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Some Suggestions on How to Make the Banking System More Strong, Competitive, and Abuse-Resistant
If recent events provide an opportunity for reforming bank regulation, let's use it productively
In the wake of the failures of Silicon Valley Bank and Signature Bank, the invocation of the systemic exemption by the bank regulators, extraordinary interventions, including making whole uninsured depositors, and ongoing uncertainty in the market, how we regulate banks has resurfaced as a major topic of debate. Banking regulation is in need of reform. This has been true for a while, but the recent turmoil, which appears to be the result of bad monetary policy, mismanagement, inadequate capital standards, and failed supervision makes the need even more acute.
What follows every crisis and bailout are new rules, restrictive guidance, and social priorities. As the government provides expanded support to the industry in times of economic stress, it exacts a price in terms of more control over the industry. The favored industry participants in exchange see their firms take on some characteristics of government, including a backstop enforced by law and greater sway over the levers of the economy. We should consider such quid-pro-quo(s) carefully as they impinge on the basic concept of capitalism, property rights and individual choice. Thus, the banking lobby, regulators, Congress, and voters should honestly consider the consequences that follow bailouts.
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We need a new paradigm for banking regulation that protects the American people as customers, taxpayers, and citizens. Americans need protection from the risk that they become collateral damage of an unstable system that lacks sufficient capital and market discipline to be safe, instead relying on excessive leverage, failed regulatory paradigms, and the expectation of government support. Instead of doubling down on the current system, we should adopt a system that provides more stability and properly aligns incentives to encourage prudence and accountability.
Americans must also be protected from the risk of oppressive public and private regulation that leverages the power of the banking system as a tool of universal regulation. While this threat is already serious, it will become even greater the more the line between banks and government blurs.
Steps must be taken to mitigate these risks. While by no means an exhaustive list, the following proposals would likely improve the banking system by making it more stable, safer, and less prone to abuse, and should be considered as part of any change to the banking regulatory system:
1. Simpler, Higher Capital: The recent failure of SVB has shown the inadequacy of our current regime. The bank held billions of, assumed to be, safe government or government-backed securities for which the regulatory risk-weighted rules required little or no capital. Thus, the bank was free to increase its growth in deposits at rates as high as 60%, investing them in government guaranteed securities at a very low cost of capital. However, as interest rates rose the value of these securities declined substantially, creating uncertainty about its solvency and the market value of equity declined, and ultimately a loss of depositor confidence and a run on the bank. More non-runnable capital could have helped maintain the safety of the deposits.
Further, insisting on more equity funding for banks will help restore the market discipline that will be lost with if people believe that deposits, even those above the current limit, are effectively insured by the government. By placing equity investors between the deposit insurance fund and failure, investors will have a strong incentive to police bank management and prevent excessive risk taking or incompetence. Additionally, higher equity capital will help buy banks and regulators time to resolve distress or fail gracefully. This is essential in a world where bank runs can be organized over the internet and funds withdrawn from anywhere via smartphones. Regulators may not be able to react quickly enough unless there are far more substantial non-runnable capital buffers in place. In fact, when one looks at SVB’s equity value you see a prolonged decline that could have served as both an early warning and a lifeline to regulators if they noticed and intervened earlier.
While opponents assert that raising equity capital buffers will hamper banks’ ability to lend this is by no means certain. Banks with higher capital levels often are able to maintain their lending programs during economic slowdowns, which cushions their effects on the economy. Further, a more stable banking system will likely have fewer destructive banking crises, preventing the devastating loss of wealth and economic productivity that accompany such cataclysms. Finally, we must also consider the costs of political instability as people see banks and the wealthy being bailed out again and again. If banking is to have any moral legitimacy as a profit seeking enterprise the risk must be borne fully by those who receive the profits before anyone else is put at risk, otherwise banking would be nothing more than a corrupt bargain between government and industry elites.
2. Prohibit Banks acting as Private Regulators: Banks receive copious amounts of privilege and protection from public policy. Banks enjoy regulatorily imposed barriers to entry, more favorable legal treatment compared to non-bank competitors, exclusive access to valuable government services (including deposit insurance), and barriers to exit. The former was demonstrated by the recent response of the Federal Reserve to the failures of SVB and Signature bank. Yes, those two banks were allowed to fail, but the Fed announced a new facility aimed at propping up other weak banks, rather than allowing market discipline to take its course, in the name of preventing contagion.
This special treatment of banks is justified by its proponents because banks are considered necessary to facilitate lawful commerce and their failure can have significant collateral damage. It is, therefore, contrary to this purpose for banks to intentionally withhold or condition services to lawful businesses because they wish to modify or harm the market for those businesses, as has been observed in areas including firearms, energy, and immigration, though there is no reason to assume that this phenomena would be limited to those. These actions may be the result of management preferences or may reflect management seeking to placate shareholders, employees, other customers, the media or, distressingly politicians or regulators who lack the power or ability to prohibit this but seek to use the banks as their instrument. Regardless of the reason, it is an inappropriate use of the privileged position banks are placed in via public policy and should be prohibited.
To be clear, this is not to say banks should become a public utility with the corresponding duty to serve. Banks play an important role in allocating capital to its most productive use, and that will require banks exercise discernment in which customers they serve. To impose a duty to serve, especially with regards to credit, could lead to malinvestment and the further politicization of credit allocation. This would pose a significant threat to both the economy and liberty.
Rather, banks should be prohibited from using a desire, either by the bank itself or some other constituency, to regulate or curtail the market for a legal good or service as a criterion for when assessing whether to serve a customer. Such a prohibition is not unheard of in American banking law. For example, in 1976, partially in response to efforts by Arab governments and businesses to achieve their geopolitical goals against Israel by pressuring banks they did business with to discriminate against Israeli and Jewish customers, the Equal Credit Opportunity Act was amended to prohibit discrimination on the basis of race or national origin. In this case American policy makers clearly rejected the use of the American banking system as a tool of political coercion, this principle should be expanded on.
3. Require Regulators to Focus on Concrete Threats to Bank Stability and Prohibit Reputational Risk Consideration (Especially third-party reputational risk): The failure of SVB was predictable given the information available to regulators, and yet it was apparently not caught, or sufficiently acted upon, in time. It is worth asking whether, as John Cochrane wonders, regulators have become too focused on “big” issues like climate and less focused on the types of problems most likely to kill a bank, such as interest rate risk.
An undue focus on speculative threats risks hampering regulators’ ability to detect concrete threats in time, frustrating their primary purpose. Under current law regulators are granted broad discretion when assessing what matters to bank safety and soundness. (Though that discretion is probably not as broad as they claim.) Congress should clarify and constrain the areas regulators look at to those that pose a concrete threat to bank stability, rather than vague and theoretical risks.
One such theoretical risk that is in desperate need of reform is the use of “reputational risk” in bank regulation. This risk, that the action of a bank, one of its partners, affiliates, or even customers, may cause banks to lose customers and therefore became imperiled has been the source of some of the highest profile examples of abuse by bank regulators imposing their policy preferences under the guise of safety and soundness. Its nebulous nature provides ample space for arbitrariness and bias to creep in.
Further, as Julie Hill shows, based upon available information reputational risk is almost always a subsidiary risk of some more legitimate concern, such as compliance or credit risk. It is almost never used legitimately as the sole risk justification by regulators. It is at best redundant and at worst used as a license for abuse.
This is especially dangerous in cases where it isn’t the bank but the bank’s customers that the regulators take exception to. Such analysis is inherently speculative and risks regulator preferences and assumptions to take on the force of law. It also incentivizes activists to try to de-bank legal but disfavored industries via the regulators, as happened with refund anticipation loans.
Unfortunately, as Hill and Nicholas Parrillo note, the nature of bank regulation deeply discourages banks from challenging abuse by their regulators, as such abuse may never be discovered. Congress must step in to make clear that regulators are not to consider reputational effects of otherwise lawful conduct, especially not the effects that serving certain customers may have.
4. Meaningful Independent Review of Material Supervisory Determinations: Another fixture of banking regulation is that regulators who supervise banks will often seek to steer bank behavior informally through the supervisory process. This informal and opaque process is where much actual bank regulation is done and can provide regulators significant power over how banks conduct their business, in effect modifying the law and regulations without any process.
There is very limited recourse for banks who feel they are being treated unfairly, especially because any appeals of material supervisory determination are handled by the agency whose examiner made the determination. Congress tried to provide some independence to the process but the reality is that independence is largely illusory. The FDIC tried to create a more independent regime but that effort was reversed abruptly in 2022.
Congress must step in to create truly independent review of material supervisory decisions. This could involve the use of Article 3 courts or some independent agency that is not connected to or in any way dependent on the leadership of the banking regulators. This may result in additional cost but given the importance of banking to the broader economy and the importance of protecting the due process rights of citizens the cost should be well worth it.
5. Banking Regulators Should Be Placed On Appropriations: Finally, Congress must reverse its abdication of responsibility with regard to banking regulators and place them on appropriations. Whatever belief that banking regulators would be non-political technocrats exercising little real power that may have existed should be abandoned in light of reality. These agencies wield considerable and broad ranging power over the banking system and by extension the broader economy and society. They should be subject to the full panoply of constitutional checks and balances, most especially being placed on congressional appropriations.
To be clear, this does not mean that the FDIC insurance fund itself, or the Federal Reserve’s central banking function, should be subject to appropriations. But the agency budgets that fund regulatory activities should be. In this way all of Congress can have a meaningful tool to provide democratic accountability on what have been insular and opaque agencies. Given the broad acknowledgement that a stable financial system is vital there is little reason to fear a threat of massive defunding, unless of course there is evidence that an agency has abused its power. In that case the threat of defunding is serving its constitutionally appointed role of protecting the people from abuse.
Banking is a peculiar industry that has an outsized effect on society. Its regulation regularly deviates from expected norms of government activity and the relationship between government and market participants. It is beset with moral hazard and the potential for abuse, and often lacks basic constitutional checks and balances. These reforms are by no means the complete fix, but would be an important step in reestablishing a banking system that is strong, competitive, and resistant to abuse.
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