On taking over the distressed First Republic Bank last week, Jamie Dimon, CEO of JPMorgan Chase, said: “No crystal ball is perfect, but yes, I think the banking system is very stable.” Well, what else was the boss of America’s biggest bank going to say? A determination to declare that things are under control is widely shared by industry leaders, regulators and policymakers alike. It’s understandable. Nobody wants to start a panic. But that’s also the root of the problem.
Banking is a fundamentally unstable business. Depositors might have no good reason to think their particular bank is in danger, but if they run, they’ll turn out to be right. Making banks safer through regulation, desirable as it might be, doesn’t always solve this riddle; depositors also need to believe they’re safe. Making banks safer and making people believe it are often at odds.
Hence a recurring pattern in such crises: Regulators hesitate to act pre-emptively to deal with stresses before they become dangerous, because identifying an issue and acting early to fix it risks causing the alarm they hope to prevent. So signs of trouble are quietly set aside, complacency rules, and banks are spared the embarrassment of conforming with accounting principles like marking assets to market. Partly because such candour might scare people.
After the failures, another pattern kicked in. Regulators resolved both SVB and First Republic by quietly amending articles of faith about sound bank regulation, like three canons of the post-2008 regime. SVB, a medium-sized bank hitherto deemed systemically insignificant, was upgraded to systemically significant to justify an extension of deposit insurance to all its deposits. First, this acknowledged broader fragility than was allowed. Second, it abandoned the idea that limits on deposit insurance are necessary to apply market discipline to banks. And with First Republic, regulators kept it from collapse by letting JPMorgan acquire the business. Think ‘too big to fail.’
Silicon Valley Bank and First Republic were special cases, but not as special as one might wish. Both were brought down by a combination of runnable retail deposits and unrealized losses on long-term assets.
There was nothing mysterious about either vulnerability. Managers and regulators had the data. But believing that banks are stable induces one to think deposits are sticky and that falling asset values due to higher interest rates cause ‘paper losses’, not real losses. This is reassuring until, at a certain point, such beliefs become not just false but untenable. Then the system is suddenly not so stable. SVB was indeed unusual in relying so much on large (so uninsured) deposits, but that isn’t the whole story. When interest rates on cash and close equivalents are zero, there’s no point in searching for better terms. But when rates go up, depositors start shopping around and moving their money. Tech makes it easy.
With or without insurance, this combination of frictionless deposits and rising rates can complicate customer retention. It also unsettles the other side of the balance sheet. If you have to compete for deposits with higher rates, you might be paying short-term creditors more than you’re collecting from long-term borrowers. If so, you’re losing money and seeing capital erode. This is a concern for all banks with portfolios heavy in long-term fixed-rate lending for housing or other real estate (like First Republic), or in supposedly safe assets such as long-term government bonds (like SVB). Keep in mind that the prices of housing and commercial real estate, hence the value of loans linked to those assets, might not yet have fully adjusted to higher rates.
It’s all but impossible to break the cycle of wishful thinking, forbearance and occasional panic. The best approach would be to accept that banking is unavoidably risky and learn to live with it. In that world, nobody would be unduly alarmed by the asset-value volatility laid bare by mark-to-market accounting, or by prudent early action to reduce leverage—such as selling equity in what might be a falling market or using bond-conversion triggers that draw attention when they replenish capital.
Yet, the need to see banks as stable is hard to dislodge. Regulators are again insisting that small rule tweaks will make banking safe, finally, without eliminating risk. This ignores the trade-off between risk and return: A bank with more capital, say, or assets and liabilities with better matched maturities, is indeed safer—but also less profitable and somewhat impaired in its core role of allocating resources.
Worst of all, many ideas for making banks safer really do the opposite. Insuring all deposits makes runs less likely but pushes banks to take bigger risks. ‘Too big to fail’ creates essentially the same moral hazard. As long as there are banks, there’ll be crises. The slower we are to see the risks, the bigger the eventual damage.