“There we go again” were the words that came out of a lot of mouths when SVB (Silicon Valley Bank) failed on March 9. We thought that after the 2008 financial crisis the Dodd-Frank Act of 2010 would have ushered in a more stable banking environment. Closer supervision and more onerous resolution of bank failures for shareholders and uninsured deposits were expected to instill more discipline in banking. The SVB case exposed the limits of these expectations.
The seemingly ad hoc way the regulators chose to avert another financial debacle exposed the fragility of the regulatory architecture. It also brought to the fore the sense that we may have a selective approach to supervision and resolution. As Daniel Tarullo, a former Fed governor, said “… concerns about moral hazard, and concerns about who the system is protecting, are front and center again.”
Despite statements to the contrary, the SVB case was a bailout and bailouts have winners and losers. In this case, the answer to “who the system is protecting” is wealthy millionaire depositors and the Silicon Valley tech companies whose uninsured deposits were granted full protection. Along with these firms, their employees, among the best paid in the American workforce, also became the indirect beneficiaries of the bailout.
The question is why the Fed opted for a bailout instead of a bail-in that the Dodd-Frank Act allows in such cases. In a bail-in uninsured deposits are converted into equity, thus bearing the ultimate consequences of risk taking. The Eurozone was an early user of the bail-in mechanism when Cyprus suffered a banking collapse during the Euro debt crisis and has adopted bail-ins as a resolution mechanism.
Bail-ins and deposit insurance up to a reasonable level are tools to limit the moral hazard problem in banking operations. Exposing large depositors to the risk of substantial losses and converting their deposits into equity has a dual purpose. It aims at compelling large depositors to monitor a bank’s risk and signal their disapproval by withdrawing deposits. It also aims at making shareholders more cautious with respect to pursuing profits at high risk by exposing them to losses on their equity positions once uninsured deposits turn into equity.
In the case of SVB, we had a failure of bank supervision before the collapse and of selective rescue afterward. It seems that SVB’s regulatory supervisors were remiss in making sure SVB would act and reverse cited lapses the regulatory examiners had identified prior to its failure. And then following its failure, SVB and its privileged depositors were offered a resolution with disregard to the moral hazard problem. What good is any regulatory framework if the checks on reckless profit seeking are undermined by limiting losses on shareholders and large depositors?
Interestingly, both supporters and critics of bank regulation are now proposing that deposit protection cover millions of dollars or even become unlimited. There are two issues here that merit consideration. First, raising or eliminating the limit of insurance for deposits relieves both large (and mostly wealthy) depositors as well as bank shareholders from careful and costly risk assessment and monitoring. Second, with less skin in the game, both large depositors and bank shareholders (especially the latter) can potentially become a lot less careful with risk taking. Protecting us from bank failures then will fall more on the shoulders of regulators and their capacity to resist powerful interests and less on the market’s assessment of risks and rewards. So welcome to socialized banking. Not in the sense the state takes control of the banks but in the sense that bank shareholders and wealthy depositors reap extra profits in good days and share their losses with us on bad days.
There are two arguments that circulate in reference to the SVB debacle that appear to me to be incompatible. One is that the SVB failure was a one bank’s failure due to mismanagement and failed supervision. The other is that we had to act decisively and quickly to avert a bank panic. If it were the first, then no special treatment should have been extended to this bank and its clients. If it were the second, then regulators signaled that even isolated bank failures are enough to spread public fear and uncertainty.
I believe the second concern is more valid. And this argument exposes the fragility and limited reassuring power of regulation in the face of fear. Fear is one of the strongest human emotions. It’s what tells us to take flight whether from a shadow that jumps in front of us or from a sudden banking incident. Behind fear is the human difficulty to handle threats and uncertainty. Fear triggers reflexive reaction before we have the time to process any available information or collect new information.
Now add to the rapid reaction to fear the speed with which information spreads and how fast money can be moved around, both made possible thanks to digital technology. So, we can have a reality in which negative information, valid or not, spreads like a brush fire, it ignites fear, which rapidly, and before our reasoning has time to process facts, triggers money movements that may deplete a banks’ deposits. The question then is: Is our approach to safeguarding the stability of banking and financial markets designed so that it can deal with human psychology and modern technology? I am not sure. We still cling to the model of the rational homo economicus and we are enthralled by the boundless possibilities of modern technology and thus we tend to ignore their destabilizing effects.
Given the fragility of trust and the potency of human fear, we should err on the side of prudent and responsible banking that protects the economic welfare of society. Laws and regulations should reward responsible banking practices and not the pursuit of profits and executive remuneration through irresponsible risk seeking. In a capitalist economy, entrepreneurial rewards are justified by risk taking. When these risks are, however, spread across society when they become reality, then what is the meaning of entrepreneurship?
More broadly, we need to be honest about our understanding of the effects of moral hazard. By that I refer to the pervasive notion that the adoption of social support programs (anti-poverty measures, child support, publicly-supported health care, student debt relief and so on) erode the incentive to work, while believing, at the same time, that the risk of moral hazard is impervious to assisting or rescuing businesses by using public funds.
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