Want to Prevent SVB-Style Collapses? Scrap Dodd-Frank
Frank Dodd is a stupid and ill-conceived piece of legislation. Very complex and largely ineffective.
I agree it should be scrapped. Are the authors right about avoiding SVB-style mistakes? Nope! So long as the regulatory staff (OCC) of the Federales hires morons to watch over financial institutions, little will change. Any 2nd-year business student would have known that a bank with liabilities tied to short-term interest rates (ergo deposit) can't be paired with assets (ergo investments) with long time rates (especially in a rising interest rate environment. Talk about a rookie mistake!
Likewise, did the staff of the SEC catch Bernie Madoff after years of being tipped off by a host of accountants that suspected wrongdoing? Nope again!
Want to Prevent SVB-Style Collapses? Scrap Dodd-Frank
Stress tests have made the banking system less varied and resilient, particularly to regulatory errors.
By Michael Faulkender and Tyler Goodspeed, WSJ
March 20, 2023 6:00 pm ET
Rep. Barney Frank and Sen. Christopher Dodd speak to reporters outside the White House, May 21, 2010.
Efforts to make the U.S. banking system less risky have had the opposite effect. Since the 2008-09 financial crisis, the largest banks have started to look more alike. The stress testing mandated by the Dodd-Frank Act led banks to diversify in the same way, which elevated systemic risk even as individual banks became less risky. The collapse of Silicon Valley Bank is a case in point.
Diversification is an essential feature of a healthy financial system. If banks take different approaches to balancing risks, a loss in one’s portfolio is less likely to mean a loss in another’s. If one bank goes down in an economic shock, it doesn’t mean others will follow.
But a recent study from the Boston Federal Reserve found that banks that performed poorly on the mandated Dodd-Frank stress tests subsequently adjusted their portfolios such that they more closely resembled the portfolios of banks that performed well. The average institution’s portfolio is more diversified, but the system is more uniform. By requiring all of the biggest financial institutions to adhere to the same measures, pass the same tests and follow the same practices, America has lost diversification in the entire banking sector.
This means that if something brings down one major bank, others are more likely to fall, snowballing into a major financial system collapse. This could be set off by a macroeconomic shock—such as the worst inflation in 40 years—or by a regulatory mistake. Even a small error in government rules, such as model or parameter misspecification, will be multiplied across the entire financial architecture. And if the regulations contain plain bad policy, it could be systemic.
SVB’s fall shows this is a real possibility. In the wake of the bank’s collapse, numerous commentators were quick to blame the Economic Growth, Regulatory Relief and Consumer Protection Act of 2018 for raising the asset threshold for mandated stress testing from $50 billion to $250 billion. This was wrong for two reasons. First, the 2018 law retained the Federal Reserve’s discretionary authority to conduct enhanced stress tests on banks with assets above $100 billion, and the Fed did so in 2022.
Second and more important, government tests would have missed what led to SVB’s collapse—interest-rate risk. The bank had filled its portfolio with far too many long-term government bonds when interest rates were low and so was crippled when withdrawals forced it to sell those securities after rates spiked. Yet SVB would have sailed through the February 2022 stress test because the central bank hadn’t adjusted its scenarios for monetary realities, as Jason Mason and Kris Mitchener have noted in these pages. Regulators asked banks to assess their resiliency in a “severely adverse scenario” in which the three-month Treasury rate was near zero and the 10-year Treasury yield declined to 0.75%.
With tests like that, it’s a small wonder we haven’t seen far more SVB-like collapses. By 2023, 10-year Treasury yields rose well above the severe scenario in the 2022 stress tests. Rather than 6% losses on the value of 0.75% coupon 10-year Treasurys from yields rising to 1.5%, actual losses were in excess of 20% because yields rose to 4%.
The premise of the Dodd-Frank regulatory scheme was that super-regulators would monitor sources of risk and pre-empt individual banks’ risk mismanagement. SVB’s failure demonstrates that this simply isn’t possible; regulators can’t anticipate all risks. And because the regulatory scheme forces banks to become more similar, the government’s inevitable errors will reach across the financial system—as will any economic shocks.
The solution is to scrap Dodd-Frank’s micromanagement of banks and simply require greater capital levels. That would discourage individual banks from taking on excessive risk without making the entire system fragile.
Mr. Faulkender is a professor of finance at the University of Maryland. He served as assistant Treasury secretary for economic policy, 2019-21. Mr. Goodspeed is a fellow at Stanford University’s Hoover Institution and chief economist at Greenmantle LLC, a consulting firm. He was chairman of the White House Council of Economic Advisers, 2020-21.