No confidence in the Fed

The aftershocks of the Silicon Valley Bank (SVB) collapse, though seemingly fading, still reverberate around the world. Although Federal Reserve officials have gone out of their way to assure the public that the US banking system is sound, it’s not clear why anyone should believe them. After all, Fed Chairman Jerome Powell told Congress the same thing a few days before the SVB collapse in March.

In the weeks since, it was reported that the vaunted stress tests set by the 2010 Dodd-Frank financial reforms did not anticipate the fall in the value of government bonds caused by the Federal Reserve’s aggressive interest rate hikes. A recent study by Erica Jiang and her co-authors found that “market-adjusted bank assets have declined by an average of 10 percent across all banks” following the Fed’s rate hikes, “with the bottom 5th percentile experiencing a 20 percent decrease.”

While US President Joe Biden has vowed to hold those responsible for SVB’s collapse accountable, such promises must also be met with a healthy dose of skepticism. After all, the Obama administration, in which Biden served as vice president, never held any banker accountable for the 2008 financial crisis.

The fact is that regulators, including the Federal Reserve, have failed to keep the banking system safe. Banks depend on trust: depositors must be sure that they can withdraw their money whenever they want. That has always been true. What has changed is the ease with which billions can be withdrawn in a nanosecond online.

Even a hint of danger that they may not get their money back is enough for rational people to withdraw uninsured funds, and even insured amounts, if there is a risk of delay. The result is that when a bank fails, the people left with the bag in hand are those who have not been paying attention or, like many older customers, do not use digital banking services.

The current status quo, in which sophisticated depositors use intermediaries to engage in regulatory arbitrage to ensure that all of their deposits are insured, or are prepared to withdraw funds above the insured amount at any time, is no way to run a system banking. To stabilize the sector, policymakers need to establish comprehensive deposit insurance, paid for by depositors based on the benefits they earn and the systemic risks they pose. Until that is done, the banking system will remain fragile.

As head of the government agency responsible for overseeing SVB, Powell bears responsibility for the oversight failures that precipitated its collapse. Unlike the massive home loan fraud that caused the 2008 financial crisis (the extent of which became clear only years later, following numerous lawsuits and other legal actions), SVB’s loans appeared solid.

To be sure, even good loans can turn bad in the midst of a significant recession, and suspicions of questionable activity inevitably arise when so much money is kept in uninsured low-interest accounts. But SVB’s problems were more mundane, and any self-respecting bank regulator should have acted, especially when the regulator was the one creating the risk.

Banks are always involved in maturity transformation, turning short-term deposits into long-term investments. While this process is inherently risky, banks are often tempted to gamble their depositors’ money if taxpayers directly or indirectly bear the downside risk. Here’s what SVB did: It invested some customer deposits in seemingly safe long-term securities, betting that long-term interest rates wouldn’t rise. Supervisors must not allow this to happen and must make it a central part of stress testing when it does happen.

Yet the Fed allowed it to happen and, by ignoring the role of interest rate hikes in triggering financial sector fragility, undermined the effectiveness of its own stress tests. In addition to these supervisory failures, the collapse of SVB was preceded by regulatory failures, as the Fed under Powell relaxed regulations on banks like SVB, which it viewed as regionally economically important but not systemically important.

Most people do not have the capacity, resources, or access to the information necessary to assess the health of banks. Such assessments are a fundamental public good and, as such, a government responsibility. If a bank can accept money from the public, the public must have confidence that it can pay it back. The US government, particularly the Fed, has failed in that regard.

The Fed, like other independent central banks, guards its credibility closely. The risk of losing it has been cited as the reason for the Fed’s rate hikes last year, which went far beyond the normalization of ultra-low rates that characterized the post-2008 era. posed by its rapid rate hikes, and how more than a decade of near-zero interest rates had exacerbated these risks, the Fed undermined its own credibility—precisely the outcome it sought to avoid.

Worse yet, the rate hikes reflect the Fed’s misdiagnosis of the source of inflation, which is largely due to supply-side shocks and demand shifts related to the Covid-19 pandemic and the war in Ukraine. Also, unless it triggers a severe economic downturn, raising interest rates could actually make inflation worse. A major contributor to increases in the consumer price index is rising rental rates due to housing shortages, which exacerbate higher interest rates. Meanwhile, the Fed’s disinflation strategy could push youth unemployment among African Americans past 20 percent, leaving lasting scars in a highly unequal country.

As it is, the Fed and its chairman have lost credibility on all fronts. The current crisis has exposed the Fed’s failure to address the governance problems that contributed to the 2008 crisis. The fact that SVB CEO Greg Becker was on the board of the regional Fed he was supposed to oversee your bank is a good example.

Whether the still-simmering financial turmoil triggered by the SVB collapse will escalate into a deeper crisis remains to be seen, but investors and depositors have no reason to trust the Fed’s assurances that it won’t. Only significant reforms to deposit insurance, governance, the regulatory structure, and supervision can restore confidence in banks and the credibility of the Federal Reserve.

Joseph E Stiglitz, Nobel laureate in economics, is a university professor at Columbia University and a member of the Independent Commission for the Reform of International Corporate Taxation.

www.project-syndicate.org