Saturday, 3 Jun 2023

Opinion | Seven Ideas to Prevent the Next Bank Crisis

If there’s ever been a topic about which fresh thinking is sorely needed, it’s how to fix the banks so they stop doing what they’ve been doing lately. It’s worth casting the net wide to include even ideas that aren’t fully developed or that are politically unrealistic.

So let’s dive in:

Issue more Treasury bills. Silicon Valley Bank failed in part because it put way too much of its money in long-term Treasury bonds, which lost value when interest rates rose. Lots of other banks are suffering indigestion from the vast sums of Treasury bonds they consumed. They would have been better off owning more Treasury bills, which have shorter maturities. Treasury bills aren’t as affected by rising interest rates, and investors replace them with higher-yielding bills when they mature.

Markus Brunnermeier, an economist at Princeton University, told me Tuesday that the Treasury Department should give the banking system more of what it needs and less of what it doesn’t need by changing how it raises money, selling more bills and fewer bonds. It could still sell some bonds to finance long-term infrastructure projects, Brunnermeier said. The natural buyers of those bonds would be pension funds and insurance companies — not banks, whose liabilities are short term. He also said stress tests should gauge banks’ ability to cope with rapid increases in interest rates.

Stop “hide to maturity” accounting. Another lesson from Silicon Valley Bank’s failure is that banks can be at more risk than you’d ever guess by looking at their balance sheets. Securities that they don’t plan to sell — that they will hold to maturity, in other words — can be recorded on the books at face value even if their market value is much less. One commentator called this “hide to maturity” accounting.

Even in good times, revaluing securities every quarter based on market prices would add a lot of volatility to the financial statements. Today, with many banks sitting on huge unrealized losses, it could trigger a panic. (As the chart below shows, banks took in lots of deposits early in the pandemic but were losing some of them even before the latest storm.) At a minimum, though, once things calm down, stress tests on the banks should verify that a bank would be able to cover all its liabilities, including deposits, if it had to sell all its assets for what the market would bear.

Insure all deposits. Protecting all depositors, even those with more than $250,000 in a bank, would eliminate the risk of bank runs. Robert Hockett, a Cornell Law School professor who has been banging the drum for the idea, argued that it would instill faith in small and midsize banks and stanch the flow of deposits into a handful of banks that are considered too big to fail. Riskier banks would pay more for their insurance, as they do now. And regulators would have to keep an even closer watch, since uninsured depositors would no longer have a financial incentive to make sure their money was safe.

The House’s Freedom Caucus said universal deposit insurance would encourage “future irresponsible behavior to be paid for by those not involved who follow the rules.” That’s something to be considered. But the reality is that while the F.D.I.C. is supposed to resolve banks in the least costly way possible, it makes exceptions when there’s a risk of contagion. That’s why uninsured depositors at Silicon Valley Bank and Signature Bank were made whole. Uninsured depositors lost just under $100 million in the failure of IndyMac Bank in 2008, according to a spreadsheet the F.D.I.C. sent me, but that was an exception. By my calculation, based on the F.D.I.C. data, IndyMac alone accounts for 47 percent of uninsured depositor losses since 1993.

Consolidate regulation. People are asking why regulators didn’t stop Silicon Valley Bank’s blunders in mismanaging its balance sheet. One reason is that its primary regulator was the California Department of Financial Protection and Innovation, which seemingly wasn’t up to the task. The department has announced a “comprehensive review” of the job it did. The Federal Reserve, which also had oversight authority, repeatedly warned Silicon Valley Bank that it was mismanaging risk — but it never forced action.

The good thing about having multiple regulators is that each bank has a lot of eyes on it. The bad thing is the possibility that none of the regulators feel fully responsible. It might be better to have just one federal regulator take clear primary responsibility. The F.D.I.C. would be a good candidate, particularly if it ends up insuring all deposits.

Force banks to borrow less. Anat Admati, a finance and economics professor at Stanford University’s Graduate School of Business, has argued for years that banks are getting away with murder by relying almost entirely on money from depositors and lenders to take risks and make profits. When an investment or loan makes money, the bank and its shareholders keep the upside. If enough investments and loans go bad — whoops — the shareholders don’t lose very much, because they didn’t put in very much in the first place and they can walk away if the bank becomes insolvent. The government often steps in to pick up the pieces: Privatized gains, socialized losses.

Admati and others have argued that banks should raise much more of their funding from shareholders, as other kinds of companies do. Bank lobbyists have argued that banks have plenty of capital already, but more equity funding is just a good, sensible idea.

Make banks narrow. If none of these ideas are extreme enough for you, consider an even bolder one that goes back to the 1930s and comes up every time there’s banking turmoil: the narrow bank. A narrow bank would hold deposits entirely in cash, short-term Treasury bills or interest-paying reserves at the Federal Reserve. Bank runs would be eliminated, and deposit insurance would be unnecessary, because depositors would know that even if everyone wanted all their money back the same day, they could get it.

Amit Seru, a professor at Stanford’s Graduate School of Business, said that “there’s huge merit” to the concept of narrow banking. Brunnermeier of Princeton said he’s not against narrow banking but said that requiring deposit-taking banks to invest only in liquid government securities — rather than, say, loans to companies — would dry up financing for businesses. Plus, he said, “the transition is quite tricky.” Banks would have a hard time paying off depositors if they started switching their funds to specialized mutual funds en masse.

End leverage. Laurence Kotlikoff, an economist at Boston University, told me narrow banking is too narrow to deal with two flaws in the broad financial system: leverage and opacity. He has proposed going even further and removing leverage from the entire financial system — not just banks but also securities firms, insurance companies and others. His “limited-purpose banking” limits financial institutions to serving as go-betweens, not gambling with other people’s money. The institutions would be set up as equity-funded mutual funds, which are safer than banks because they don’t borrow. Mutual funds that hold only cash or reserves at the Fed would take the place of bank deposits. Other mutual funds would finance mortgages and small business loans. As for ending opacity, a new government agency would verify and disclose all mutual fund assets.

The status quo is unacceptable, according to Kotlikoff. He told me: “Even if this crisis calms down, it’s just a matter of time before the system fails again. It’s a bridge made with rotten timber.”

Treasury Secretary Janet Yellen was trying to reassure the public last week when she testified to the Senate Finance Committee that “our banking system is sound.” But she also said less reassuringly, referring to the run on Silicon Valley Bank, that “no matter how strong capital and liquidity supervision are, if a bank has an overwhelming run that’s spurred by social media or whatever so that it’s seeing deposits flee at that pace, a bank can be put in a danger of failing.” If social media can bring down a bank, I’d say there’s something wrong with the banking system as presently constituted.

I hope all of these ideas and others will get a good airing as we figure out how to make sure this doesn’t happen yet again.

Elsewhere: A Bearish Signal for the U.S. Economy

Even before the banking system turned runny, the Conference Board’s venerable Leading Economic Index was indicating trouble ahead. The index for the U.S. economy fell in February for the 11th straight month, the Conference Board, a think tank, announced on Friday. Eight of the 10 indicators were negative or flat, more than offsetting an increase in stock prices and a better-than-expected report on residential building permits. The current banking turmoil could worsen the outlook if it persists, the Conference Board said. Justyna Zabinska-La Monica, the senior manager in charge of business cycle indicators, said in a statement that the think tank “forecasts rising interest rates paired with declining consumer spending will most likely push the U.S. economy into recession in the near term.”

Quote of the Day

“Few will doubt that humankind has created a planet-sized problem for itself. No one wished it so, but we are the first species to become a geophysical force, altering Earth’s climate, a role previously reserved for tectonics, sun flares and glacial cycles.”

— E.O. Wilson, “Consilience: The Unity of Knowledge” (1998)

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