Making Banking Safe

The regulatory reforms that followed the financial crisis of 2007-09 created a financial system that is far more resilient than the one we had 15 years ago. Today, banks and some nonbanks face more rigorous capital and liquidity requirements. Improved collateral rules for market-making activities can dampen shocks. And, some institutions are subject to well-structured resolution regimes.

Yet, the events of March 2023 make clear that the system remains fragile. The progress thus far is simply not enough. What else needs to be done?

In a new essay, we address this critical question. Our assessment of the banking system turmoil of 2023 leads us to several obvious conclusions, some of which clearly escaped both bank managers and their supervisors. Perhaps the simplest and most significant is that banks can survive either risky assets or volatile funding, but not both. Another is that supervisors are willing to treat some banks as systemic in death, but not in life.

We also draw two compelling lessons from the recent supervisory and resolution debacles. First, a financial system which relies heavily on supervisory discretion is unlikely to prove resilient. Second, authorities with emergency powers to bail out intermediaries during a panic will always do so. That is, policymakers are incapable of making credible commitments to impose losses on depositors and others. In our view, the only way to address this commitment problem is to prevent crises….

The Extraordinary Failures Exposed by Silicon Valley Bank's Collapse

The collapse of Silicon Valley Bank (SVB) revealed an extraordinary range of astonishing failures. There was the failure of the bank’s executives to manage the maturity and liquidity risks that are basic to the business of banking: they failed Money and Banking 101. There was the failure of market discipline by investors who either didn’t notice or didn’t care about the fact that the bank was severely undercapitalized for the better part of a year before it collapsed. There was the failure of the supervisors to compel the bank to manage the simplest and most obvious risks. And, there was the failure of the resolution authorities to act in mid-2022 when SVB’s true net worth had sunk far below the minimum threshold for “prompt corrective action.”

Waiting several quarters to act deepened the threat to the financial system, undermining confidence not only in many other banks but also in the competence of the supervisors. The extraordinary rescue actions last week by both the deposit insurer (FDIC) and the lender of last resort (Federal Reserve) are just a sign of the high costs associated with restoring financial stability when confidence plunges.

In this post we discuss each of these four failures, as well as the actions that authorities took to stabilize the financial system following the SVB failure. To anticipate our conclusions, we see an urgent need for officials to do at least five things:

First, to regain credibility, supervisors need to do an immediate review of the unrealized losses on the balance sheets of all 45 banks with assets in excess of $50 billion.
Second, they should perform a speedy and focused stress test on each of these banks to assess the impact on their true net worth of a sizable further increase in interest rates. Any bank with a capital shortfall should be compelled either to issue new equity or shut down. (To ensure the availability of the necessary resources, authorities will need to have a pool of public funds available to recapitalize banks that cannot attract private investors.)
Third, to restore resilience, Congress must reverse the 2018-19 weakening of regulation that allowed medium-size banks to escape rigorous capital and liquidity requirements.
Fourth, the authorities must change accounting rules to ensure that reported capital more accurately reflects each bank’s true financial condition.
Finally, policymakers should assess the impact on the financial system and on the federal debt arising from the now-implicit promise to insure all deposits in a crisis. To limit risk taking, correspondingly greater fees and higher capital and liquidity requirements should accompany any explicit increase in the cap on deposit insurance.

SEC Money Market Fund Reform Proposals Fall Far Short, Again

As the principal regulator of U.S. money market mutual funds (MMMFs), the SEC has a duty to end the market distortions and moral hazard that repeated public rescues create. There have been two MMMF bailouts, so far. The first came at the height of the Great Financial Crisis of 2008, while the second followed in the March 2020 COVID crisis. While the Treasury provided guarantees only once, the Federal Reserve offered emergency liquidity assistance both times.

These repeated government interventions encourage MMMF managers to behave in ways that make future liquidity crises more likely. Moreover, there is no credible way for the Fed to promise not to intervene should a systemic disruption again loom in short-term funding markets. The only realistic means to end the subsidies created by the implicit promise of future bailouts is to force MMMFs to be far more resilient than they are today.

Against this background, the SEC’s December 2021 MMMF reform proposals are seriously disappointing. In this post, we start with basic facts about the scale and mix of MMMFs today. We then describe the SEC’s proposals, before focusing on their key shortcomings. We hope that the public comments that the SEC receives will motivate it, at the very least, to conduct a serious quantitative assessment of introducing capital requirements for the most vulnerable MMMFs, to re-assess the scale of additional liquid assets needed for MMMF resilience in the absence of a Fed backstop, and to propose ways to enhance the effectiveness and utility of MMMF stress tests….

Stablecoin: The Regulation Debate

Last month, the President’s Working Group on Financial Markets (PWG) called for the introduction of a regulatory framework for “payment stablecoins”—private crypto-assets that (unlike the highly volatile Bitcoin) are pegged 1:1 to a national currency and “have the potential to be used as a widespread means of payment.” Most notably, to limit the risk of runs, the Report calls for legislation restricting stablecoin issuance to insured depositories.

In this post, we first document the rapid growth of stablecoin usage. We then highlight the features which make stablecoins subject to run risk that, in the absence of appropriate governmental controls, could destabilize the financial system. Next, we consider the three regulatory approaches that Gorton and Zhang (GZ) propose for making stablecoins resilient: the first, and the one favored by the PWG, is to limit stablecoin issuance to insured depositories; the second is to require 1:1 backing of stablecoins with sovereign securities (in the case of the United States and the U.S. dollar, these would be U.S. Treasury issues); and the third is to require 1:1 backing with central bank reserves. We conclude with a brief discussion of whether central bank digital currencies are an appropriate means to displace stablecoins.

To foreshadow our conclusions, we view the PWG proposal as the preferred alternative. However, absent near-term prospects for legislative action, we hope that the Financial Stability Oversight Council (FSOC) will consider—as GZ suggest—using its powers under the Dodd-Frank Act to designate the issuance of payments stablecoins as an activity that is “likely to become” systemically important. FSOC designation would authorize the Federal Reserve to promote uniform standards without waiting years for legislation that authorizes a new regulatory framework.

Stress tests lack COVID-scale stress

In recent months, the Federal Reserve acted aggressively to support nearly all parts of the U.S. economy. Unprecedented monetary policy actions, both in size and scope, served to maintain market function and the flow of credit. And, while we have misgivings about the Fed’s CARES Act-driven moves to support the nonfinancial sector, we applaud Chair Powell and his colleagues for their quick and decisive actions (see our previous posts here, here and here). This, together with fiscal policy support for individual households and small firms, has kept an awful situation from becoming far worse—at least for now.

But, the Fed’s responsibility extends beyond monetary policy to the regulatory and supervisory arenas: it is obliged to maintain the safety and soundness of the banking system (and, to some extent, of the broader financial system). On this score, and in stark contrast to its actions in 2009, the Board of Governors has come up significantly short. Without full disclosure of the latest stress test results, suspicions will linger about the ability of the largest banks to provide credit to healthy borrowers if the COVID recovery falters. (See our earlier post for details.)

In this post, we examine the results from the Fed’s 2020 assessment of bank capital adequacy published on June 25. Based on the COVID-related sensitivity analysis—for which individual results are unavailable—one-quarter of the 33 banks tested fall below the regulatory minimum in the worst of the three cases. The fact that we can only guess which banks those might be creates suspicion regarding many banks….

An Open Letter to Randal K. Quarles, Federal Reserve Vice Chair for Supervision

Dear Vice Chair Quarles,

Nearly three years ago, we wrote an open letter congratulating you on your nomination as the first Vice Chair for Supervision on the Board of Governors of the Federal Reserve System. In that letter, we highlight the central mission of ensuring the resilience and promoting the dynamism of the U.S. financial system.

Today we write to express our profound disappointment regarding the plans (expressed in your June 19 speech on “The Adaptability of Stress Testing“) to limit the disclosure of this year’s large-bank stress tests. In our view, failure to publish the individual bank results from the special COVID-19 related “sensitivity analysis” weakens the credibility and effectiveness of the Fed’s stress testing regime.

Consequently, we urge you to reverse course and to announce this week the individual bank sensitivity results, along with the aggregates. To put it bluntly, the point of a supervisory stress test is disclosure. Anything short of full transparency leaves potentially destabilizing questions unanswered.

COVID-19 Stress Test

The COVID-19 shock is almost surely leading to a larger economic downturn than the Great Financial Crisis of 2007-09. However valuable, neither stress tests nor financial supervision in general has prepared us for a shock of this magnitude.

These developments leave us profoundly concerned that the global financial system lacks the resilience needed to weather what will clearly be a very violent storm. In our view, the most up-to-date information regarding the impact on the financial system of COVID-19 comes from NYU Stern Volatility Lab’s SRISK. By utilizing timely weekly market equity data, rather than less accurate and substantially delayed book-value information, SRISK enables us to gauge the aggregate shortfall of capital in the financial system during a crisis (defined as a 40 percent drop of the global equity market over the next six months). Analogous to a severe stress test, the idea behind SRISK is that an intermediary contributes to fragility to the extent that it is short of capital at the same time that there is a system-wide shortfall (see, for example, here). Just as a forest is more vulnerable to fire during a drought, so the financial system is more vulnerable to a large shock when there is a large aggregate capital shortfall.

In the remainder of this post, we highlight some recent SRISK developments and compare them to those during the 2007-09 crisis. We view these developments as a clear warning to regulators and supervisors that the COVID-19 shock meaningfully threatens financial stability across major jurisdictions….

The Costs of Inefficient Regulation: The Volcker Rule

By creating a new regime to limit threats to the U.S. financial system—including heightened scrutiny for systemic intermediaries and a new resolution framework—the Dodd-Frank Act (DFA, passed in July 2010) has made the U.S. financial system notably safer. However, DFA also included burdensome regulations that, in our view, reduce efficiency while doing little to improve resilience. The leading example of such a provision is DFA section 619, known as the Volcker Rule. As Duffie noted before regulators began to implement the Rule (see the citation above), it is not “cost effective.”

Ultimately, the need to focus on this overly complex and relatively ineffective regulation distracts both the government authorities and private sector risk managers from tasks that really would make the system safer. Not only that, but cumbersome rules almost surely increase pressure to ease regulation more broadly. This leads policymakers to scale back on things like capital requirements and resolution plans that we truly need to ensure financial system resilience.

In this post, we briefly describe the Volcker Rule, highlighting its complexity, its tenuous links to risk management, and its apparent negative impact on the financial system….

Libra's dramatic call to regulatory action

Facebook’s June 18 announcement that it has created a Geneva-based entity with plans to issue a currency called Libra is sending shock waves through the financial world. The stated objectives of creating Libra are to improve the efficiency of payments and to ease financial access. While these are laudable goals, it is essential that we achieve them without facilitating criminal exploitation of the payments system or reducing the ability of authorities to monitor and mitigate systemic risk. In addition, any broad-based financial innovation should ease the stabilization of consumption.

On all of these criteria, we see Libra as doing more harm than good. And, for the countries whose currencies are excluded from the Libra portfolio, it will diminish seignorage, while enabling capital outflows and, in periods of stress, accelerating capital flight.

Like Bank of England Governor Carney, we have an open mind, and believe that increased competition, coupled with the introduction of new technologies, will eventually lower stubbornly high transactions costs, improving the quality of financial services globally. But in this case, we urge a closed door….

Bank Capital and Stress Tests: The Foundation of a Thriving Economy

We submitted this statement to the Subcommittee on Financial Institutions and Consumer Credit of the Committee on Financial Services of the U.S. House of Representatives for its hearing on July 17, 2018.

We appreciate the opportunity to submit the following statement on the occasion of the hearing entitled “Examining Capital Regimes for Financial Institutions.” We welcome the Subcommittee’s further examination of the existing regulatory approach for prudentially regulated financial institutions.

We are academic experts in financial regulation with extensive knowledge of the financial industry. Our experience includes working with private sector financial institutions, government agencies and international organizations. In our view, a strong and resilient financial system is an essential foundation of a thriving economy. The welfare of every modern society depends on it. The bedrock of this foundation is that banks’ capital buffers are sufficient to withstand significant stress without recourse to public funds. Furthermore, it is our considered view that the benefits of raising U.S. capital requirements from their current modest levels clearly outweigh the costs.

To explain this conclusion, we start with a definition of bank capital, including a discussion of its importance as a mechanism for self-insurance. We then turn to capital regulation and a discussion of stress testing….

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Money, Banking, and Financial Markets