If the banking crisis offers one lesson, let it be this

Relaxed rules for midsized banks allowed SVB to ignore certain losses and liquidity issues that might otherwise have required it to shore up its finances sooner. (Source: Bloomberg)

US regulators have extracted some valuable lessons from the country’s first banking crisis in more than a decade. But one stands out: If banks were stronger in the first place, the whole unfortunate episode might’ve been avoided.

How, despite all the regulatory reforms since the 2008 financial crisis, did officials yet again find themselves scrambling to avert a systemwide disaster? Last week, both the Federal Reserve and the Federal Deposit Insurance Corp. offered their explanations in separate reports on the failures of Silicon Valley Bank and Signature Bank — part of a rash of collapses that persisted this past weekend as authorities seized distressed regional lender First Republic Bank and sold it to JPMorgan Chase & Co.

The Fed’s review of SVB’s demise elaborates on a now-familiar story. The bank’s management sacrificed soundness for profit, relying too heavily on large, uninsured deposits from its tech-industry customers and investing too much in long-term bonds that lost value as interest rates rose. Its rapid growth outpaced the Fed’s oversight processes: Supervisors saw the problems, but didn’t recognise their full significance or press hard enough to fix them. Relaxed rules for midsized banks, adopted in 2019 as part of a broader regulatory easing, allowed SVB to ignore certain losses and liquidity issues that might otherwise have required it to shore up its finances sooner. When depositors recognised that the bank’s losses exceeded its capital, they fled with unprecedented speed, triggering a broader run that only government intervention could stop.

The official takeaways are perfectly sensible. Supervisors need to be more assertive, and attentive to the dangers of sudden growth spurts and interest-rate increases. Given that SVB-sized banks can pose systemic risks, they should face the same rules as the largest banks in areas such as liquidity, recognition of losses and stress testing.

Yet one observation from Michael Barr, the Fed’s head of banking supervision, deserves special attention: “While the proximate cause of SVB’s failure was a liquidity run, the underlying issue was concern about its solvency.” The bank operated with a typically thin layer of loss-absorbing capital: At the end of 2022, its tangible equity of $11.8 billion was just 5.6 percent of tangible assets, easily overwhelmed by its $17.7 billion in losses on bond investments. If it had twice that amount of equity or more — as research and experience suggest would be prudent — uninsured depositors would’ve been better protected, and hence might never have started the run. The consequences of management’s mistakes could have fallen entirely on shareholders, who explicitly sign up to bear that risk.

The same is true of First Republic Bank. At the end of 2022, it had tangible equity of $13.6 billion (6.4 percent of tangible assets), woefully inadequate compared with $22.2 billion in losses on loans. The fact that SVB and First Republic hadn’t realised the losses by selling the assets, and hence were still solvent by regulatory measures, ultimately did little to maintain confidence — or to prevent the FDIC’s deposit insurance fund from incurring billions of dollars in costs.

One great advantage of equity capital is its versatility. Supervisors will never be able to anticipate everything that could possibly go wrong. The next shock will be different. Managers will take ill-advised risks. But as long as banks have ample capacity to bear the inevitable losses, the financial system and the broader economy will be much more resilient. This is why Barr has been conducting a review of capital standards, which have eroded significantly in recent years. This latest series of failures should inspire regulators to aim higher.

Bloomberg Editors are members of the Bloomberg Opinion editorial board. Views are personal, and do not represent the stand of this publication.

Credit: Bloomberg