Will banking change after the collapse of Silicon Valley Bank?

The collapse of Silicon Valley Bank (SVB) last month has led to major debates among economists who wonder what caused the bankruptcy, and how strong and stable is today’s banking system? But beyond these immediate questions, the issue that may have the most lasting impact on our economy is how it relates to financial risk and how regulations are made and enforced.

Having served on several bank asset/liability committees, I know how the sausage is made, and that the process can be ugly. The creators and administrators of bank regulations played a major role in the current financial problems, and fault must be placed.

The current situation is nothing new. Mistakes made by SVB and other financial institutions resemble the dumb moves taken by banks that led to the savings and loan (S&L) crisis in the early 1990s and the financial crisis of the late 2000s.

Those crises were created when financial institutions loaded up on longer-term fixed-rate assets, concentrated in one sector, and/or interest rates rose sharply, and the potential effects of those decisions were not recognized.

In the S&L crisis, balance sheets were top-heavy with fixed-rate loans (mortgages) as deposit rates soared. In the 2008 financial crisis, institutions bet that skyrocketing home prices would not come down, so they again became top-heavy with housing loans or assets. In both cases, regulators either acquiesced to those decisions, or failed to curtail the bank management’s decisions.

In the current crisis, financial institutions loaded up with fixed-rate assets and deposits from one sector, while interest rates soared. They hit the lottery of bad decisions.

So, who was at fault for SVB’s collapse? Was it the financial institutions for taking identifiable risks, the regulators for not being on top of those risks, or those who created regulations that were either not strong enough or didn’t provide the power to enforce the regulations?

The answer, as any good economist would tell you, is all the above.

Bank management is the most at fault. As SVB’s loan demand slowed, bank managers bought longer-term government securities to earn more revenue. When deposit rates rose, SVB wound up with a balance sheet similar to an old-fashioned S&L — heavy on income-generating, fixed-rate assets and cost-creating, variable-rate deposits. While there is no default risk in Treasury securities, there is price risk. When rates rose, the value of their assets fell, their expenses rose, and SVB went the way of many S&Ls.

Next comes the regulators. Regardless of whether they allowed balance sheets to get out of whack or did not have the power to change them, the net result was a largely preventable crisis.

But we cannot be too hard on the regulators. The Silicon Valley Bank collapse highlighted a new regulatory issue in which the concept of concentration changed.

SVB concentrated its loans in start-up firms, which didn’t trigger any of the usual red flags among regulators because the firms covered a variety of industries. But the borrowing companies were funded by small numbers of venture capitalists (VCs). If you lend to a group of companies largely funded by a limited number of VCs, the investors become the concentration, because they control the money.

Once there were rumors that SVB could be having troubles, the bank was doomed. A relatively small number of VCs alerted their start-up founders to move their money and given the ease of electronically transferring funds, it took no time for a run on the bank to occur and bankruptcy to follow.

It doesn’t appear regulators thought of that possibility.

When placing blame for the current banking crisis, we must also consider the regulations themselves — not just the words in the regulations but the enforcement powers and environment in which regulators must operate.

Following the SVB collapse, Congress is being criticized by some economists for passing the 2018 “Regulatory Relief and Consumer Protection Act,” and correctly so. The legislation made it easier for banks that have between $50 billion and $250 billion to take risks. Though SVB had grown to $200 billion, it was no longer required to submit to a government-mandated “stress test” that would have picked up its balance sheet foolishness. There were also reductions in liquidity and capital requirements that might have helped it survive the crisis.

In 2018, Congress and President Donald Trump made it clear that deregulation was needed to increase economic growth. The bill’s supporters argued this would not create greater risk for the economy.

Obviously, that was a major miscalculation.

Of course, we cannot forget about the business community, which views regulations as the beasts that block their ability to operate profitably.

Nevertheless, there are many reasons to regulate economic activity. Governments create regulations to protect health and safety and insure the workings of the economy.

To accomplish that, regulations must be designed to protect against future crises, not just address current concerns. Changing conditions requires regulations to be structured and interpreted broadly so they can adapt to emerging circumstances.

If regulators had recognized the concentration issues and required SVB to limit its lending to the VC community and unwind the badly matched balance sheet, it might have prevented the crisis from occurring. But the business community and members of Congress would have screamed, ranted, and raved that there was over-regulation and it was killing the venture capital sector.

That illustrates the most important conundrum facing regulation and regulators: You cannot prove a negative. It would have been impossible for the regulators to show that the crisis that didn’t happen would have happened if they didn’t take the actions they took.

It is also impossible to know, in advance, what is the correct level of regulation. What we do know is when there is too little regulation, crises occur and we pay a massive price for failing to regulate aggressively. Given we didn’t learn that lesson from the two previous crises, I doubt we will learn it from this one.

Joel L. Naroff is the president and founder of Naroff Economics consulting firm in Margate. naroff@inquirer.com