Yves here. Gerald Epstein, who has written regularly about bank regulation and the inadequacy of “reforms” since the 2008 financial crisis, weighs in with his take on the 2023 panic. Epstein focuses on the tension between the Fed’s monetary and bank supervisory roles, and the colossal failure to coordinate them during the central bank’s very aggressive rate hikes. He also flags, among other things, the Fed’s failure to regulate and how deposit influxes made banks vulnerable to their reversal. Epstein calls for a major restructuring of the Fed, which despite being a logical response is unlikely to happen due to the central bank’s role as protector in chief of moneyed interests.
One related matter: the banks that got in trouble, particularly SVB, were bad at banking. One of the basic requirements of being in that business is managing your asset-liability mix and among other things, regularly stress testing for exposure to interest rate increase. The Fed put them though at such a fast and furious pace that one might argue that banks can’t be blamed overmuch for being caught out. But there’s a difference between underestimating the magnitude of the changes and being caught flat-footed.
In SVB’s case, the bank had gotten repeated regulatory warnings from the Fed over its defective risk models, yet had neither corrected them nor taken rough and ready measures to reduce its exposure. The Fed failed to crack down and impose or even threaten enforcement action. Needless to say, this was far too permissive. Cognitive capture is at least as big a problem as formal authority.
By Gerald Epstein,Professor of Economics, University of Massachusetts Amherst and Co-Director, Political Economy Research Institute (PERI). Originally published at the Institute for New Economic Thinking website
There are five main causes of the SVB collapse and the subsequent knock-on problems facing the US and global financial system: the Federal Reserve’s anti-inflation obsession causing it to raise interest rates too high and too fast; the inherent fragility of banking which for centuries has periodically erupted in crises; inadequate regulation of this fragile system which often leads to high profits that accrue to bankers’ and their wealthy owners; the corruption and self-dealing that often result from banks’ insufficient supervision; and the lack of public alternatives for financial institutions and services that could perform many of the key functions of banking and finance with less risk and without the private financiers taking their cut. Some of the huge profits the financiers make from this system are funneled back to buy support from the politicians to prevent adequate regulation, and to secure bail-outs when the system crashes.
The rapid increase in central bank interest rates to fight inflation is a major precipitating factor driving the financial problems facing the banks today. The more than 4 percentage point increase in the Fed’s rates in the last year rapidly led the prices of Treasury bonds and mortgage-backed securities to plummet, wiping billions off the balance sheets of SVB’s books. When SVB sold these to cover deposit losses from big venture capital firms and their start-ups, SVB had to sell bonds and realize these losses, cutting deeply into SVB’s already insufficient capital levels.
Importantly, though, the problem of low-interest rate government bonds and mortgage securities threatened by the Fed’s excessive tightening is not confined to SVB. The potential losses on banks’ balance sheets from the interest rate hikes have been estimated to be as much as $1 trillion if these had to be marked down. This interest rate overshooting by the Fed is, as my colleague Bob Pollin and his co-author Hannae Bouazza have shown, due to their wrong-headed commitment to driving inflation down to its arbitrary 2% target.
Some of the origins of these huge holdings of lower interest rate bonds stem from the zero interest rate policy the Fed has operated since the great financial crisis (GFC) and reinstituted during the Covid pandemic. At such low-interest rates, banks and other financial institutions loaded up with somewhat higher-rate securities such as long-term Treasuries. Ignorant of their risks or confident of a bail-out, some of these banks like SVB failed to hedge their interest rate risks which cost money.
These banks are to blame, of course, for taking such massive risks with their depositor’s money. But also to blame is the Fed. The Fed implemented a zero-rate monetary policy for years, followed by a rapid increase in interest rates to slay mostly supply-side and foreign-initiated inflation. But the Fed did not implement regulatory or supervisory policies to make sure these monetary policies did not wreak havoc with the solvency and stability of the financial industry, or to ensure the healthy allocation of credit by the banks.
During the low-interest period, the Fed did not make sure that banks – including medium size banks – kept reasonable levels of leverage and adequate liquidity based on the types of deposits they attacked. And when the Fed raised rates dramatically, they did not make sure their regulatory and supervisory ducks were in line to limit the possible financial stability problems.
What is the point of having both the monetary and regulatory/supervisory roles under one roof at the Federal Reserve if the Fed is not going to coordinate these policies in a coherent way for the good of the public? During the debate over Dodd-Frank, the Fed insisted on keeping and indeed enlarging its roles in this area. To what purpose? As Aaron Medlin and I have suggested, the purpose is to coordinate monetary and regulatory policy to help protect the wealth of the top 1% during low inflation periods by pumping up asset prices and to protect the real value of these assets when inflation increases by increasing interest rates and bailing out the financiers potentially hurt by the collateral damage.
A surge in bank deposits in recent years is also an important part of this story. In SVB’s case, the need to sell Treasuries was precipitated by withdrawals from the bank’s tech-oriented venture capitalists and other tech-connected depositors. A newer source of massive deposits is connected to cryptocurrencies. Signature Bank was closely tied into the crypto universe; Silvergate, a bank that collapsed a few weeks before SVB was primarily a crypto-connected bank. SVB had over $ 3 billion in deposits from crypto platform Circle – the issuer of its USD crypto-connected “stable-coin”. These are Circle’s U.S. dollar reserves to try to maintain a 1 to 1 relation to its “stable” coin. When SVB went under, USD fell off its peg to about 80 cents. When the Treasury, FDIC, and Fed announced that all depositors at SVB would make made whole, they implemented the first major government bail-out of the cryptocurrency industry. US financial regulators such as the SEC’s Gary Gensler had warned that these so-called stable coins were unstable and could only be made stable with bailouts. Gensler was proved right by the SVB depositor rescue operation.
Many critics have pointed to the Trump era partial deregulation of medium-sized banks (less than $250 billion in assets) which contributed to SVB’s failure: SVB’s capital and liquidity requirements were reduced, mandatory stress tests were eliminated, the rules against proprietary trading (the Volcker Rule) was suspended, and the need to prepare plans in case the bank became insolvent (so-called ‘living wills”) was eliminated. These stricter rules would have made it much more likely that the problems with SVB would have been dealt with by the Federal Reserve and FDIC sooner and in a much less disruptive way. Others have pointed to the lack of supervision from the San Francisco Regional Federal Reserve Bank which was supposed to be supervising SVB. The fact that SVB’s CEO Greg Becker was on the board of the San Francisco Federal Reserve points to possible serious conflicts of interest between banker influence on the Fed and the ability of the Fed to serve the public interest.
The recent crisis highlights a structural problem in our current financial system: there needs to be a safe place for businesses to place their reserves and working capital without providing funds to speculative financiers, and without fear that their deposits will be wiped out in a bank failure. That, among other reasons, is why we need publicly provided accounts where households and businesses can hold their money, risk-free. A healthy economy needs a set of basic institutions that provide financial services to families and businesses that facilitate their productive and necessary activities. The problem with private, more speculative, banks like the ones that dominate our economy is that they provide poor and costly services to most families and smaller businesses, and when they do, such as offer deposit accounts, they often put these at risk by engaging in highly leveraged and overly risky activities that often have little social value.
Thirty years ago, my colleague Jane D’Arista wrote a prescient piece on the need for widespread, unlimited deposit insurance for transaction accounts.
More recent proposals along these lines, such as for FED Accounts or updated Postal Savings Bank accounts are important to consider.
But busting this Fed – Big banker de-regulate and bail-out cycle, initiated in the 1990s and only temporarily paused following the GFC, is the only real fix for the financial problems that have erupted again in these last few weeks. It’s a bipartisan problem, one that needs an energetic response from the rest of us.
 Jane D’Arista, “No More Bank Bailouts: A Proposal for Deposit Insurance Reform,” in Gary Dymski, Gerald Epstein and Robert Pollin, eds. Transforming the US Financial System; Equity and Efficiency for the 21st Century, M.E. Sharpe, 1993. pp. 201-220.
Why cannot the deposits of all the banks be with a central bank which in turn allows them a fixed %age to manage? This will solve the problems of bank runs and bank’s management will have to focus on properly managing assets and liabilities.
Systemic failures such as this signalled here by Epstein in (neo)liberal democracies are becoming more and more apparent. The big problem being signalled here too is that there are no functioning repair mechanisms. On the contrary, the problems look poised to become more severe. The system is no longer flexible. Looses adaptability and resiliency.
Musical interlude by The Boss.
I was watching a mutual fund manager the other night who said multiple times ” but you can’t bet that because it is a system reset”. Essentially, there are no safe havens for money to move to, and anyone taking a contrarian view will never get paid, or payment will be meaningless. I think there will be lots of crisis events along the way, but the next true crisis will be in the dollar itself. They can’t bail that out. But they can replace it with digital currency. That is the system reset, imho.
Do you mean state-backed digital currency? Wouldn’t it be the same as the dollar?
I would like to hear what some of the more fiscally educated comentarists have to say about the report that Gorgio Meloni has again proposed a seperation in the Italian banking system of investment banks from retail banks. One might assume that the retail banks would feature insured deposits, and the investment banks no.
The US has already tried that and it worked, so naturally we gave it up.
We didn’t give it up. The upper class took it away from us.
If you get on Twitter: here’s the name of an Italian financier who, surely, would be able to answer your question.
I like the idea of properly structured safe harbor rules as a concept.
Businesses have regular recurring expenses for payroll; but also rent, insurance, taxes etc.
Allow these funds on average to remain safe and be able to continue their automated distribution.
Restrict Banks from leveraging them. They are usually in fee based transaction accounts paying zero interest.
Similar rules for loans that generate funds required to remain in the Bank.
Reducing Bank leverage needs to occur and the cross pollinating derivative producing fog that results.
Just going to say that with the way that the system has been set up, what we are seeing is positive feedback at work here-
‘Positive feedback (exacerbating feedback, self-reinforcing feedback) is a process that occurs in a feedback loop which exacerbates the effects of a small disturbance. That is, the effects of a perturbation on a system include an increase in the magnitude of the perturbation. That is, A produces more of B which in turn produces more of A. In contrast, a system in which the results of a change act to reduce or counteract it has negative feedback. Both concepts play an important role in science and engineering, including biology, chemistry, and cybernetics.’
Finance too I would suggest. So the Glass-Steagall Act was a tool that helped with negative feedback but when it was gutted, this led to positive feedback leading to more instability in the system which crashed less than a decade later.
From the article: “But busting this Fed – Big banker de-regulate and bail-out cycle, initiated in the 1990s and only temporarily paused following the GFC, is the only real fix for the financial problems that have erupted again in these last few weeks.”
I’m going to put this in stark terms. What institution created the housing bubble with its fifteen years of easy money? The Fed. What institution is responsible for tens of millions in America living in financial precarity or, even worse, living in their cars, under bridges, on the streets or in parks in tents? The Fed. Housing is the most important, costly, and inescapable expense for all of us. Does the Fed care? Nope. By its past actions the Fed shows that it only cares about the financial sector.
I’ve said this before, I’ll say it again. The Fed, given its reliance on macro-economic data (often inaccurate, incomplete, or outdated) can only distort the economy, even if its intentions are good (which is doubtful). So the best it can do is favor certain assets like stocks, bonds, and housing. That it has done very well, to the detriment of everyone else.
Why does the Fed still exist? It’s record over the past thirty years has been disastrous, with bubbles and the predictable popping of those bubbles, Greenspan’s pathetic mea culpa that “I thought markets would regulate themselves”, the consequent expensive rescues, and the stunning increase in its (bad-debt) balance sheet.
The time has come to question the shibboleth of the necessity for a central bank. Can an economy without it possibly be worse?
” A healthy economy needs a set of basic institutions that provide financial services to families and businesses that facilitate these productive and necessary activities.”
It has often been the case (see Korea, China, Japan) that small community banks existing in an environment where bank regulation directly targets different types of bank credit (i.e. restricting credit for transaction that do not contribute to nominal GDP, like credit for financial transactions that accelerate asset-boom bust cycles or cause banking instability are highly restricted, while promoting bank credit that contributes to a prosperous local development).
The fact that small, private banks have historically created credit and money out of nothing which, if used productively, results in non-inflationary growth, is a powerful argument for the expansion of small banking networks, not their elimination.
In Europe we have payment institutes which are not allowed to issue loans. There are many of them, see EUCLID database. Their primary purpose is for payment services, but given they are not allowed to leverage they could fulfill the purpose of a safe money haven.
They don’t advertise themselves as an alternative to banks though. And I believe most people would pick a bank offering token interest payments and assume they get bailed out over no interests and 100% safety.