SPIA Reacts: Bank Bailouts – No Bank Is Too Small to Matter
The Silicon Valley Bank bailout was necessary. But was it timely or fair? If the intervention itself was timely, the decision to intervene was by all indications anything but. In a similar vein, the bailout does not do particularly well on the fairness test.
By excluding shareholders and bondholders from the benefits, it would appear that the cause of fairness is served, if one is willing to sweep under the rug the fact that not all of those “rich guys” are equally rich, necessarily richer than some of the large depositors who are made whole, or endowed enough to take the hit. But, more fundamentally and as a general proposition, any time “other people’s money” is used for a bailout, there is a clear potential for unfairness, the more so the larger the depositors, and needlessly so to the extent that not all depositors are equally in need of being made whole completely.
Something else is bound to happen when “other people’s money” is involved in bank bailouts in the way those have tended to be handled so far—namely, bankers become less risk-averse in their investment decisions and operations, and depositors less discriminating when it comes to choosing where to park their money. Where the insurance is comprehensive, with no deductible, and with someone else paying for the premium, a moral hazard of the kind described here begins to infest the banking system, and it becomes dangerously more entrenched the more bailouts are undertaken.
It is not that governments, central banks, or other regulatory agencies are oblivious to this problem. Truth be told, they effectively ignore it. This is understandable when regulators find themselves totally preoccupied with “putting out the fire,” with their focus being on calming financial markets and staving off a broad-based run on banks. Where they have consistently gone wrong, however, lies in their failure, in the aftermath of past banking debacles, to install and keep in place guardrails that reduce future incidents of bank failures and the consequent need for bailouts, and to do so in a manner that bolsters confidence in the banking system while minimizing the moral hazard risks.
The SVB bailout was indeed necessary, as was the subsequent bailout of Signature Bank. But precisely because of the lack of a previously codified rational intervention strategy, it is not free of downstream moral hazard risks. By extension, the next bank bailout will not be good enough, and so it will continue to go until the moral hazard consequences become so grave as to make intervention by bailouts too costly to undertake. And then what?
What is at stake here is too consequential to continue to go ignored. The case for early intervention is often compelling. Its recurrence is a problem that is made more serious by continuing to ignore the seriousness of the downside risks of poorly designed, hurriedly carried-out interventions. Those risks are real, and they are not going to go away by downplaying them or wishing them away. It is definitely a case of malpractice and dereliction when, even before they explain the nature of their intervention, officials rush to defensively assert—incredulously, no less—that their intervention is not a bailout. And when pushed, they would say, among other things, that the case being dealt with should not be viewed as a replicable precedent, that intervention is reserved for exceptional cases involving banks deemed to be too big to fail, and that continuing to make intervention more of a guessing game is an effective enough antidote to moral hazard risks.
Rather than continuing to tinker with what really is a non-system of intervention and, in the process, merely kick the can down the road, it is time to embark on a serious effort aimed at putting in place and codifying into law an effective intervention strategy for dealing with problem banks. The overarching objective here ought to be ensuring the soundness of the banking system and instilling confidence in it. It is well to remind ourselves that when the dollar peg was abandoned in 1971, the United States financial system became solely anchored on faith and confidence in its soundness and capacity to function smoothly. Insofar as the banking sector is concerned, maintaining such faith requires, among other things, embracing, rather than disavowing, intervention, including bailouts, as and when it is needed, and ensuring the existence of adequate guardrails and competence in administering regulations.
In regards to intervention, the question should no longer be whether or not, but when and how to intervene. Timely and well-designed interventions are a key ingredient in fostering faith and confidence in the banking system. Toward that end, discretion as to whether a bank is to be deemed systemically important enough to save should be done without. Rather than the too-big-to fail, loosely-defined standard—a bar evidently judged to be met in the case of the midsized SVB and the much smaller Signature Bank—the mantra ought to be “no bank, if it meets all statutory requirements, is too small to matter.” Beyond that, the focus ought to be on designing bailouts in a way that strikes a reasonable balance between, on the one hand, providing enough assurance to depositors so that they would be less likely to make a run for their money, and, on the other hand, mitigating the moral hazard risks and minimizing the cost of intervention.
To take the case of the SVB bailout as an example to illustrate how that bailout could have done better on the fairness and effectiveness tests, what if, rather than make all depositors whole completely, that privilege was confined to small depositors, with the rest of the depositors tiered into brackets of compensation that is inversely related to the size of their deposits?
That would do more than maintain the only element of fairness in the existing system, with the small depositors defined as those with deposits up to the FDIC insurance cap of $250,000. Under the proposed tiering, that cap may be maintained, raised, or even lowered, and it would serve the role of a “de minimis” below which depositors are made completely whole. Above that threshold, all depositors can be assured of a progressively apportioned minimum compensation that could rise once the bank’s soundness and profitability are restored and the cost of intervention is recovered. Such a system would lead to outcomes that are less unfair and less costly. Moreover, by incorporating some elements of uncertainty regarding the extent to which large depositors (and, should recovered resources be adequate, bondholders and shareholders) might be compensated, the moral hazard problem would be mitigated. It would also incentivize early detection and intervention, as well as the adoption of intervention schemes that enhance the prospects of recovering the cost of intervention.
Last, but not least, a few words about regulation. It is possible that the 2018 roll-back of the Dodd-Frank regulations may have contributed to the SVB failure. That is something that should certainly be examined. What calls for closer scrutiny, however, is the apparent laxity in the implementation of existing regulations. For it is inconceivable that the regulatory regime that predated the Dodd-Frank regulations was so deficient as to not make it possible to detect early on the glaring mismatch problem that led to the SVB failure, and to trigger in a much timelier fashion an intervention of the kind that, in the end, was undertaken.
For all the criticism leveled, with good reason, against the Federal Reserve’s aggressive interest rate hikes over the past year, the Fed cannot be charged with not having adequately telegraphed its intent to embark on such a treacherous policy path. The attendant heighted risk of the mismatch problem in the new interest rate environment should have been obvious enough for all to see. What hit the SVB was not a sudden twister but a hurricane that was long in developing way off shore. Yes, bank executives should be thoroughly investigated. But an equally rigorous inquiry should be launched to find out what the San Francisco Fed and the Office of the Comptroller of the Currency (OCC) were doing—or not doing—throughout. It seems an inescapable conclusion that they, too, were not minding the store.
Salam Fayyad is the Visiting Senior Scholar and Daniella Lipper Coules '95 Distinguished Visitor in Foreign Affairs at Princeton SPIA.