Changed Deposit Payout”
Other proposals go further.
For example, William Isaac, who chaired the FDIC from 1978 to 1986, is calling on the government to insure all noninterest-bearing checking accounts, regardless of size. But he also has a recommendation that could potentially discipline banks that get into trouble.
Isaac distinguishes between deposits that are essentially investments, such as deposit receipts that people use for long-term savings, and, for example, a checking account that a customer holds primarily for basic transactions.
Investors with large sums of money in CDs are generally wealthy individuals who can assess the financial risks themselves or with the help of a paid advisor. People with CDs also have an incentive to leave them in the bank because withdrawing the money tied to them before the due date can result in paying a fine or forfeiture the high interest rates that make them attractive investments.
Isaac also advocates returning to the way uninsured deposits — currently those over $250,000 — were treated in the 1980s. He calls this the “modified deposit payoff” model.
In resolving a bank failure, the FDIC would cover the full cost of compensating customers with uninsured deposits that pay no interest, yet issue certificates to uninsured depositors worth 80% of their uninsured funds.
If the government were to recover at least 80% of its cost of covering the uninsured deposits, often through selling bankrupt banks to financial institutionswould investors with large deposits at a bankrupt bank get paid more, Isaac explained in a Wall Street Journal op-ed.
“This reform would protect business accounts essential to keep the economy going and would significantly reduce the risk of panic,” he wrote.
4. Ring Fencing
The most comprehensive proposals calling for restructuring of the banking system would use what is known as a “ring fence” model.
Ring fencing separates part of the bank’s assets and liabilities from the rest. The The United Kingdom is already following this approach.
Since 2019, UK banks have had to separate their retail banking activities from their supposedly riskier investment banking and international lending activities.
The most radical of these proposals would place all insured deposits in “narrow bencheswhich should hold only cash and US Treasury bonds.
All bank lending would take place outside of small banks, perhaps in finance company-like firms financed by uninsured loans and capital instruments such as stocks and bonds.
Economist Robert Litan wrote a book about it narrow banking in the 1980s, but the idea may be traced back to Milton Friedman – the late University of Chicago economist and Nobel laureate.
Banks are typically required to set aside a portion of their deposits as reserves held as cash or as deposits with their local Federal Reserve bank. However, the Fed reduced that share to zero in March 2020 – effectively eliminating the requirement altogether.
Some experts wonder if ring-fencing, by preventing the transfer of capital between banking unitscould make banks less flexible in responding to financial shocks – and therefore more risky.
Critics of the narrow banking model point out that this approach would drastically reduce the amount of money banks could lend. As a result, systemic risk would shift from real banks to “shadow benches” – securities firms, hedge funds and other credit intermediaries facing less regulation and oversight. Shadow banks have contributed to the 2007-2009 global financial crisisaccording to the International Monetary Fund.
5. Compensation Chargebacks
At the heart of the banking reform debate is ‘moral hazard’. That’s a concept about how insurance can create an incentive to take greater risks when people, institutions and even countries realize that they will not bear the full cost of that risk.
One way to mitigate risk in this context is to have bank executives bear some of the costs when the banks they run fail.
A bipartisan group of senators has introduced a bill to do just that. It would require regulators to recover compensationincluding the bonuses and stock awards paid to bank executives in the five years prior to bankruptcy.
In my opinion, it is still too early to say whether policymakers will make minor adjustments or opt for more far-reaching reforms.
One thing I hope all policymakers will bear in mind is that there are tradeoffs between banks’ financial stability and market discipline. Providing too much government support – such as insuring all liabilities in the event of a bank failure – incentivizes banks and their customers to ignore risk or engage in risky behavior.
This article has been updated to clarify Robert Litan’s contributions to the banking reform debate.
