The Problem With Bank Regulation: Why Banks Will Keep Failing & Bailouts Will Rise?
One the things we were able to do while we were out is dig into some of the themes that we have written about over the last few months.
Right at the very top were some of the larger questions around banking in modern society and further, how we approach risk more broadly.
During this process, we were reminded of two perennial truths:
Banking without risk is nigh on impossible.
It is entirely possible that our well intentioned efforts to further regulate banking and minimize risk will only create bigger problems.
Why? How the heck can that happen?
Well, there is one perspective that says that banking regulation is regrettable but necessary. And when there is a crisis like we just had with Signature Bank, Silicon Valley Bank etc the argument is made that, well, we just have to do better.
"Better" in this case can mean a few things but in the end it generally means setting aside more capital (i.e.: money) to serve as an emergency buffer. This money exists to serve for a rainy day when a bank run occurs or the business environment turns unexpectedly and losses on loans suddenly rise.
After each crisis the buffer is found wanting. If only we had more capital and fewer loans then the present situation could have been avoided etc.
The calls for more banking regulation especially around capital requirements are not hard to find. Turn on a financial news show or open the financial pages and you will read some sage figure from business or government arguing that "we simply must do more."
This impulse is in many respects the natural corollary of the "our banking system is safe and secure" that also gets frequently repeated.
The latter has obviously not been the case but if it was, then why must we do more? As we have pointed out earlier this spring, it is never: this regulatory regime has failed, how can we improve this structural system? It is also never, how can we have minimize the amount of disruption while keeping risk taking in check?
Instead, it is always a variation of "we must do more." We need a bigger firewall of capital.
Here is a good example from a recent example by a former central banker, Thomas Hoenig:
Bank capital should be built up cautiously but swiftly. Interest rates will continue to increase or at least remain high, investment securities will have further price declines and loan quality will deteriorate. There may be legitimate arguments as to why the US will avoid a recession, but one remains likely. Strong bank capital is an essential complement to active monetary policy in moderating the effects of any downturn that may develop.
There are two rather uncomfortable problems with this solution.
The first is encapsulated by the recent history of Credit Suisse.
The second is a wider and more theoretical problem around whether the constant effort to mitigate risk in banking is even wise.
The aim here isn't to pick on Mr Hoenig - far from it. His approach is simply symptomatic of the viewpoint that the answer to failed regulation is always more regulation. Central bankers and regulators never seem to pause and ask themselves whether "limiting risk" is possible or even advisable.
The problem with this worldview can be neatly summarize by the recent experience of Credit Suisse. Credit Suisse was a famously very troubled bank but, inarguably, it had sufficient capital. In fact, at the time of its fire sale to UBS it exceeded all regulatory requirements.
For instance:
Slightly before that, its own executives claimed that CS' liquidity coverage ratio, high-quality assets that can be quickly liquidated in case of an emergency, were of 150% of assets - far above the regulatory minimum of 100%.
Its key capital ratio was also above the mandated level and was one of the highest of any bank.
The Swiss National Bank had also injected tens of billions of emergency Euros into the bank to try and prop it up.
And the Swiss giant was a Systemically Important Financially Institution, unlike SVB or First Republic and therefore supposedly so regulated that they were "boring" and less profitable but ultra-safe.
All of this was for nought. If a bank's customers collectively decide you are in trouble then they will act rationally and it can very quickly become a self-fulfilling prophecy. It is very, very difficult for any government or regulator to halt it.
As we just learned this is especially the case in an age with social media and online banking can fan the flames of fear and start a run on even a large bank in hours.
Never forget that investors now know definitively that even too big to fail banks can and will fail under the right circumstances. What is the point of giving your money to a large and sclerotic institution when it too can fail?
That CS experience and the basic reality of risk would seem to call for some humility and perhaps even reasonable acknowledgement of the basic facts from politicians and regulators alike.
Both groups are doing the exact opposite. That might not be surprising but we do think it could be a big mistake. It might not be wise to have the US Treasury Secretary or head of the Federal Reserve constantly talking about vulnerabilities in the banking system but we could at least be honest about the in built realities of borrowing short and lending long.
This brings us to the second and wider point.
What if regulating banking isn't just extremely difficult but also perhaps counterproductive? What if our efforts don't just not create the safety we crave but rather store up problems and create the conditions for a larger crisis.
The idea that by trying to minimize risk you actually incentivize risk taking and therefore raise the overall level of risk and the probability of a larger crisis eventually.
Hyman Minsky, a particularly dour economist, was the person that first pointed this particular conundrum out. His work has since been expanded and strengthened by others.
Nassim Taleb of Black Swan fame has also made this point again and again usually when pointing that as our regulatory efforts have expanded and deepened we keep having larger and larger crises that require larger and larger bailouts.
That isn't a bug but rather a feature of the system that encourages excessive risk taking from participants who assume that they too will be too big to fail. What about the Silicon Valley Bank episode has discouraged that approach?
The biggest trend in financial crises over the last 40+ years is that the bailouts are getting bigger and bigger and the "totally unforeseen" panics are getting faster and harder to control.
Bank runs and crises cost about 1% of GDP per event in the 19th century. The Savings & Loans crisis cost about 3% of GDP in the 1980s. The 2008 banking crisis cost over 7% of GDP. You get the picture.....
The irony of all this is that it is broadly known by those power but by constantly repeating that the "banking system is safe and secure" and "the financial system is stable" you then not only have to do whatever it takes to achieve it but you also can't really change course.
You keep promising that with only some more capital and some more tweaks you can fireproof a system that may actually require, like a forest, small fires periodically to keep the system honest and in sync. Otherwise you risk a long period of stability that lull everyone, including regulators until a major conflagration necessitates another huge round of bailouts and rescues.
We are trapped, in other words. Trapped by our words, by our regulatory regime and by our mistaken belief in our own ability to control human nature and human risk taking.
After all, you risk your credibility as regulators, politicians and institutions if you suddenly pivot to saying actually people need to take far more care, the US government may not be there to bail you out.
Chair Jerome Powell has found out it can be very hard to change your tune over the last few years. After all, as Greg Beckert, former CEO of Silicon Valley Bank argued (in disingenuously, we would say) the US Federal Reserve told banks they would not raise rates and so they took them at their word and bought the low yielding mortgage bonds that later proved so problematic.
In fact, in June of 2020 Chair Powell famously said:
We're not thinking of raising interest rates. We're not even thinking of thinking of raising rates.
That lasted about 21 months before not only did they change their mind but set off on one of the fastest rate rise cycle in the history of US monetary policy.
This sudden pivot to a new monetary policy regime created a perfect storm for Signature, Silicon Valley and First Republic Bank. The fact that regulators themselves had no idea about the coming problem is all you need to know.
In the end, banking is a confidence game. You need to balance risk taking with taking care of small and unsophisticated depositors. Both those elements are important and must be held in balance.
We just wish more people referenced both the tradeoff involved and the culpability of the regulatory regime that is storing up problems and will shortly make it more difficult to raise credit in the US economy.
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Have questions? Care to find out more? Feel free to reach out at contact@pebble.finance or join our Slack community to meet more like-minded individuals and see what we are talking about today. All are welcome.
