NRPLUS MEMBER ARTICLE I nterest-rate policy makes the headlines, and the very words of Fed chairman Jerome Powell make markets quake. But the Fed is also one of the institutions charged with regulating the American financial system, and that task occupies most of its day-to-day work.
The failure of Silicon Valley Bank should have been foreseen. SVB’s undiversified depositor base and undiversified asset holdings made it susceptible to a bank run. It was not doing anything underhanded or confusing. It bet that the Fed would keep interest rates low and failed to manage its risk appropriately. When interest rates rose and its long-term bonds declined in market value, it didn’t have the money to pay back depositors if they all withdrew at once.
Progressives want to say that the financial sector isn’t regulated enough, but the financial sector is among the most regulated industries in the country, and regulators already had the tools sufficient to spot the problems with SVB. They failed to do so because they failed to learn the right lessons from banking history.
What the Federal Reserve Banks Do
Similar to the federal courts, the Federal Reserve System is split into districts. Each one has its own regional Federal Reserve Bank, with its own president and staff. Those banks conduct economic research and regulate the financial institutions within their regions.
David Andolfatto is the chairman of the economics department at the University of Miami. He previously worked at the St. Louis Fed from 2009 to 2022, where he was a senior vice president and a close adviser to bank president James Bullard. “Every Fed has their own research divisions,” Andolfatto told National Review, and they work on all sorts of issues, including housing policy and regional economic analysis. He said they will also ask, “How does balance-sheet policy or interest-rate policy ultimately translate to the broader economy?”
That sort of research should have shed light on the effects of interest-rate increases on bank stability. It’s a fact of life that rising interest rates cause the decline in market value of long-term bonds, so banks holding long-term bonds will see a decline in the market value of their assets.
“About a month ago, everyone was worried about the effect of these rate hikes on the Fed’s balance sheet,” Andolfatto said. The Fed is taking heavy accounting losses because its liabilities rise when interest rates rise. Andolfatto explained that concern over the Fed’s losses were not important. The Fed is not a normal bank because it has the power to create money, and it is not required or expected to make a profit, he said.
For normal banks’ balance sheets, though, rising interest rates can cause problems. The Fed has talked a lot about the effects of rising interest rates on the labor market, and not as much about their effects on banking stability. Yet despite the first series of significant rate hikes in years, unemployment remains below 4 percent — and now banking stability is being called into question.
Andolfatto said that it shouldn’t be surprising that the Fed focused on unemployment, given that its mandate from Congress is to promote stable prices and low unemployment. “If the presumption is that the financial sector is ring-fenced appropriately, you can understand why the Fed would want to focus on its dual mandate,” he said.
The Fed is partly responsible for that regulation, but Andolfatto pointed out that the U.S. is somewhat unusual in that it has financial regulatory functions spread throughout the government. The Office of the Comptroller of the Currency, the FDIC, the Treasury, and authorities in every state government all have roles in regulating banks as well. “It’s hard to say that just the Fed dropped the ball when you have the whole kit and caboodle of the United States regulatory system,” he said.
Fighting the Last War
That doesn’t mean the Fed didn’t drop the ball, though. Its stress-testing for the past few years did not include a situation in which interest rates increased as much as they have. Will Diamond, a professor of finance at the University of Pennsylvania, told NR that policy-makers seem to have been fighting the last war. “The main thing that blew up in 2008 was people not paying their mortgages, but this time it was something totally different,” he said.
The regulations created after 2008 were designed to prevent another 2008. They focused almost entirely on credit risk, with very little attention on interest-rate risk. The stress-test scenarios are no exception. “They pick these scenarios to look like the 2008 scenario, since that’s what everyone remembers,” Diamond said. “When the world forgets about ways to blow up, regulators don’t test for it.”
This truly was a matter of forgetting history. You only need to look at the last time the Fed raised interest rates to quell inflation.
The swift increase in interest rates in the early ’80s triggered a debt crisis in Latin America that came back to destabilize U.S. banks that were exposed to those markets, most notably Continental Illinois, the seventh-largest bank in the country at that time. Within the U.S., the savings-and-loan industry went into a death spiral. Federal regulations capped the interest rates S&Ls could pay depositors, so when the Fed increased interest rates, depositors pulled their money out of S&Ls in search of the higher returns. At the same time, loans that S&Ls had made when rates were low ceased to be profitable, and the entire industry went under.
The financial story of the ’80s is not exactly the same as today’s, but the lesson of paying attention to interest-rate risk in the financial system seems not to have been learned. The Fed employs thousands of economists, and they are some of the brightest minds in the world. Interest-rate risk should have been on its radar.
The Fed’s radar has been full of other issues as of late. For example, Diamond said that the New York Fed, under current president John Williams, who was previously president of the San Francisco Fed, split its research department into three divisions: bank, nonbank, and climate. “Over the next 100 years, is climate a problem? Yes, absolutely,” Diamond said. “But you have a finite amount of talent in an organization, and I definitely think there’s been a reallocation of talent away from the core issues.”
Cluttered Regulations Obscured the Simple Issues
Andolfatto emphasized that this was not a repeat of 2008. “The 2008–09 financial crisis was in the wholesale-banking sector, not commercial regional banks,” he said. “This crisis was a conventional, retail-level bank run.”
Dodd-Frank was passed in response to the 2008 crisis and has little, if any, bearing on this one. As Norbert Michel and Nicholas Anthony wrote in a blog post for the Cato Institute, Dodd-Frank was barely touched by Congress in 2018, contrary to claims from Elizabeth Warren and other progressives that it had been gutted. In 2018, Michel and Anthony continue, Congress only “amended how the Fed can regulate the companies that own commercial banks, not how it can regulate the commercial banks themselves.” The bill also gave the Fed discretion to regulate as it saw fit, and it did so, imposing new rules on categories of firms that would have included SVB’s holding company.
Looking back through past annual reports from SVB’s holding company, Michel and Anthony found that it comfortably exceeded the regulatory minimums from the Fed and from the law, as did SVB itself. To the extent that regulation failed, it wasn’t because it wasn’t strict enough. It was because it wasn’t looking for the right things.
What happened, as Andolfatto mentioned, and as economist John Cochrane wrote in his blog, was not complicated at all. “It strikes me that both accounting and regulation have become so complicated that they blind intelligent people to obvious elephants in the room,” Cochrane wrote.
There was another sign of trouble that should have been obvious to regulators: SVB’s rapid growth. Healthy banks grow slowly, and as former Fed governor Daniel Tarullo told the Wall Street Journal, “Rapid growth should always be at least a yellow flag for supervisors.”
Thomas Hoenig, president of the Kansas City Fed from 1991 to 2011 and vice chairman of the FDIC from 2012 to 2018, wrote:
The bank grew by over 60% per year for three years. Such growth should have been examined and dealt with early on in the bank’s expansion. If this had been done, its regulator would have observed the concentration of deposits and could have taken action to require a more stable funding source, which would have also slowed its growth.
The nature of SVB’s depositors should have been a simple red flag as well. Former Boston Fed president Eric Rosengren told the Wall Street Journal, “They should have known their portfolio was heavily weighted toward venture capital, and venture-capital firms don’t want to be taking risk with their deposits. So there was a good chance if venture-capital portfolio companies started pulling out funds, they’d do it en masse.”
These are former top regulatory officials expressing the conventional wisdom of the central-banking profession. The issues they mention are straightforward and able to be analyzed with publicly accessible information. SVB wasn’t hiding from regulators, and regulators didn’t need more power to uncover its problems.
As is common when the Fed errs, central bankers failed to learn the right lessons from history. The 2008 crisis is not like today’s problems, and focusing on complicated rulemaking left problems hiding in plain sight. Let’s hope that this time, perhaps, the Fed can learn its lesson.