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.

Climate Finance

Climate change is the topic of the day. The World Meteorological Organization tells us that the 2011-20 decade was the warmest on record. Earlier this year, the U.S. government re-joined the Paris Accord, and is proposing a range of new programs to mitigate the long-run impact of climate change. Now that a warming planet has made the Arctic increasingly navigable, national security specialists are concerned about geopolitical risks there. Thousands of economists have endorsed a carbon tax. Even central banks have joined together to form the Network for the Greening of the Financial System—a forum to discuss how to take account of climate change in assessing financial stability.

Against that background, last month, NYU Stern’s Volatility and Risk Institute (VRI) held a conference on finance and climate change. Speakers addressed issues ranging from the modeling and measurement of climate risk in finance to assessing its impact on the resilience of the financial system. In this post, we primarily focus on one of the central challenges facing policymakers and practitioners: what is the appropriate discount rate for evaluating the relative costs and benefits of investments in climate change mitigation that will not pay off for decades? We also comment briefly on several other issues in the rapidly growing field of climate finance research.

Past responses to the discount-rate question vary widely. Some observers call for a discount rate matching the high expected return on long-lived, risky assets—a number as high as 7%. This would imply a very low present value of benefits from investments to mitigate climate change, consistent with only modest current expenditures. Others postulate that climate change could lead to the extinction of humanity. For plausible discount rates, the specter of a nearly infinite loss means that virtually any level of mitigation investment is warranted (see, for example, Holt).

Recent climate finance research that we summarize here comes to the conclusion that over any reasonable horizon, the appropriate discount rate for computing the net present value of investments in climate change mitigation should be relatively low….

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….

Replacing LIBOR

Publication of LIBOR―the London Interbank Offered Rate―will likely cease at the end of 2021. This is the message U.K. Financial Conduct Authority (FCA) CEO Andrew Bailey sent in 2017 when he announced that, after 2021, the FCA would no longer compel reluctant banks to respond to the LIBOR survey. Given the small number of underlying LIBOR transactions, and the reputational and legal risks banks face when submitting survey responses based largely on their expert judgement, we expect that most banks will then happily retreat. In just over two years, then, the FCA could declare LIBOR rates “unrepresentative” of financial reality and it will vanish (see, for example, here).

Most financial experts know this. Yet, LIBOR remains by far the most important global benchmark interest rate, forming the basis for an estimated $400 trillion of contracts (as of mid-2018; see Schrimpf and Sushko), about one-half of which are denominated in U.S. dollars (as of end-2016; see Table 1 here). While the use of alternative reference rates is increasing rapidly, to beat the LIBOR-countdown clock, the pace will have to quicken substantially. In the United States, the outstanding notional value of derivatives linked to the alternative secured overnight reference rate (SOFR) jumped from less than $100 billion to more than $9 trillion in just the past year (see SIFMA primer). Yet, this amount still represents a small fraction of outstanding dollar-LIBOR-linked instruments.

In this post, we examine the U.S. dollar LIBOR transition process, highlighting both the substantial progress and the major obstacles that still lie ahead. The key goal of the transition is to ensure that the inevitable cessation of LIBOR does not trigger system-wide disruptions. Unfortunately, at this stage, count us among those that remain deeply concerned….

GDP at Risk

For several decades, central bankers have been the key risk managers for the economy and the financial system. However, they failed spectacularly to anticipate and prevent the financial crisis of 2007-2009. The financial regulatory reforms since the crisis—capital and liquidity requirements, resolution regimes, restructuring of derivatives markets, and an evolving approach to systemic risk assessment and (macroprudential) regulation—have all been directed at improving the resilience of the system to help sustain strong and stable economic growth. As a result, the likelihood of another crisis-induced plunge in GDP is much lower today than it was a decade ago.

But we still have plenty of work to do. We are at an early stage in the process of building a financial stability policy framework that corresponds to the inflation-targeting framework which forms the basis for monetary policy. Such a framework requires measurable financial stability objectives that are akin to a price index, tools comparable to an interest rate, and dynamic models that help us to understand the link between the two.

In this post, we describe a step forward in developing such a framework: the concept and measurement of GDP at risk....

The Fed's Approach to Risk Management

“[W]e may well at present be seeing the first stirrings of an increase in the inflation rate--something that we would like to happen.” Stanley Fischer, Vice Chair of the Federal Reserve Board

The primary task of the central bank is to avert catastrophe, making sure that nothing really bad happens. This risk management approach imparts a natural asymmetry to policymakers’ words and deeds. Sometimes, it calls for bold, aggressive action. Others times, it means cautious plodding. Everyone agrees that 2008 was a clear case of the former. Most Federal Reserve officials argue that the current circumstance exemplifies the latter...

The Scandal is What's Legal

If you haven’t seen The Big Short, you should. The acting is superb and the story enlightening: a few brilliant outcasts each discover just how big the holes are that eventually bury the U.S. financial system in the crisis of 2007-2009. If you’re like most people we know, you’ll walk away delighted by the movie and disturbed by the reality it captures. [Full disclosure: one of us joined a panel organized by the film’s economic consultant to view and discuss it with the director.]

But we're not film critics, The movie—along with some misleading criticism—prompts us to clarify what we view as the prime causes of the financial crisis. The financial corruption depicted in the movie is deeply troubling (we've written about fraud and conflicts of interest in finance here and here). But what made the U.S. financial system so fragile a decade ago, and what made the crisis so deep, were practices that were completely legal. The scandal is that we still haven't addressed these properly....

Is International Diversification Dead?

At least since Harry Markowitz’s work in the 1950s, diversification has been viewed as the key to an efficient portfolio that minimizes risk for a given expected rate of return. When James Tobin received his Nobel Prize in 1981 – in part for his work on the subject – he summarized portfolio selection theory in the classic fashion: “don’t put all your eggs in one basket.”

Over the years, academicians and market professionals extended this fundamental principle to the global asset universe, highlighting the benefits of going beyond simply holding a broad group of domestic instruments to the idea of international diversification. In the case of equity portfolios, they also observed that people typically hold a smaller share of foreign stocks than simple portfolio selection models prescribe. This gap between actual and model-based optimal allocations of equity portfolios has become known in finance as the equity home bias puzzle.

Bank of America: The challenge of unified accounting

If we asked you the value of your assets, how close would you get? Okay, we’ll give you a few hours to figure it out, but you need to include the value of the house and car(s). Do you think you could estimate the value to within 0.2%?

Commentary

Money, Banking, and Financial Markets