We try our best not to "bash" the Fed gratuitously; we believe that strong public institutions are important for solving society's biggest problems. But the events over the past four days should not be sugar-coated: we have a substantial Fed failure on our hands. We have seen the failure of a bank that was then deemed worthy of the FDIC's systemic risk exception. The Fed has also rolled out a Bank Term Funding Program to generously support banks that would otherwise face even greater vulnerabilities now. The Fed's failure spans three dimensions: 1) regulation, 2) supervision, and 3) interest rate policy. This post aims to summarize the sources of what we see as the key deficiencies.
The Fed played its own unique role in the deregulatory efforts relevant to the recent failures of Silicon Valley Bank (SVB) and Signature Bank of New York (SBNY). The failure of these banks was driven by a deficiency of adequate liquid assets relative to their funding risks (deposit outflows).
When Congress passed the Economic Growth, Regulatory Relief, and Consumer Protection Act (S.2155) in 2018, it legislated substantially lower regulatory 'burdens' for 'mid-sized' banks. The actual implementation of the legislation required the Fed to develop more detailed regulatory revisions in a manner consistent with the law. In October 2019, the Federal Reserve Board of Governors (“Fed”), including current Chair Powell and current Governor Michelle Bowman, voted to go above and beyond Congress' mandate for deregulation. They were not merely following the orders of Congress. Then-Governor Lael Brainard submitted a prescient dissent against the rest of the Board's favored actions. Brainard’s dissent included specific discussion of banks that were of Silicon Valley Bank's size ($100B - $250B):
The disruption associated with liquidity stress at two large domestic banking institutions in the $100 to $250 billion size range necessitated distress acquisitions [in 2008]...The liquidity insolvency of a large banking institution with...even $100 to $250 billion—would pose substantial risk of loss to the deposit insurance fund, especially since a distressed acquisition of a large banking institution by one of the largest domestic banking institutions is a less plausible option today than previously.
To address this vulnerability, we voted to finalize the [Liquidity Coverage Ratio] five years ago. The LCR was designed as a baseline requirement appropriate for all large banking firms that is already tailored to bank size and business model, and the compliance burden is relatively low. Although S.2155 does not require us to weaken this critical post-crisis safeguard for large banks...For domestic banks in the $100 to $250 billion size range, who account for $1.9 trillion in assets overall, today's rule would eliminate entirely their current modified LCR requirement, a reduction of the LCR requirement by $167 billion - Lael Brainard, October 10, 2019
The LCR requirement aims to ensure a sufficient quantity and quality of liquid assets to manage a deposit outflow over a stress period. Deregulation in 2019 gave SVB a longer runway to grow rapidly without triggering tighter liquidity regulations.
It's an open question just how much a binding-LCR would have mattered in practice, but the purpose of the regulation should serve as a regular warning system to regulators to investigate (1) the quality of a bank's liquid assets and (2) the potential causes of a stressful deposit outflow. SVB's liquid assets were not sufficient in quantity or quality; the scale of their interest rate risk seems unforgivable. As for the risk of deposit outflow, it seems clear in retrospect that SVB had highly correlated and concentrated deposit outflow risk on its hands. The existence of a binding LCR could have flagged some of these issues earlier.
It would be one thing if SBNY and SVB's failures proved to have a trivial impact, in which case one could credibly argue that tighter liquidity regulations were not necessary for curtailing systemic risk. The FDIC, Treasury, and the Fed all invoked the 'Systemic Risk Exception' to the FDIC's general obligation to protect the Deposit Insurance Fund. That the exception was ultimately invoked says it all: these institutions have long been systemically risky and should have faced much tighter liquidity regulations as a result. As current members of the Federal Reserve Board who contributed to some critical sources of deregulation, Chair Powell and Governor Bowman have a special responsibility to explain their decisions, and whether they would consider a different approach now.
The Fed could have tried to compensate for their deregulatory efforts through vigilant supervision of those institutions left outside of the new regulatory perimeter, but here too, the Fed has clearly come up short. The Federal Reserve System is not lacking for resources, personnel, authorities, or information when monitoring the health of its bank members. Bank supervisors have valuable and unique authorities for eliciting the requisite information.
If you told most Fed officials 'there is a bank that is growing rapidly that sits just outside some triggering thresholds for additional liquidity regulation' or 'there is a bank that is involved in activities that could prove sensitive to cryptocurrency prices,' that alone should trigger some additional surveillance and scrutiny. Maybe that surveillance and scrutiny happened, but if so, it did not get communicated up to Fed leadership or was not taken seriously by leadership. No matter how you slice it, the Fed had tools at its disposal to investigate SVB and SBNY well ahead of time, and could have pushed these institutions to rectify their behavior accordingly. It's not everyone's job to foresee these material risks, but it is the job of supervisory authorities, including the Federal Reserve.
You can read the Fed's latest semi-annual report on Financial Stability back from November. Across all 80 pages and the 9 pages devoted to funding risk, you're not going to find much that fleshes out how regional banks had vulnerabilities associated with their stock of liquid assets, nor will you see much discussion of deposit outflow risk. Maybe the Financial Stability report is not the appropriate forum for flagging some of these risks, but there is little in the public record that reflects even a cognizance that such elevated risks were ever present for recently-deregulated institutions.
How are Interest Rate Hikes Affecting Financial Stability and the Economy?
SVB's failure is also a prime example of how interest rate policy affects both the financial system and real economy. More importantly, the failure shows just how blind the Federal Open Market Committee (FOMC)—the part of the Fed that sets interest rate policy—was to these critical dynamics.
Higher interest rates have contributed to lower valuations on speculative venture-capital-funded enterprises ("tech"). That likely did impair the illiquid asset side of SVB's balance sheet in a way that invited more direct financial stability risks and negative employment effects if it failed. Were these channels identified ex-ante and analyzed for their potential scale?
Even more damning is the poor risk management associated with SVB's stock of liquid assets. Interest rate risk exists with all fixed income securities and there are straightforward methods for constraining the sensitivity of a liquid asset portfolio to such risk. Is there a framework by which FOMC members and Fed staff can flag these potential issues and get an integrated view across Supervision and Research? The Fed has uniquely privileged access to information concerning the state of bank portfolios. One would hope that FOMC members have enough curiosity to think about how their central policy tool is transmitting itself across the full array of potential financial channels. These channels are complex and nonlinear; sometimes they matter and sometimes they don't. The only way you can know is by systematically paying attention.
The Fed's rate hikes did not have to deplete SVB's liquidity position, and with competent regulation and supervision, it shouldn't have. But with SVB's reckless risk management practices going unchecked, the Fed's rate hikes did have outsized impact. SVB's recklessness is its own; it is wholly inappropriate to scapegoat the Fed for this (as a certain set of loud venture capitalists on Twitter are now exclaiming). But the Fed should be on alert for foreseeable effects from their policies. Fed staff should not be assuming that interest rate hikes merely interact with ideal risk management practices. Now that the risk of deposit outflows has spread across banking institutions, the effect of rate hikes are also likely to amplify. Two dynamics that should affect how the Fed sets interest rates (but are likely still not fully appreciated): (1) funding cost pressures rising independently of changes in the Federal Funds Rate, and (2) a precipitous drop in how much risk capital the banking system makes available for lending (as deposits flow to more conservative banks).
The SVB case shows how the Fed's approach to conducting monetary policy is not sufficiently informed by what it can observe within the banking system. Surely if the Fed was aware of SVB's fragilities even a week ago, Chair Powell would not have turned his back on what Federal Open Market Committee members had previously communicated: that lagged, latent, and uncertain effects from past tightening warranted a slower pace of interest rate increases. Instead, his Humphrey Hawkins hearing testimonies consciously signaled the opposite, opening a firm pathway to re-accelerating the pace of rate hikes at the March FOMC meeting. Financial markets immediately got the message that a 50 basis point hike was the new base-case.
The banking runs of the past few business days exemplify the bigger blindspot in the Fed's approach to setting monetary policy. It is not enough to just move interest rates in response to macroeconomic indicators that represent the Fed's objectives (e.g. inflation, employment). The economic machine is infinitely complex and forever changing. Without knowledge of how the system is behaving and what kinds of effects interest rate hikes are actually having, the Fed will continue to risk flying blind. The Fed should not be so satisfied with vague abstractions about how interest rate hikes simply "reduce aggregate demand," which thereby must reduce inflation. Nonlinearity, unreliability, and high collateral damage risks already make interest rates an incredibly challenging tool to use judiciously. Without a clear view of how the system is working, the Fed's interest rate settings risk causing too much damage before the Fed is able to correct course.
It's true that alternative policy tools, no matter how conceivable, are not readily available. Monetary policy is often the only game in town when trying to address major macroeconomic objectives. But that is all the more reason for the Fed to take a more holistic and detail-oriented view of how their policies take effect, including a better view of how interest rate hikes and financial stability interact. The current failures reveal severe blindspots in the Fed’s approach to regulation, supervision, and even monetary policy.