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The US banking system is more safe and stolid than it was before 2008, but the shambles surrounding Silicon Valley Bank and a handful of other lenders showed that it could still be a bit safer and stolider (please).
Of course, occasional bank failures may simply be unavoidable. They just have to be managed. And it is encouraging to see how the broader financial system and the US economy shrugged off the whole mess. Remember that at the time a lot of people thought this would become a redux of the S&L crisis and that a recession was unavoidable as banks retrenched.
Still, it would be silly not to try to learn something from the debacle (beyond, you know, not selling all your rate hedges in the middle of a massive rate hiking cycle, loading up on uninsured deposits from a flighty, highly-concentrated customer base, not having a chief risk officer, or shopping around for a second opinion when everything went FUBAR).
With that in mind, here’s a new report from the Center for Financial Stability on the topic, authored by an eclectic handful of industry luminaries — Sheila Bair, Joyce Chang, Charles Goodhart, Lawrence Goodman, Barbara Novick and Richard Sandor. As it argues:
Regrettably, little has been done to meaningfully address those weaknesses. Capital and liquidity stress tests continue to treat government securities as risk-free and highly liquid. Uninsured deposits remain vulnerable to runs. As it becomes apparent that the Federal Reserve will need to maintain a “higher for longer” interest rate stance, pressure on banks’ funding costs and net interest margins will intensify, increasing the risk of more bank failures. Regulators have proposed massive changes to capital requirements, known as the “Basel III End Game,” but these primarily address issues stemming from the Great Financial Crisis (GFC), not current bank turmoil. Whatever the merit of these proposals, the more urgent need is to address the very real risk of future bank failures and their impact on system stability.
For the most part it retreats ground covered by the many, many, many other postmortems into the 2023 banking shenanigan, both in terms of what weaknesses it revealed and what should be done about it. For the most part it plays it safe.
For example, the group shied away from recommending an increase in the US bank deposit guarantee, increasing capital requirements, ending the risk-free treatment of US government debt, reforming the FHLB system, or scrapping the chaotic hodgepodge of US financial regulators and replacing it with a single powerful watchdog.
In an accompanying report, it also lays a lot of blame on tighter monetary policy and for the Fed not taking financial stability concerns more seriously, but this argument feels a bit weak. The US central bank is obviously concerned with financial stability, but inflation-fighting was the priority and it patently couldn’t be thrown off course just in case some US banks turned out to be incompetently run.
But it made one intriguing proposal. The report’s own emphasis below:
. . . The group felt that a separate regulatory and supervisory board at the Fed had merit and could be less controversial. This could be accomplished by placing the Fed’s monetary policy responsibilities under a newly constituted, seven-member Monetary Policy Committee (MPC) and placing regulation and supervision under a separate, seven-member Financial Policy Committee (FPC). This would leave regulation and supervision with the Fed, but strengthen and elevate its importance in decision-making. . Recent bank failures were the regrettable, yet predictable, manifestation of a rapid inflationary surge on financial institutions with interestrate-sensitive assets and runnable liabilities. A closer connection between the Fed’s monetary policy and bank regulatory/supervisory responsibilities might have done a better job of focusing supervision on those risks. Completely separating the two might have made it worse. To maximize this potential benefit of a new FPC, the group felt there should be overlapping membership with it and the Monetary Policy Committee. One way to accomplish this would be to have the Chairs of the MPC and FPC sit on both committees and perhaps one additional member.
If this sounds familiar to some Alphaville readers it is because it is the model now followed by the UK.
As part of a sweeping regulatory overhaul after the global financial crisis the UK scrapped the Financial Services Authority and set up a Financial Conduct Authority to be more of a classic consumer protection agency. Regulating individual financial companies was handed to the the Prudential Regulation Authority, a new body set up inside the Bank of England, and a new Financial Policy Committee was set up to watch for system-wide dangers.
The FPC is a 13-member group that includes the BoE governor, four deputy governors and the Bank’s executive director for financial stability, the CEO of the FCA, five external members with expertise in the field and a non-voting Treasury official. It meets quarterly, pushes out reports, and raises its eyebrows at people makes recommendations that people tend to follow.
It’s kinda like the US Treasury’s Financial Stability Oversight Council and the Office for Financial Research, but with actual teeth (eg it can also give binding instructions to the PRA and FCA).
Sometimes it can lead to grimly amusing situations, such as the Andrew Bailey-chaired FPC voting to buy long-term gilts to calm last year’s chaos even as the Andrew Bailey-chaired MPC was selling them to quell inflation. Here is an entire BoE report on how the FPC and MPC interact, if you’re into that kind of thing.
But on the whole it’s a set-up that seems intuitively smart, and so far doesn’t seem to have had any major blemishes aside from the whole LDI mess?
Without actually explicitly mentioning the UK system anywhere the CFS certainly seems taken with it, specifically highlighting how it could help with one of the weirder aspects of the US Federal Reserve system. The report’s emphasis below.
The creation of an FPC could also address concerns — which the group shares — about bank executives serving on the boards of the Federal Reserve’s regional banks. The board of the Fed’s 12 reserve banks each have nine-person boards, three of whom come from the banking industry. There has been considerable public criticism of the fact that SVB’s CEO, Greg Becker, served on the San Francisco regional bank’s board. While regional bank boards have no role in setting regulatory or supervisory policy, the optics of bank executives serving on them undermine public confidence and inevitably lead to speculation that their presence compromises bank oversight. We note that the San Francisco Regional Bank has suffered significant reputational damage from SVB’s failure, even though SVB’s supervision was functionally overseen by the Federal Reserve Board in Washington. The best solution is to prohibit banks executives from serving on the Fed’s regional bank boards. However, if they continue to do so, we would recommend that all regulation and supervision, functional as well as administrative, be completely removed from the regional banks and placed under the FPC.
Placing regulation and supervision under an FPC could help ensure that bank examiners are overseen in Washington by a committee comprised of experts in the fields of regulation and financial stability. This would also help guard against local political influence over the supervisory process. At the same time, as previously discussed, examiners need to be supported and respected in their supervisory roles. They will have the best “on-the-ground” understanding of a bank’s weaknesses and gaps in risk management. They must be empowered to act swiftly to remediate major problems that could threaten a bank’s viability. A key responsibility of the FPC should be to ensure that examiners are well-trained, well-resourced, and have the ability to act quickly, unencumbered by layers of Washington bureaucracy.
The report also thinks an FPC-MPC split would ameliorate another of its main criticisms of the Fed:
The creation of an FPC would also help address Fed groupthink. The resistance to thinking in monetary quantity terms is deep seated at the Fed, even though this metric can be an important predictor of financial instability. Similarly, there is seldom meaningful dissent on monetary or regulatory matters. Ideally, the FPC would include un-conflicted individuals with practical financial markets knowledge and experience. A new FPC should actively work to strengthen stress testing capabilities by a focused number of meaningful and realistic scenarios. A less academic, more realistic reflection of real-world risks that a bank faces would better inform institutions and their regulators about the full landscape of potential risks.
Still, it is grimly amusing to see someone advocate the US copy the UK’s approach to financial regulation. Perhaps not mentioning that the FPC-MPC model is a UK one was a strategic choice to make it more palatable?
Read the full article here