Bankers suffer from 'disaster myopia'; regulators shouldn't ignore it

K.- P. Adler - stock.adobe.com

My Wharton mentor, Jack Guttentag, "The Mortgage Professor," recently explained how our latest banking crisis is yet another example of "disaster myopia," referring to his 1986 argument that banking crises are recurring events.

This is because bankers are "myopic," insofar as they disregard the growing probability of adverse outcomes as time goes by without a crisis. Meanwhile, the financial system becomes increasingly vulnerable to major shocks.

The longer "good times" continue, the more prevalent the short-sighted view they will continue even further becomes, so there is less need for preventative measures. Disaster myopia helps explain the previous international banking, savings and loan and 2007-2008 financial crises, as well as the recent one starting with the failure of Silicon Valley Bank.

For example, SVB's CEO testified that he thought the Fed's low interest rate policy would continue, since the Fed's chair said inflation was only "transitory." We had low rates for over 20 years, so why shouldn't they continue?

Banking myopia, however, also exists with our bank regulators and their congressional overseers, who always seem to be behind the curve when it comes to their response to banking crises and preventing future ones.

Professor Guttentag reminded me of the asset/liability mismatch similarities of the recent banking crisis with the S&L crisis. Although the Volcker anti-inflation interest rate shock was from 1978-1981, the industry's supervisor, the Federal Home Loan Bank Board, did not begin to seriously address Interest Rate Risk (IRR) problems at thrifts until 1984. As a result of that crisis, the strong S&Ls became banks and the weak ones, like their regulator, became history.

Banking history once again repeated itself with the maturity mismatch now involving investments rather than loans. Myopic regulators were not only caught off guard with this latest maturity mismatch crisis caused by rapidly rising rates but made matters worse by allowing banks to sweep their colossal IRR problems under their held-to-maturity rug.

While Congress demanded clawbacks in response to the recent banking crisis, regulators predictably demanded more capital. Both of these nearsighted public policy efforts fail to address the real causes of the recent banking crisis.

Any independent autopsy of Silicon Valley Bank will conclude its failure resulted not only from negligent bank management but also negligent federal and state supervisors, both of whom ignored record IRR. So why not claw back from them? 

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SVB's IRR supervisory failures go beyond the California Department of Financial Protection and Innovation and the Federal Reserve Bank of San Francisco and lead directly to the Fed's board of governors itself. This is because they gave SVB's IRR management a clean bill of health in June 2021 with the approval of SVB's acquisition of Boston Private Bank. Their approval concluded that "existing risk-management policies, procedures, and controls are considered acceptable from a supervisory perspective." 

SVB's directors, only one with a financial background, may have taken the Fed's IRR stamp of approval to justify allowing management to continue with what turned out to be banking's greatest IRR disaster. SVB's federal and state examiners, who were certainly familiar with Washington's approval of this major deal, may have likewise assumed SVB's IRR management was in good hands.

The Fed's postmortem of SVB conveniently omitted this key IRR management finding from the Boston Private approval, another reason why we need a truly independent analysis of the nation's second largest bank failure.

At the very minimum, those supervisors who failed to require proper IRR management at SVB, Signature and First Republic Bank should be demoted and retrained, as would be the case at any private sector or responsible public sector organization.

Bank supervisors have the authority to require proper IRR management with actual or potential underwater investment portfolios. They must first, however, understand how effective hedging works, which does not appear to be the case based on our recent crisis.

IRR management is not rocket science, but a prerequisite for every safety and soundness examiner. Examiners were in First Republic, Signature and SVB for the last two years when IRR was rising out of control. None of them, however, were willing or able to require those banks to do what JPMorgan Chase's Jamie Dimon recently did in two days after buying First Republic: "The interest rate risk they bore that took them down, we hedged within two days. So, we've got it simple." 

Just as in previous banking crises, our myopic CAMELS regulators emphasizing Capital have it backward, when they should be focusing on sensitivity to risk and liquidity, the real reasons for the recent big bank failures. If we reversed this acronym and had "SLEMAC" supervisors focusing on IRR management and liquidity, SVB would still be around. At least one regulator, a former banker, got the SLEMAC memo, and hopefully more will follow.

Even those too-little-to-late regulators finally taking liquidity seriously have tunnel vision as they continue to penalize wholesale vs. traditional retail deposits. For example, an analysis of First Republic Bank concluded that brokered and similar deposits were more than eight times stickier than traditionally favored retail deposits. 

Good public policy should focus on all the causes of a banking crisis rather than just those with headline appeal like clawbacks and capital. While we may never be able to correct banking myopia within the industry, a good start would be to reduce it at our prudential regulators and their congressional overseers.