Why US bank regulation needs a system upgrade

SVB collapse shows supervisory framework is not fit for a changing industry and new systemic risks

Silicon Valley Bank was in many ways a very modern failure. It was also a symptom of the dramatic changes that have occurred in the economy and financial landscape over the last 160 years – and of a US regulatory system that has failed to keep up.

SVB’s fate was sealed online. Customers withdrew $42 billion in a single day – the fastest bank run in US history – amid a frenzy of alarming tweets and WhatsApp messages. Many accounts were emptied with little more than a few taps on a smartphone.

The bank’s assets consisted largely of fixed rate securities – another modern phenomenon. The rise of shadow banking and private credit has squeezed traditional depository institutions out of the lending business, leaving them heavily exposed to interest rate risk.

The collapse reveals an uncomfortable truth: the current supervisory system for banks was not designed for these new realities.

The size of the shadow banking industry and the opacity of the hazards therein make it perhaps the single largest contributor to systemic risk

The US bank regulatory framework is anchored by three acts of Congress, the first of which was written 160 years ago.

The National Currency Act of 1863 created the Office of the Comptroller of the Currency, nationally chartered banks and a uniform national currency.

Next came the Federal Reserve Act of 1913, which established a central bank to increase liquidity in the payments system, manage the money supply through monetary policy actions, improve stability in the financial system and reduce systemic risk, and provide supervision and oversight of banks.

The Glass-Steagall Act of 1933 effectively separated commercial banking (depository institutions) from investment banks (market-making) and created the Federal Deposit Insurance Corporation.

Although all three acts have been amended in the years since, they remain largely intact – the exception being the repeal in 1999 of Glass-Steagall’s ban on depository institutions engaging in market-making. The Dodd-Frank Act of 2010 raised capital requirements for banks but did not materially change the shape and substance of the regulatory framework.

When these foundations were first laid, deposits were sticky and local banks were the only source of credit. Business loans, commercial and residential mortgages, car and instalment loans were all originated by depository institutions and kept on their balance sheets. These, along with small portfolios of short-duration government securities for the purposes of liquidity, were the banks’ only assets. Aside from some mortgages, these assets were predominantly floating-rate, and therefore a natural fit against variable-rate deposits.

Out of the shadows

Since the 1990s, shadow banking has taken over as the primary provider of credit for individuals and institutions in the US. The business loans that were previously held on banks’ balance sheets have been replaced by leveraged loans, which exceeded $1.6 trillion in 2019. These are funded by private sources or by collateralised loan obligations in which pools of high-risk instruments are made institutionally palatable through the wonders of structured credit and ratings agency arbitrage.

Stabilised commercial mortgages, once a mainstay of banks, are now financed by commercial mortgage-backed securities – of which there are currently more than $4.5 trillion outstanding. The figure for outstanding residential mortgage-backed securities – issued privately or by government agencies – is more than $6 trillion.

Banks are no longer interested in offering retail instalment loans. Again, the wonders of structured finance and ratings agency arbitrage mean large parts of the pool of credit card receivables are deemed virtually risk-free, and the cost of financing offered by ‘shadow banks’ is impossible for depository institutions to compete with.

Last, but by no means least, there is the private debt phenomenon that emerged in the wake of the global financial crisis, and which led to almost $2 trillion of credit being issued outside of any regulatory framework. Regional banks and depository institutions in the US cannot compete with the pricing of this credit because of the costs involved in holding capital on their balance sheets for regulatory purposes. Instead, their asset portfolios have shifted away from floating-rate loans towards predominantly fixed-rate securities with high credit ratings and little in the way of credit spread – creating a strong urge on the part of these institutions to move out the yield curve and add duration.

In short, the size of the shadow banking industry and the opacity of the hazards therein make it perhaps the single largest contributor to systemic risk in our financial system.

Fact and friction

On the liability side, we have also moved away from a world where money was a physical thing that was difficult to transport and store safely, with high transaction costs. Those with money essentially had two choices: leave it in a bank, which would offer safety and liquidity, or put it into the equity markets, where the risks were high and liquidity low as the securities settlement process was expensive and time-consuming.

Banks’ deposits will require near-total guarantees if these institutions are to compete with the non-bank alternatives

For most people, accessing money used to require a physical presence at the bank. Today, publicly traded debt – currently amounting to more than $65 trillion – is a potentially safe and higher yielding alternative to bank deposits. Through the wonders of repo it can offer same-day liquidity, and digital technology has reduced settlement and transaction costs to a mere pittance. Similarly, liquidity in equity markets has been much improved over recent decades and transaction costs have been reduced substantially.

When I first joined the banking industry more than 40 years ago, wiring money was exorbitant and the purview of companies or the very rich. Currency was defined as a medium to facilitate the frictionless exchange of goods and services, but the exchange of currency itself was far from frictionless. Today, cash can be moved across accounts through Zelle and its equivalents with no friction in terms of time or cost, and transactions can be executed from a phone while riding a chairlift or taking a bus. Securities can also be bought or sold with perilously little friction, from virtually anywhere and at any time.

Information travels just as quickly. Financial news is now available to virtually everyone, with media outlets working 24/7 to keep us up to speed on what is happening. Social media gives a megaphone to every perspective, though this isn’t always a good thing.

Does this mean regulators are wrong in their interpretation of the risk? Not necessarily, but it does mean there are gaps in the way risk is perceived by rating agencies on the one hand and regulators on the other. And because of these gaps, material parts of our world are now financed by investors that rely solely on agency ratings as the determinants of risk.

In the case of longstanding agencies with more than 100 years’ experience in rating a particular company’s issuances, this might be OK. But it is not OK in a world of asset classes created through structures that have been in place for less than three decades; with models calibrated using 30 years of data at most and that create substantive capital arbitrage opportunities for issuers and structurers; and with agencies that have been in business for less than 20 years. This state of affairs is unlikely to end well, including for individuals who are exposed either indirectly through their pensions or directly through investments in fund structures where even advanced quants find it hard to discern the risks.

Time to reboot regulation

As difficult as it will be, we must redesign our system of regulations and controls to capture all the factors and entities that contribute to systemic risk. Rating agencies have perhaps become the most significant of these contributors and should be regulated accordingly. Any investment vehicle, private or public, that takes money from investors with fiduciary responsibilities, such as pension funds, must be included within the regulators’ remit, in addition to the traditional intermediaries such as banks and insurers.

On the liability side, more must be done to preserve the status of banks as a safe harbour for deposits, no matter how great the amounts. We need to recognise that money has many options these days and can move quickly. Banks’ deposits will require near-total guarantees if these institutions are to compete with the non-bank alternatives. This must be done in a way that does not encourage risky behaviour by banks or unduly raise the costs to customers. Banks with large corporate and ‘hot-money’ deposits may also need closer oversight, above and beyond what is appropriate for institutions with diversified and retail sources of funding.

With the growth in leverage in virtually every corner of the economy and the expansion of shadow banking, systemic risks are at an all-time high. Much of this risk is contained within publicly traded instruments, CLOs, commercial and residential mortgage-backed securities, and public mutual funds that allow for some investment in illiquid or private credit.

This, combined with a world in which one only has to whisper the word ‘fire’ and the news will spread, suggests that the days when we could regulate depository institutions and feel we had covered most of the risks in the financial system are now over.

Nicholas Silitch is a former chief risk officer at Prudential Financial and in Bank of New York Mellon’s alternative investment services, broker dealer services and Pershing businesses

Editing by Daniel Blackburn

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