Is It a Wonderful Life? Why We Need Rigorous Financial Regulation
Silicon Valley Bank (SVB), Signature Bank, and now the systemically important Credit Suisse have all failed within less than two weeks in March 2023. Two points are particularly important to mention at the outset: First, while Credit Suisse faced problems that were vastly different from the problems at SVB and Signature Bank, each bank’s failure was due to horrific mismanagement. Second, the world of finance moves at breakneck speed, and regulators’ responses had to match this speed. All three banks unraveled within a matter of days. Within 48 to 72 hours, regulators officially announced their responses to the failures, which all involved sweeping guarantees for one party or another in an effort to calm markets. How did this happen, and what should we learn from this about what kind of financial regulation of banks is morally justified?
It all began with an old-fashioned, Jimmy Stewart-type depositor bank run on SVB. Even though interest rates had been on the rise for a year, SVB held on to a heavily devalued portfolio of long-term treasuries (devalued, because with rising interest rates, currently issued treasuries offer much higher interest payouts). When the firm clumsily signaled trouble by issuing new shares, its largely uninsured tech company depositor base (around 97% of the deposits were above the federally insured amount of $250,000) withdrew its funds in a rush. SVB suffered large outflows on the deposit side, which it could not stem by selling its stake in heavily devalued long-term treasuries. Within 48 hours, the bank became insolvent and US authorities took over. When it turned out that Signature Bank in New York faced similar issues, depositors once again tried to save their funds and ran on this bank, too. Unsurprisingly, two days after SVB was taken over by the authorities, so was Signature Bank.
But the “contagion” did not stop spreading. Markets began to signal that their global distrust in the stability of banks by dumping shares. For Credit Suisse, one of thirty “global systemically important banks, this was the last drop in the bucket. Years of risky investments with heavy losses (most importantly, its investment in Archegos Capital Management, which led to a loss that wiped out a year’s profits for the bank), as well as millions in penalties for money laundering ruined the bank’s financial standing and reputation. The turmoil that started in the US triggered depositors to run on Credit Suisse, too. Swiss authorities stepped in and facilitated a takeover of the bank by its main Swiss rival, UBS. The punchline: Even though banks should be doing fabulous when interest rates are rising (because their core business, providing loans, becomes much more profitable), some large banks failed to adapt their balance sheet appropriately. Bottom line, this was their only job. And yet, they failed at it.
It was hardly surprising that both US and Swiss regulators were extremely keen on sending out one particular message in response to the failures: No bailouts. The Financial Crisis of 2008 is not going to be repeated. Quite apparently, no one has a good grasp on what a bailout actually is, which is why we continue to see sharp disagreements over whether bailouts have taken place or not.
Instead of arguing semantics, it is much more useful to focus on the big picture. While there are very apparent differences in how authorities handled the 2008 crisis and the recent bank failures, both reactions have one thing in common: regulators threw out their own rulebook at the last moment. First, in the case of SVB and y Signature Bank, US regulators wiped out sthareholders and uninsured creditors, but guaranteed all deposits at the failing bank. This is a deviation from the rulebook because deposit insurance is not designed to mitigate losses of depositors. Instead, deposit insurance is capped at a low level to ensure that depositors choose their banks carefully (see the work oftlast year’s Nobel Prize winners in economics, Diamond and Dybvig). Second, both in the US and Switzerland, regulators decided to provide effectively unlimited liquidity assistance. More precisely, US regulators announced the “Bank Term Funding Program”, which allows banks to borrow against long-term treasury bonds – not at their current low market price, but their original purchasing price. Swiss authorities instead provided UBS with access to emergency liquidity funding to the tune of roughly $108 billion, as well as loss guarantees of 9 billion Swiss francs, in case UBS turned out to suffer significant unexpected losses from buying Credit Suisse, effectively a black box of assets byand liabilities. Shareholders of the banks were not consulted, emergency plans submitted by Credit Suisse (so-called “living wills”) were abandoned (and inadequate to begin with).
[...] no one has a good grasp on what a bailout actually is, which is why we continue to see sharp disagreements over whether bailouts have taken place or not.
In short, the big picture tells us that when a sufficiently large bank fails, regulators tend to adopt ad hoc measures (SVB, Signature Bank, Credit Suisse and the crisis of 2008 are by far not the only examples). Ad hoc measures come at the cost of distorting incentives in the financial sector that are supposed to be aligned with the public interest. This leads to the well-known phenomenon of moral hazard: If banks can expect the state to help them out of any trouble, they will take far more risks. In a worst-case scenario, these risks can spark a full-blown financial crisis. In a best-case scenario (as we are arguably experiencing right now), we end up with mergers which swallow risky banks only to create even bigger and systemically more important banks (see UBS). Neither outcome is in the public interest.
Should we then rather permit banks to simply fail and leave it to the market to absorb them? This is also not an option. Even individual bank failures can spark fears that other banks are in similar trouble – irrespective of whether they really are. These fears can spread losses throughout the financial system, as illustrated by the cases of Signature Bank and Credit Suisse. Without any regulatory safeguards and emergency measures, financial crises only become more likely. Believing in a self-regulating financial system that carries no risk of a severe financial crisis is as well-grounded as believing in elves and unicorns.
The only available avenue left is effective and rigorous ex ante regulation – instead of ad hoc measures applied ex post or no measures applied at all. There are plenty of issues with current banking regulations, allow me to name a few: First, post-2008 banking regulations focused almost exclusively on systemically important banks. The risk that a coalition of small banks might default simultaneously and trigger a financial crisis has been largely ignored (SVB demonstrated that the failure of a comparatively small bank can still spread fear). Second, regulations regarding capital are too complex and therefore too easily side-stepped by the industry. Instead of a simple ratio determining how much a bank can rely on debt instead of capital, we have an overly complicated system of “risk weights,” i.e., discounts on the capital required to hold any particular asset. This is entirely unnecessary and incentivizes innovation to get around holding sufficient capital. Third, given the liquidity issues that banks have recently had with depositor runs, perhaps it is all in all better to move to central bank digital currencies. Doing so would permit retail and business customers to open their deposits directly with the central bank, cutting out the middleman – i.e., commercial banks. (Therefore, no more runs by small depositors). Fourth, a natural solution to “Too Big To Fail” is to limit banks’ capacity to grow beyond a certain amount of total assets. This suggestion has largely disappeared from policy debates. What we got instead (and continue to get, apparently) were ad hoc measures that consolidated the banking sector, creating de facto oligopolies, eliminating competition in banking, and forcing the state to subsidize an overblown industry.
[...] private banks can be understood to form part of a social contract. We permit them to exist because they perform an important service in our economy. But just as any other social institution, they need not only perform a function; they also need to perform it well – otherwise, there is no reason to promote private banking any further.
On the surface, banking regulation appears to be a set of fairly technical problems. But there are deeply normative issues at stake here. As any other institution, private banks can be understood to form part of a social contract. We permit them to exist because they perform an important service in our economy. But just as any other social institution, they need not only perform a function; they also need to perform it well – otherwise, there is no reason to promote private banking any further. One way to measure whether an institution performs its function well in the context of a social contract is “justifiability to each.” This is the central idea in Scanlon’s version of so-called “contractualism”. Private banking does not only need to fulfill a function in the economy – it must be justifiable to you and everyone else. Ultimately, private banking must make you better off (or at least, not worse off). If it fails to do so, we have good reason to reshape private banking via regulation.
Private banking does not only need to fulfill a function in the economy – it must be justifiable to you and everyone else.
Therefore, let us zoom in on your situation now. Why should you care about rigorous financial regulation? On the one hand, rigorous regulation is your best shot at avoiding financial crises. As you probably guessed, despite the assurances of regulators, financial crises always carry the risk of burdening taxpayers. If a crisis grows to sufficient proportions, emergency funding will in a last instance always be provided by the state treasury. Your taxes partly fund the state treasury. Even perfect regulation can only diminish the risk that you will fund a bailout, it cannot eliminate it. But it can reduce the probability that you will have to pay for the risks that the financial sector takes on your behalf by exposing you to the risk of a financial crisis in the first place.
[...] private banking must make you better off (or at least, not worse off). If it fails to do so, we have good reason to reshape private banking via regulation.
More importantly, you might also want to avoid a financial crisis not only qua taxpayer, but also simply as a person. You don’t want to see your life savings eroded, the wealth you have built up devalued to zero, your employment evaporate, and the people you care about go through severe financial hardship. But financial crises can affect much more than your “economic” interests. Various studies suggest that the emergence of a financial crisis is associated with excess cancer-related deaths, higher suicide rates etc. In short: Financial crises kill. Strict regulation of the financial sector is your best chance at avoiding falling victim to the consequences of a financial crisis.
The financial sector imposes severe risks on all of us. Most of us get nothing in return. It would be foolish for us to support laxer regulation in the hope of the riches we might receive.
On the other hand, as proponents of free markets often suggest, rigorous regulation of the financial sector carries a severe risk of slowing economic growth, because it hinders the financial sector from growing. While this claim is highly disputable (some experts at the Bank for International Settlements suggest that financial sector growth crowds out growth in the real economy; a McKinsey report even suggests that half of the banks in their survey are net destroyers of economic value), let us take it at face value for now. According to Statista, the global financial industry has roughly quadrupled (in term of total assets) over the last 20 years. Even if this massive expansion was indeed a cause for massive economic growth, let me ask you this: Have you personally profited from this growth? Has your yearly income significantly increased in real terms over the last 20 years? Can you afford to buy a house or an apartment at the moment? Do you have to work more than one full-time job to support your loved ones? Are you expecting to have a stable source of income after retirement? My point is this: Most people won’t like at least some of the answers they have to give to these questions. We gave the financial sector a respectable shot at making us all rich by growing excessively; for most of us, it did nothing (at best). I doubt that you personally will lose much from stricter financial regulation.
The take-away lesson is this: The financial sector imposes severe risks on all of us. Most of us get nothing in return. It would be foolish for us to support laxer regulation in the hope of the riches we might receive.
Richard Endörfer is an Associate Researcher at the Financial Ethics Research Group at the University of Gothenburg. He received his doctoral degree from the University of Gothenburg for his thesis on ethical issues related to financial crises. His areas of specialization are financial ethics, risk ethics, and philosophy of economics.