March 17, 2023, 5:55 p.m. ET
By Jay Clayton and Gary Cohn
Mr. Clayton was the chairman of the Securities and Exchange Commission and Mr. Cohn was a director of the National Economic Council in the Trump administration.
We have spent the last 15 years focused on whether some banks are too big to fail. Today, we need to focus on the small- and medium-sized institutions that account for almost a third of all bank lending and are essential to many communities and industries. It is a perilous moment for them. What happens next could determine not only their survival but have profound effects on our future.
The regulation and supervision of smaller banks will no doubt change, as it should whenever times change or lessons are learned or, in the case of Silicon Valley Bank, lessons are relearned. But if the new regulation imposes significant new costs on smaller banks, many of them will die, customers will pay more for loans and services, and credit availability — the fuel for economic growth — will contract.
The Treasury Department, the Federal Reserve and the F.D.I.C. stepped in last weekend to prevent a classic bank run at Silicon Valley Bank from cascading through regional banks — including First Republic Bank, which, even after regulators stepped in, accepted a remarkable $30 billion support package from a consortium of large banks.
We were hours away from the failure of two regional banks and, more precisely, the new widespread recognition that deposits in excess of $250,000 might not be safe, setting off a chain reaction. Customers at other regional banks who thought their deposits were risk-free were suddenly questioning whether they should move their cash to safer havens. Withdrawals began and, as a result, previously remote risks of failure became real.
Had federal regulators not acted swiftly and broadly, the ensuing cycle — panicked withdrawals, failure, further panic, failure — would have had devastating ripple effects. And in the age of social media, with each passing hour, it would have been much more difficult to stop. Regulators’ actions drew support from both sides of the political aisle as well as from market professionals, borrowers, lenders and other bank customers.
Unfortunately, the bipartisanship of last weekend has faded, and the blame game has begun. Progressives claim that greater regulation would have prevented the failure. Others claim that the failures were the result of a shift in regulatory focus from prudence to socially oriented directives.
Both claims are off base. Worse, this opportunistic political rhetoric may distract us from both the risks of the moment and, as we look forward, the critical role banks play in our society.
There should be a thorough review of the Silicon Valley Bank collapse and, if there was improper conduct or failures in oversight, remedial actions should be taken. But we also must look forward, with a sharp eye toward improvement, recognizing that regulation and supervision must take into account the ever-changing nature of our modern, credit-driven economy, including the transmission of information — and emotion — at light speed to all with a mobile phone.
Americans have benefited greatly from a robust and diverse banking system. Today, we can choose from about 4,000 banks ranging in asset size from single-digit millions of dollars to more than $3 trillion. These banks serve different yet important roles, reflecting a remarkably wide variety of businesses and other organizations.
Smaller banks operating locally understand their communities in a way large banks cannot. Small and medium-size businesses rely on smaller banks for loans to buy property and equipment and services including making payroll, paying suppliers and extending credit to customers. Smaller banks help people in their communities buy homes and cars and pay for higher education. For large banks, the costs of acquiring local knowledge necessary to make many of these loans is too high, and the benefits of making smaller loans are insufficient.
While large and small banks are different, we must recognize that they are both subject to risk, because risk is fundamental to their operations. There is credit risk, also called asset quality: the question of whether their borrowers will pay back their loans or whether the bank’s investments will perform. There is market risk, one of the risks that played a role in Silicon Valley Bank’s downfall. For example, if mortgage rates go up, the mortgages banks already own that were issued at lower rates decline in value. Finally, there is liquidity risk, the other risk involved in the S.V.B. crisis. Depositors can withdraw their money at any time, but banks cannot require loans to be repaid at any time.
So, how do we regulate a multifaceted, socially important industry where risk-taking is an essential function? The history of banking regulation is the result of our episodic answers to this question, from the Federal Reserve Act of 1913 to the Dodd-Frank Act of 2010. By and large we have done a good job, particularly because we have recognized that our economy is ever-changing, and some risks are the responsibility of the government to manage.
Today, we have expansive regulation for our largest banks. The cost of operating large banks has almost doubled since the Dodd-Frank Act. Banks are required to hold capital against their loans and other assets, maintain high levels of liquidity and continuously monitor a wide array of risks. They are subject to constant supervision, including having federal regulators on site with free access to management and information. The costs of compliance personnel and systems stretch into the tens or even hundreds of millions of dollars annually.
But regulation also increased the resiliency of large banks. That resiliency was key in allowing the Federal Reserve and Congress to respond swiftly to alleviate the economic effects of the Covid-19 lockdowns.
The events of the past week have proven that smaller bank oversight, regulation or both should be improved. Clearly, risk-management functions, on-site supervision, and the qualifications and role of boards of directors should be evaluated. The $250,000 limit on deposit insurance should be raised, perhaps substantially to at least $2 million but perhaps as much as $5 million or even $10 million. This step reflects the reality that depositors cannot be expected to monitor the financial condition of banks as if they were sophisticated investors.
But we must be realistic. Smaller banks cannot afford anything close to what the large banks must do, as the latter are able to spread the costs over their huge global operations, including large deposit bases. Calls for increased capital and liquidity, appealing in their simplicity, inevitably follow bank failures, but Silicon Valley Bank had plenty of both. If we impose large bank regulation on small banks, the small banks would be forced out of business, in many cases landing in the hands of larger banks.
It is clear that size-based regulation is necessary if we are to have a diversified banking system. We are concerned that this need will be ignored.
Excessive regulation is not the only threat facing smaller banks. With interest rates relatively high, banks not only face the market risk that helped bring down Silicon Valley Bank, they also have stiff competition for deposits, including from short-term U.S. Treasury bills. For anyone in a high-tax state, the after-tax yield of a Treasury security is likely to be superior to a bank deposit. The issuance of Treasury securities for January and February is already up 13.4 percent over those months in 2022, or $3.4 trillion. Because deposits are a key funding source for banking lending, if businesses and consumers move from bank deposits to treasury securities in search of greater safety and higher returns, banks will not be able to lend as much. This will hurt key parts of our economy.
Whatever steps the government takes in the wake of the Silicon Valley Bank collapse, it must preserve the role of our diversified system, recognizing this truth: There are no ratios or tests that can replace the need for risk management and regulatory supervision. Moreover, regulators must always be ready to step in if panic selling or other destabilizing behavior emerges. It is why we have had banking supervisors and F.D.I.C. insurance for 90 years.
New tailored regulations that make smaller banks safer and help to protect all constituents makes sense, but they must be devised so they don’t result in more bank concentration or a reduction in available credit. Either outcome would harm economic growth and consumer welfare.
Jay Clayton was chairman of the Securities and Exchange Commission from 2017 to 2020. Gary D. Cohn was director of the National Economic Council from 2017 to 2018.
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