It's Not Just an SVB Problem: the Systemic Nature of the Bank R...


A mid-sized regional bank specializing in lending to tech start-ups, crypto companies, or law firms hardly seems of systemic importance, even if its failure would have caused disruption in some industries regionally and might have triggered a cascade of corporate bankruptcies because of large uninsured deposit balances. That sort of collateral damage from a bank failure is unfortunate and painful for those involved, but that's the nature of market discipline.

If that's where things ended with Silicon Valley Bank, I suspect regulators would have said too bad, so sad, as they were initially prepared to do. Yet the problem with Silicon Valley Bank's failure was that it had the potential spark for a banking-industry-wide panic, in which depositors pull their funds from smaller banks and move them either to big banks or to money market funds. That sort of panic could have been devastating to small and medium banks, as they would have faced a liquidity crunch that many could not meet...for the very same reason that SVB got into trouble, namely that they are sitting on large unrealized losses on their bond portfolios because they failed to manage interest rate risk appropriately. And if we had a correlated failure of lots of small and medium-sized banks, it would have resulted in serious economic disruption in small business and agricultural lending and a lot more spillover insolvencies of firms that had large uninsured deposits at those banks. That's the systemic risk scenario with SVB, and I suspect that as the weekend after the SVB failure advanced, that's what scared federal bank regulators into guarantying all deposits at SVB and SBNY.

But notice the nature of the problem: it wasn't just SVB that mismanaged its interest rate risk. It was lots and lots of other banks. Mismanaging rate risk is a Banking 101 screw-up, but it's also a Bank Regulation 101 screw-up. Rate risk is hardly a novel problem, and it's an easy one to address through derivatives like interest rate swaps, but those eat into profitability. Why bank regulators let rate risk get out of control almost across the board is something Congress needs to understand—I suspect that the story is much like consumer protection violations, which historically were tolerated because they were profitable. This much is clear, however:  if regulators had done their job generally, SVB's bank would not have posed systemic risk because there wouldn't have been the possibility of a panic. It would have been a one-off bank failure and nothing more. Regulators should have been on SVB's problems much sooner, but the real regulatory failure was an across-the-board failure to ensure that banks managed their rate risk because that's what set up the panic scenario.

Put another way, this isn't just a problem that can be hung on the neck of the Federal Reserve Bank of San Francisco. The problem here implicates every federal bank regulator.