Bank stocks continued to fall on Friday, signaling problems with the financial system that may run deeper than deposit flight at SVB and other regional banks. 

One industry-wide challenge is that, after steadily declining for decades and spurred by the fastest tightening of monetary policy since the 1970s, interest rates have soared. Bond prices move inversely to interest rates. Banks are some of the largest holders of government bonds and have suffered billions of dollars in unrealized losses. 

It’s clear how this dynamic contributed to SVB’s collapse. The bank invested its depositors’ money in volatile, long-dated government bonds and failed to account for their devaluation as the Federal Reserve raised interest rates. SVB’s fickle and sophisticated depositors fled en masse as these errors came to light. 

But falling bank stock prices could also be a sign of a broader loss of confidence in the soundness of the financial system. This is an indictment of regulation. Writing in the New York Times last week, Senator Elizabeth Warren argued, “...these recent bank failures are the direct result of leaders in Washington weakening the financial rules.”

To be sure, SVB’s failure exposed some egregious loopholes in the current regulatory framework. Flagrant political lobbying seems to have played a part in expanding those loopholes recently, at least as they applied to SVB. As the bank grew in size, regulators were shifting the goalposts by subjecting only increasingly larger banks to the most stringent regulation.

As a result, SVB was never subject to the stress tests that come with the “enhanced supervision” the Fed applies to large banks. It was also exempt from maintaining the liquidity coverage ratios that are designed to ensure banks have enough high quality liquid assets to sell if they experience a sustained outflow of funding. SVB never grew large enough to be required to disclose how unmarked bond positions would erode capital if they were marked to their fair market value, rather than the inflated prices at which they were purchased.

But this narrative elides some complications. It’s not clear that SVB would have run afoul of regulations—either liquidity tests or the Fed’s stress tests—even before their recent dilution. And if regulators are to blame, so are the credit rating agencies. Moody’s conferred an A1 credit rating on Silicon Valley Bank right up until the moment it collapsed. Investors were no more prescient: SVB’s stock price had been rallying in the weeks leading up to its demise. 

Our persistent inability to foresee bank crises is leading some observers to a more realistic, if somewhat fatalist, conclusion: bankers and regulators will forever be engaged in a game of cat-and-mouse. Despite regulators’ best efforts, bank failures are as old as banks themselves. 

How we got here

Bank crises come in two flavors: liquidity-driven and solvency-driven. In a liquidity-led crisis, sources of funding, such as depositors, get spooked and withdraw their money. In a solvency-led crisis, bank loans and investments sour, and the associated writedowns lead to bankruptcy. Often these two risks are intertwined: funding flees because of concerns about bad loans, forcing banks to sell assets at knockdown prices, leading to existential losses.

Compared to firms in other sectors, banks rarely go out of business. But they impose severe costs on the wider economy when they do. Sensibly, they are therefore highly regulated.

Today’s financial regulations are a patchwork of rules established over more than a century (the Fed was established after the banking panic of 1907, the FDIC after the crash of 1929). The most recent regulations were written in the months following the financial crisis in 2008, and reflect the particular set of events that led to that crisis: banks’ real estate loans soured and their access to short-term “wholesale funding” (borrowing through bond markets) disappeared.

In response, regulators forced banks to turn to more stable sources of funding—longer term borrowing in financial markets, and customer deposits. And they required banks to hold more of their assets in safe and easily-sellable “high quality liquid assets” (like government bonds), and to hold more capital, allowing them to weather steeper falls in their assets without becoming insolvent.

Bigger banks faced stricter regulation. The thinking was that, since the degree of damage to the economy upon a bank’s failure is proportional to the size of the bank and its linkages with the rest of the financial system, the stringency of regulation should also be proportional to the size of the bank. The largest banks were designated “globally systemically important banks” (GSIBs), and faced the most stringent new regulation.

Viewed through the lens of the 2008 meltdown, it is easier to see why SVB flew under the radar. Regulators had focused on large banks with a lot of wholesale borrowing and little deposit funding. SVB was a smaller, regional bank with very little wholesale borrowing and a lot of deposits. 

Looking ahead

Regulations undergo the biggest fortifications following crises. The regulatory holes that SVB exposed now need to be patched over.

SVB’s achilles heel was its fickle deposit base. That’s where regulators could start. In assessing liquidity risks, current regulations assume deposits are much more stable than overnight borrowing. That assumption should now be questioned.  As Bloomberg columnist Matt Levine writes, “existing regulations do not seem to be particularly attuned to the risk of bad depositors.”

Another assumption that should be re-examined is that banks smaller than $250bn do not pose a systemic risk to the financial system and should therefore be regulated more lightly. In winding down SVB to minimize spillovers rather than to minimize losses to taxpayers, the FDIC implicitly recognized that banks in the $100-250bn range are large enough to constitute systemic risks. 

SVB would have been under closer supervision had regulations not been “tailored” in 2018 to exclude banks of its size from closer scrutiny. As then Fed governor (now director of the National Economic Council) Lael Brainard argued, the 2018 rollback went “beyond what is required by law and weakens the safeguards at the core of the system”. Those safeguards should be restored by treating smaller banks like larger ones.

The Bank Policy Institute, an advocacy group representing banks, calculates that SVB would have passed the liquidity tests applied to larger banks. Professors Mason and Mitchener argue in the Wall Street Journal that Fed stress tests would not have identified the risks lurking in SVB’s huge portfolio of unhedged, long-duration (riskier) government bonds. But these are not arguments to exclude SVB from regulation, they are arguments for making regulatory tests more robust.

If these fixes sound cosmetic, it’s because they are. The stability of the financial system is built brick by brick.

As higher interest rates expose other weak financial institutions, regulators will surely come under more fire. Crises, almost by definition, come from the corners of the financial system that regulators have overlooked. But each crisis presents an opportunity to fortify the rules, and we should never let a good crisis go to waste.