The acerbic writer H.L. Mencken observed in a 1936 column:
Under our present laws, [anyone] is free to set up a bank and anyone is free to own stock in it. The Federal Insurance scheme has worked up to now simply because there have been very few bank failures. The next time we have a pestilence of them it will come to grief quickly enough, and if the good banks escape ruin with the bad ones it will be only because the taxpayer foots the bill.
Those words have carried relevance for National Taxpayers Union (NTU) over many decades up until today, when policymakers are discussing increased capital requirements for financial institutions after the Silicon Valley, Signature, and First Republic Banks all failed earlier this year. These standards are one tool that bank regulators utilize to ensure the safety and soundness of the financial system. Overseen by the Federal Deposit Insurance Corporation (FDIC), the Federal Reserve, and the Office of the Comptroller of the Currency in accordance with an international body called the Basel Committee, capital requirements generally involve combinations of risk-weighted assets and leverage ratios (i.e., balance sheet size).
Establishing capital requirements for banks can be complex, but properly balancing the task is important. Set them too low, and taxpayers could be on the hook for more failures from poorly managed banks; set them too high, and taxpayers suffer from a slow economy as the lending needed for worthy investments becomes scarcer.
Would higher capital mandates be the right response to the current bank failures? In NTU’s experience, history would counsel to go slow and consider other steps instead.
During the late 1980s and early 1990s, NTU helped hold politicians accountable for the Savings and Loan crisis and fought to minimize the impact of resulting scandals on taxpayers. In 1989, we helped force the resignation of M. Danny Wall, whose direction of the Office of Thrift Supervision worsened government bailouts. In 1991, NTU championed a congressional provision known as “core banking,” which placed a limit on the total loans outstanding as a percent of a bank’s capital, and capped rates that taxpayer-guaranteed deposits could have paid to comparable U.S. government debt interest rates.
As a response to criticisms of core banking, we offered a compromise plan for a “permissive rate cap,” which would have allowed the Federal Deposit Insurance Corporation to evaluate the soundness of a given institution that wished to offer extraordinarily high interest rates. At the time then-NTU Chairman James Dale Davidson observed that “taxpayers need protection from future bank bailouts” rather than “a multi-billion-dollar invoice.” Ultimately, Congress demurred on these reforms, but over the years, NTU did work with policymakers to revise oversight mechanisms and standard-setting for bank capital. At the same time, NTU warned that Government Sponsored Enterprises (GSEs) like Fannie Mae and Freddie Mac, with weak capital standards and nearly non-existent oversight, presented a grave threat to taxpayers. During testimony before Congress in 1989 and 2000, our concerns were met with derision from lawmakers in both parties, until the GSEs came to grief during the financial crisis of 2008.
Is the past now prologue, with the failure of several banks in less than two months during 2023? Some public officials seem to think so. Michael Barr, Vice Chair for Supervision of the Fed’s Board of Governors, is conducting a “holistic review” of U.S. capital requirements and is expected to propose changes to current capital standards and banking stress test frameworks.
Unfortunately, based on NTU’s long history of involvement in this policy sphere (see above), the answer is not a simple matter of a one-size-fits-all regulatory crackdown. Silicon Valley Bank (SVB), for example, was heavily leveraged in tech investments and notorious for poor management; it is also widely recognized as a victim of interest rate shocks that made its already-anemic balance sheet untenable by the time regulators closed down the institution. As Thomas Kingsley of the American Action Forum neatly summarized:
While the bank’s sudden failure took many by surprise (including apparently its regulatory supervisors), it quickly became apparent that the bank’s abrupt liquidity crisis was the result of a few key factors: weak risk controls and basic business failures by SVB’s management; a lack of oversight by state and federal banking supervisors; and the challenges posed by the macroeconomic environment and in particular the Fed’s quantitative tightening.
The resulting interest rate increases from quantitative tightening were a response to inflationary pressures brought about in part by excessive government spending, which included the ill-advised Inflation Reduction Act. Higher capital standards might have temporarily staved off the crises at these institutions, but not for long. Arguably, stricter rules could even have masked fundamental managerial problems for a greater period of time, making the cleanup all the more expensive.
At the same time, more prudent banks would have been punished by such standards and restricted in their own lending, making the recession that many continue to fear a much nearer reality. Any very limited benefits of imposing higher capital standards would have come at much higher borrowing costs to small businesses, consumers, and ultimately taxpayers.
The recent, accidental disclosure from FDIC that Sequoia, a massive venture capital fund, held over a billion dollars in Silicon Valley Bank, demonstrates one thing clearly: capital standards and federal oversight of financial institutions are vital, but they are no substitute for the ongoing discipline that major depositors and boards of directors must exert on bank managers. Nor can they substitute for fiscal discipline on the part of elected officials, who should know by now the consequences of spending money out of an empty pocket.
Meanwhile, many of those same officials continue to ignore the very real problems with government lending problems right at Washington’s doorstep:
- In February the Federal Housing Finance Agency proposed a new rule to begin unraveling solid capital requirements -- which were still lower than required for some banks -- enacted less than three years ago for mortgage giants Fannie Mae and Freddie Mac. Now approaching their 15th year of federal “conservancy,” with no end in sight, these Government-Sponsored Enterprises triggered a taxpayer bailout when the financial crisis hit in 2008, eventually reaching nearly $200 billion. The relaxed standards are estimated to relieve Fannie and Freddie of more than $5 billion in capital cushion requirements – initially a small amount, but a troubling direction that, in NTU’s view, needs to be reversed.
- The federal Farm Credit System (FCS), also a form of GSE, has repeatedly teetered on the brink of financial disaster since the 1980s. One reason is that Farm Credit System Insurance Corporation doesn’t assess risk-based premiums for the banks and associations it oversees. Unlike FDIC, FCS lenders pay a flat rate for their insurance, regardless of how risky their portfolios may be. Yet, FCS participants are exempt from many of the same laws governing private banks, giving them undeserved competitive advantages.
- Although it may be a worthy way to honor those who have served their country, the Veterans Administration (VA) Loan Guarantee program for home purchases has nonetheless taken on an astonishing load of liabilities in a short period of time. According to an analysis by NTU Foundation’s Demian Brady, “The total outstanding principal supported through this guarantee has skyrocketed from $87 million in 2000 to $394 billion today.” One reason: “Unlike loan guarantees from the Federal Housing Administration, Fannie Mae, and Freddie Mac, there is no down payment requirement through the VA's program.” Shamelessly, Members of Congress often utilize the VA loan guarantee fees as budget gimmicks to offset higher spending that has nothing to do with the integrity of the program itself.
- From flood insurance to student loans to the Export-Import Bank, the federal government fails to utilize the private-sector standard of fair value accounting to ensure that risks of failure are properly estimated. As a result, taxpayers have repeatedly been forced to bail out poor decision-making in these programs. In the case of student loans, however, the Biden Administration even consciously chose to set aside any pretense of financial opprobrium with its “forgiveness” initiative – thereby adding over $570 billion to the national debt.
- Perhaps most relevant, why did the Federal Home Loan Bank (FHLB) network, privately funded but chartered by the government and overseen by the Federal Housing Finance Agency, exercise such poor judgment in lending some $30 billion to SVB and other failed banks? As Kingsley put it, “it is fundamentally difficult to square these loans with the FHLB’s purpose of boosting the country’s mortgage market.”
With glaring, manifest maladies such as these across the entire federalized financing and lending empire, it seems more than a little incongruous for policymakers or regulators to be focusing so much attention on private banking. Many taxpayers would have another word for it: disingenuous.
A more rational, measured response to the recent bank failures is needed now – one that takes a wider view of the financial sector and the economy as a whole. Heavier regulations could reverse economic growth at a time when everyday Americans are just beginning to climb out of the COVID recession as well as the inflationary hole of the past two years. They could also fuel additional, unwelcome rules on innovative financial products that are giving families more opportunities to live the American Dream.
What should be done?
For one, federal spending must be brought under control to reduce the pressure for sudden increases in interest rates. The Fiscal Responsibility Act is the first of many steps Congress will need to take in paring back federal spending growth and thereby stabilizing the long-term interest rates that could keep more banks from finding themselves underwater.
In addition, investors should not be distracted by extraneous public policy initiatives that only make the fundamentals in financial institutions’ balance sheets more difficult to discern. A case in point is the Financial Accounting Standards Board’s latest plan to burden public companies with new public country-by-country reporting of tax liabilities and projections.
Furthermore, Congress must avoid the temptation to create incentives for riskier financial practices, such as by raising the current insurable limit on deposits that FDIC provides. Doing so would short-circuit the accountability by which depositors can hold bank managers to good practices.
Repealing other regulatory relief measures that have benefited taxpayers, such as the Economic Growth, Regulatory Relief, and Consumer Protection Act, would be equally unwise. As Christopher Russo, Republican Chief Economist with Congress’s Joint Economic Committee recently explained, not even the rules prior to that Act could have “positioned SVB to withstand the significant deposit outflows it faced in March 2023 ($142 billion in two days).”
At the same time, public officials can look to policies that help to strengthen banks’ financial positions without resorting to even more restrictive capital standards, when U.S. institutions already have some of the highest such standards in the world. Regulatory frameworks can be built to allow greater availability of private reinsurance products for banks, which provides risk transfer – a benefit for banks’ soundness that regulators should, to the extent they are not already doing so, factor into the calculation of each bank’s risk-based capital requirement. Simpler tax policies, especially at the state level, could allow banks to build long-term reserves.
The Federal Reserve’s own post-mortem report on SVB points to another follow-up item – sharper eyes among existing regulators. The Fed admitted that “[s]upervisors did not fully appreciate the extent of the vulnerabilities as Silicon Valley Bank grew in size and complexity,” and that “[w]hen supervisors did identify vulnerabilities, they did not take sufficient steps to ensure that Silicon Valley Bank fixed those problems quickly enough.” Boosting capital requirements or rolling back regulatory relief would have done nothing to address those two errors.
Taxpayers have a major stake in preventing another bank meltdown. There are many safety valves for doing so that are better designed for the current situation than increased capital standards.