Bank failures were supposed to be a thing of the past after 2008. And yet the second- and third-largest bank failures in U.S. history happened in March and came as a surprise to most, including regulators and rattled depositors.
The withdrawal of $42 billion in deposits at Silicon Valley Bank in one day had regulators scratching their heads as to what happened and, more importantly, why our current bank safety nets were insufficient to overcome the factors driving depositor and investor behavior. It turns out that with changes to deposit insurance and enhanced supervision this latest turmoil could have been avoided.
Ever since its creation, Federal Deposit Insurance Corp.'s deposit insurance has stood as a deterrence to the bank panics of the Great Depression. Then the 2008 financial crisis came along, upending the commonly held belief that deposit insurance would prevent bank runs during a crisis. At that point, coverage levels had more than doubled to $250,000 per account.
But the FDIC faces competing risks. First, there is the risk that deposit insurance by its nature promotes moral hazard and hence risky behavior by banks. Second, there is also the risk of bank runs in the absence of such insurance. Striking the right balance between insurance coverage levels, risk-based deposit insurance pricing and enhanced supervision of large banks is the antidote for future banking crises.
Fundamentally, the most important factor in the collapses of SVB and Signature Bank was raising the asset threshold for enhanced supervision from $50 billion to $250 billion. Enhanced supervision would have at least placed greater regulatory scrutiny on these banks and required adherence to additional interest rate risk, liquidity, capital and other regulatory requirements. SVB was an example of where poor liquidity and interest rate risk combined with poor risk governance led to its demise.
But that's only part of the story. Lurking beneath the current regulatory and deposit insurance frameworks are a set of sorely needed changes.
The first action regulators must take is to lower the threshold for enhanced supervision to $50 billion in assets. Doing this will bring another 25 or so banks onboard for heightened regulatory scrutiny and significantly reduce moral hazard. Banks between $50 billion to $250 billion in assets are certainly not in the same class of complexity as systemically important financial institutions with assets above $250 billion.
But we saw in this latest mini crisis that dangers to the financial system exist even for banks below that threshold. Currently, the largest banks are subject to twin liquidity requirements: the liquidity coverage ratio (LCR) and the net stable funding ratio (NSFR). These metrics are meant to ensure large banks have sufficient high-quality liquid assets and stable funding sources to offset unforeseen cash outflows.
However, those metrics in their current form would not have prevented SVB from experiencing a liquidity event. So, another change that needs to happen is to modify the factors used in the LCR to assess low-risk assets such as mortgage-backed securities and Treasuries (assets that SVB was quite fond of) and the factors assessed in the NSFR against less stable deposits (another favorite of SVB).
This would help ensure banks are protected against the combined whammy of loading up on otherwise high-quality assets that pose significant interest rate risk and a lack of diversification in deposits. Beyond that, enhanced supervision should apply Basel rules for managing interest rate risk in the banking book (IRRBB) for these less complex but still large institutions.
Finally, major changes need to take place in deposit insurance. Raising deposit insurance limits would only promote moral hazard. The FDIC could change how it assesses deposit insurance premiums. This should include aligning deposit insurance premium assessment asset categories to enhanced supervisory asset categories, adding more asset categories to differentiate bank risk, and abandoning the use of the archaic CAMELS supervisory ratings and brokered deposit criteria in the assessment process.
Instead, risk-based capital requirements, LCR and NSFR ratios should be featured in risk-based deposit insurance pricing along with a new quality of risk management rating for every bank. CAMELS ratings are limited in surfacing the main factor for any bank failure, namely a lack of effective risk management.
Each time a threat to the banking system occurs, it prompts a post-mortem. In the case of recent bank failures, the problem stems from a lack of enhanced supervision of large regional banks, gaps in current liquidity and interest rate risk regulation, a lack of focus on the quality of risk management and misalignment of risk-based deposit insurance premium assessment with a bank's risk profile. Until those changes are made, we'll continue to see episodic issues in the banking system.
