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The Financial Regulatory Credibility Problem

posted by Adam Levitin

Financial regulation has a credibility problem. Actually, it's got two credibility problems.

It's not credible any more to think that financial regulators will shut down troubled institutions until they are forced to do so. And it's no longer credible that financial regulators will allow depositors to incur losses. Both are really problematic.

1. Financial Regulators Will Not Slay Zombies Prior to Runs.

Silicon Valley Bank was in prompt corrective action territory by mid-2022. And yet there was no correction and the bank was allowed to keep on operating as a zombie and even paid its CEO a bonus. Regulators only acted when their hands were forced by an acute bank run. 

The response to the current crisis only confirms that regulators will not shut down troubled banks:  the Fed's new Bank Term Funding Program is a zombie-bank life-support program. The new Fed facility allows banks to borrow against their Treasuries and agencies at par, not at market value. That's a way of extending support to banks that have failed at Banking 101 and mismanaged their interest rate risk. What that should tell everyone is that the game plan for dealing with this crisis is basically the same as in 2008:  extend and pretend. Specifically, banks will be given all sort of support to enable them to avoid immediate loss recognition (as many would be in prompt corrective action territory if their securities portfolios were marked to market) and to claw their way back to solvency through retained earnings. In 2008, the extend and pretend was about bank's loan portfolios. Now we're just repeated the song in the key of securities.

The idea that regulators simply will not order abandon ship until the bow is below water is reinforced by the history of regulatory (inaction) on all sorts of other legal violations by banks, be it for AML or consumer protection. Exhibit A here is Wells Fargo, a repeat recidivist, still having a charter. If regulators will not take away the charter of a bank that engages in repeated and egregious violations of law, when will they ever do so? This is the bank regulatory version of what Jesse Eisinger has called the Chickenshit Club. And this isn't a GOP vs. Dem issue—this is a matter of bank regulators' culture in general. I suspect that it's in part because if a bank gets into trouble and has to be shut down, it's viewed as a failing of regulators, even if regulators shut the bank down at the earliest possible moment, rather than letting the bank operate as a zombie and hitting the FDIC's Deposit Insurance Fund with worse failures.


2. Depositors Will Not Be Permitted to Incur Losses.

The second credibility problem is that deposits are only insured to the FDIC limit of $250k per account type per depositor per bank (which can be structured to a few million in insurance if you've got a large enough family). What we've seen in 2008 and now in the Panic of 2023 is that regulators will disregard deposit insurance caps whenever they get twitchy about the possibility of contagion in the banking system. Does anyone really think that regulators will hold the line next time? After two such episodes, is it not reasonable for depositors to expect and rely on such treatment in the future?

Uncapping deposit insurance is basically a way of saying that banks will not be allowed to fail. Because if deposits are all guarantied, banks should not face runs and liquidity problems and any solvency issues can be massaged through extend and pretend. That's a really troubling outcome. If we continue to have private ownership of banks (and no one is suggesting otherwise), then we're in a situation in which there's privatization of gains and socialization of losses:  heads-I-win, tails-you-lose.

I can tell you how that movie ends: S&L Hell. Banks will be incentivized to engage in every riskier behavior. And given that regulators will be unwilling to toe the line, we're going to be right back in the S&L situation of the 1980s:  zombie banks being allowed to invest in race horses, shopping mall developments, etc. because of higher yields to offset their past losses. To be sure, the FDIC will start charging more in premiums, but that won't fix the situation—they'll always be below market pricing (and will be a regressive cross-subsidy). At some point this system becomes untenable, and then there's going to be a MUCH worse crisis.

One solution to this problem would be to have some sort of Barry Adler-esque chameleon capital: a mechanism that automatically writes down bank equity and converts mandatory convertible subordinated debt into equity whenever the bank's capital (calculated on a mark-to-market basis) crosses a specified threshold. That sort of system would substantially remove regulatory discretion.

But don't count on Congress addressing the problem:  doing so would curtail credit. Congress is always incentivized to prefer easy money policy, and lax bank regulation is one way to implement easy money. The reason Congress is incentivized to prefer easy money policy is that there's a concentrated interest that cares about it—would-be borrowers (like home mortgage borrowers and small businesses)—while those who pay for it—non-borrowers who do not want to be subsidizing this system—are a diffuse interest group who aren't likely to see the connection between weak bank regulation and the costs they bear with higher deposit insurance premiums that get passed through to them in the form of lower APYs and higher bank fees. The former group donates and votes on this issue. The latter group does not.

All this leaves me somewhat despairing. Insuring all deposits would be workable ... if regulators would actually rein in banks. (Desirability is another matter...) But the combination of cravenly prudential regulation and functionally uncapped deposit insurance is really toxic. Perhaps I should just go and buy some bank stock (especially now that it's discounted) because after a couple of years of retained earnings to get back to solvency, the real winners will be bank equity holders, who will get all the upside and bear none of the downside.


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