Dodd and Frank are among the two gov idiots most responsible for the 2008 recession as the folks who relaxed lending oversight for the mortgage market. Having them be in charge of the new banking act was like having the Wolf watch the chickens after the hen house was attacked.
A dozen years later, we learn that having the Federales watch banks doesn't work so well. Are bank regulators, as a group, a bunch of inept idiots? If it walks like a duck?
Another Banking Crisis Was Predictable
The original sin was monetary policy, Thomas Hoenig says, but regulators failed to heed the warning signs of a disaster in the making at SVB and elsewhere.
By Mary Anastasia O’Grady, WSJ
March 17, 2023 5:09 pm ET
The economist Allan Meltzer liked to say that “capitalism without failure is like religion without sin. It doesn’t work.” After the 2008 financial crisis, Meltzer worried that bank bailouts were undermining public support for capitalism. He feared that politicians would steer the financial system toward more government regulation and away from the natural regulatory power of market competition. More Americans would begin to believe that only the state could protect them from the instability that comes with economic freedom.
Sure enough, in 2010 Congress passed the Dodd-Frank Act, which promised “to promote the financial stability of the United States by improving accountability and transparency in the financial system, to end ‘too big to fail,’ to protect the American taxpayer by ending bailouts, to protect consumers from abusive financial services practices, and for other purposes.”
Thirteen years later, we’re back in the banking soup. Meltzer, who died in 2017, isn’t around to say, “I told you so.” But one man who can is Thomas Hoenig, who sounded similar warnings during his nearly three decades at the Federal Reserve and the Federal Deposit Insurance Corp.
Silicon Valley Bank—the 16th-largest U.S. bank by assets—built a portfolio that was bound to crack under stress. Yet regulators didn’t seem to notice until the bank’s attempt to raise capital sparked a run. By Sunday the Treasury announced a federal backstop for all SVB depositors, even those not covered by FDIC insurance. Other midsize banks are now signaling trouble. A sense of here-we-go-again has spread.
Is there a way out of these recurring manias and panics? Mr. Hoenig, 76, thinks so. Now a distinguished senior fellow at George Mason University’s Mercatus Center, Mr. Hoenig was president of the Kansas City Federal Reserve Bank (1991-2011) and vice chairman of the FDIC (2012-18). On a visit to the Journal this week, Mr. Hoenig made the case, as he has for more than a decade, for a return to a bank-regulatory framework that links risk and reward—sin and religion. The key elements: “rules that are simple, understandable and enforceable” and “more bank capital as a source of funds in order to provide greater stability and reduce the overall risk to the industry.”
Mr. Hoenig calls the latest events “inevitable” given Dodd-Frank’s regulatory framework. He places much of the blame on the Fed’s use of “risk-weighted capital” to judge a bank’s health. This measure doesn’t account for “duration risk,” which got SVB into trouble. Long-term debt is sensitive to changes in interest rates. As rates rise, even safe assets like Treasury bonds decline in price, so that liquidating them entails large losses.
SVB “had billions of dollars of assets that were rated risk-free or low-risk from a credit perspective, but they were not duration-risk-free,” Mr. Hoenig says. “SVB’s ‘risk-weighted capital’ focused almost exclusively on credit risk. Meanwhile, duration risk was screaming danger.”
The original sin is monetary policy, Mr. Hoenig says. When he was a voting member of the Fed’s Open Market Committee in 2010, he was often a lonely dissenter. While most of his colleagues cheered near-zero rates for years, he argued for gradually returning the price of credit to something normal. By not normalizing rates, the Fed was fueling ever-greater risk-taking in search of yield. Now, in an effort to control inflation, the Fed has raised the fed-funds rate by 450 basis points over the past year, exposing this policy error.
Mr. Hoenig worries about other problems with risk-weighting capital that could soon emerge. Assets like collateral-loan obligations and mortgage-backed securities are rated low-risk, but they can become a balance-sheet weakness in a recession. “Risk-weighted capital flat-out misleads,” he says, because when uncertainty arises, “the only thing a real bank investor wants to know is how much real equity capital is there.” That “tells the investor how prepared the bank is to absorb a shock, no matter where it comes from on the balance sheet.”
This all seems obvious—so how did we end up here? Mr. Hoenig says bankers believe if they “had to use equity capital for regulatory purposes, and if they were required to meet what historically the market has demanded, closer to 10%, well, then they say, ‘We can’t make loans. The capital restriction would be just too tight and we’d have to raise our rates, and that would hurt the small-business lender and the economy would suffer greatly. There would be hundreds of billions of dollars that couldn’t be loaned because of those rules.’ But I’m saying that if you are a safer institution, your cost of capital should actually go down, shouldn’t it?”
The banking lobby pushes back against higher capital requirements with the help of economists, who “tend to be overconfident and think they have all the answers.” Their models, Mr. Hoenig says, are overly complicated and rely heavily on assumptions about probabilities. “I’m sitting there saying, ‘Guys, I only want to know one question, how long before you fail?’ Not how complicated you can make the formula to confuse me and certainly confuse the public.”
Were bank regulators confused? That’s unclear. But perhaps they were distracted by risk-weighted capital. “The duration risk could have been found, and the concentration of deposit sources looks pretty obvious, since everyone in the world knows it. So that’s not the problem,” Mr. Hoenig says. “The problem is that the Fed regulators looked at their risk-weighted number and it was pretty good, and they looked at their assets and they were all risk-free or low risk. When that’s the examination, life is good and you go on”—Mr. Hoenig pauses, looks down and mumbles—“and then there you go.”
The Fed knew the duration-risk problem was developing long before SVB hit the panic button. A second-quarter 2022 report from the Kansas City Fed notes that “since year-end 2019, U.S. commercial banks increased securities holdings by $2.0 trillion. . . . The increased holdings were in longer-dated maturities, extending portfolio duration and exposing banks to heightened interest rate risk.” The report notes that rising interest rates have “led to historically high unrealized losses on banks’ available-for-sale (AFS) securities portfolios.”
But thanks to regulatory capital rules crafted in Washington, there was a fix. Losses in securities that are designated “held to maturity,” or HTM, according to the rule, don’t need to be recognized when totaling regulatory capital. Those assets are counted by their value at maturity, not in the current market. “To mitigate the impact on regulatory capital,” the report says, the biggest banks “shifted the composition of their securities portfolio away from AFS” and toward HTM.
Non-giants like Silicon Valley Bank have it even easier. They don’t have to recognize unrealized losses, even from AFS assets, in their capital accounts. But the bill came due when SVB had to sell assets at a loss to cover deposit withdrawals. That’s when it acknowledged it didn’t have enough capital or liquidity and depositors fled.
No one knows how broad this problem is. The Fed’s launch of the new Bank Term Funding Program, which will lend to banks at par against held-to-maturity assets, is an attempt to calm depositors and markets. It may work if nothing else goes awry—a big if.
“The other thing about risk weight,” Mr. Hoenig says, “is that it’s a political process. It’s not a market process. The market no longer determines capital in the financial, especially in the banking, industry. It’s now politicians, lobbyists and the regulators who have to battle it out among themselves. Therefore you get these nonmarket solutions like risk-weighted capital. And banks are incentivized to increasingly leverage their balance sheets.”
That’s a major source of instability. “In a market system in which there is risk, if I’m a banker and someone gives me a dollar, I put it on the books and I lend it out, or I put it in the liquidity part of my portfolio. So I know how much capital I have. I’m the manager and it’s my job to allocate it for the best interest of my stockholders. That means I better damn well pay attention to liquidity. I shouldn’t need a regulator to tell me that. I know what I have to do.
“But if I say, ‘Well, I’ve got insured deposits, so I don’t need to worry about it, and I can always call in more deposits,’ things aren’t going to end well. I’ve had bankers say, ‘Tom, I can raise $100 million in deposits in two minutes off the broker market.’ But I say they can until they can’t.”
In reflecting on how we got the current panic, Mr. Hoenig sounds like Allan Meltzer. “One of the worst things I think that’s happened, and I’ve watched,” he says, is that “market discipline has atrophied. There is none.” Regulators keep insisting that the banks are “very, very sound.” He allows that bank capital is “certainly better than in 2008.” But “better isn’t adequate,” as we’ve again learned the hard way this week.
Ms. O’Grady is the Journal’s Americas columnist.