American Enterprise Institute roundtable on addressing the underlying causes of the banking crisis of 2023

• Published date: 01 June 2023
• Author: Paul Kupiec
• Date: 01 June 2023
• DOI: http://doi.org/10.1111/jacf.12568

DOI: 10.1111/jacf.12568

ORIGINAL ARTICLE

American Enterprise Institute roundtable on addressing the underlying

causes of the banking crisis of 2023

Panelists: Charles Calomiris, Henry Kaufman Professor of Financial Institutions, Columbia

University; Andrew Levin, Professor, Dartmouth College; Bill Nelson, Chief Economist, Bank

Policy Institute; Alex J. Pollock, Senior Fellow, Mises Institute; Moderator: Paul Kupiec, Senior

Fellow, American Enterprise Institute

Paul Kupiec

Correspondence

Paul Kupiec, SeniorFellow, American Enterprise Institute, 1789 Massachusettes Ave NW,Washington DC, 20036.

Email: paul.kupiec@aei.org

This Roundtable was held on May 9, 2023 at the American Enterprise Institute in Washington,D.C. Event page:

https://www.aei.org/events/addressing-the-underlying-causes-of-the-banking-crisis-of-2023

INTRODUCTION

Paul Ku piec: I’m Paul Kupiec, a Senior Fellowat AEI, and I want

to welcome everyone to AEI and today’s event, “Addressing the

Underlying Causes of the Banking Crisis of 2023.”

In June 2017, then Fed Chair Janet Yellen said that, thanks to

enhanced Dodd Frank regulation, she did not believe there would

be a new f‌inancial crisis in her lifetime. And on several recent

occasions, Fed Chair Powell and Vice Chair Barr echoed Secre-

tary Yellen’s assurance that the banking system is sound and well

capitalized.

These off‌icial statements notwithstanding, at the direction of

the Biden administration’s Financial Stability Oversight Council,

or FSOC, the Federal Reserve launched a project to add new cli-

mate change stress test capital requirements for the largest banks.

Stress tests are an opaque tool that facilitates “stealth regulation.”

Banking agencies can use the results of these hypothetical mod-

eling exercises to require banks to do an administration’s bidding

under the guise that regulators are preventing imaginary “systemic

risks” that will never materialize.

Before the banking panic that began in early March of this

year, addressing real or imaginary climate-change banking sys-

tem risk was job one on the Biden administration’s Fed “honey

do” list. Adding new climate change capital requirements and

reimposing Dodd Frank’s enhanced regulations for global system-

ically important banks on smaller banks were the goals motivating

Vice Chair Barr’s holistic review of bank capital requirements.

Ironically, the FSOC and the Fed Board of Governors did

not even mention interest rate risk or contagious bank runs—

the risks that caused the banking panic of 2023—as systemic

risks worthy of concern in their most recent f‌inancial stability

reports.

In a speech here at AEI in December, Vice Chair Barr said,

“Bank capital is strong, but in doing our review,we should and are

being humble about our ability…to predict how a future f‌inancial

crisis might unfold…That humility, that skepticism, will serve us

well in crafting a capital framework that is enduring and effective.”

Well, the Fed got a heaping serving of humble pie in March,

and then again in April, when like so many Fed assurances, its

forecast of banking system resilience turned out to be way too

optimistic. The failures of Silicon Valley Bank and Signature

Bank, and the depositor runs at First Republic and several other

regional banks forced regulators to invoke an emergency systemic

risk exception and provide unlimited deposit insurance protection

to quell depositor panic. And as far as I’m aware, no one has yet

cited climate change as contributing in any way to this systemic

risk event.

What went wrong? Was it a failure of monetary policy,

supervision, regulation? And what changes, if any, are needed?

The fact that it was the Fed Vice Chair of Supervision, Michael

Barr, who spearheaded the Fed’s review of the SVB bank failure

should itself be cause for concern. In contrast to most federal

agencies, the Fed does not have an independent inspector gen-

eral to examine its own mistakes. The Fed, to be sure, has its own

board-appointed IG off‌ice—and the GAO has some investigative

powers. But these arrangements fall well short of the investigative

powers of a truly independent Senate-conf‌irmed IG.

The Fed’s report on the failure of SVB leans heavily on

the innuendo that Barr’s immediate predecessor, former Vice

Chair Randall Quarles, somehow seriously mucked-up the Fed-

eral Reserve Board supervision oversight process when imposing

the regulatory tapering requirements that were part of the 2018

Economic Growth Regulatory Relief and Consumer Protection

Act. But the way I see it, the streamlining of bank supervision

18 © 2023 Cantillon & Mann.J. Appl. Corp. Finance. 2023;35:18–36.wileyonlinelibrary.com/journal/jacf

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associated with Quarles and the 2018 Act had nothing to do with

the failures of SVB, Signature, or First Republic Bank. Federal

banking regulators have ample powers under prompt corrective

action rules and legislation to remedy any serious bank safety and

soundness issues they identify, and the 2018 Act did not diminish

these powers.

The 2022 Federal Reserve Board stress test, the stress testing

requirement that was pared back by the 2018 Act, would not have

identif‌ied interest rate risk as a major issue for these banks. Why?

Because the Fed’s2022 stress scenario for the next banking apoca-

lypse was a steep recession with declining interest rates. And since

none of the institutions that have failed thus far are part of a com-

plex bank holding company, little would have been gained from

the Dodd Frank living will requirements that were set aside for

smaller banks by the 2018 Act.

Given the concentration of uninsured deposit funding in these

institutions, the liquidity risks were obvious for months based on

the regulatory call report data that banks report quarterly. As for

blaming former Vice Chair Quarles, Michael Barr became the

Vice Chairman of Supervision on July 19th, 2022. Instead of

launching his crusade to conquer the specter of climate change sys-

temic risk in the banking system, his holistic capital review would

have better served taxpayers had he focused on assessing less fanci-

ful, more immediate threats to U.S. banks—like interest rate and

liquidity risk.

The FDIC, to be sure, does not escape blame for the Signature

Bank, SVB, or First Republic Bank failures. The FDIC was the

primary federal regulator for both Signature and First Republic

Bank. The FDIC also continues to exercise, and pride itself on,

its role as a backup supervisor. It is empowered to participate in

any examination of a bank, regardless of the bank’sprimar y federal

regulator. In special circumstances, the FDIC also has the author-

ity to conduct its own independent exam should it deem a bank or

its holding company to pose a material risk to the deposit insur-

ance fund. The SVB failure is an example of a situation for which

FDIC backup authority was intended and designed. But even so,

I’ve seen no evidence mentioned that the FDIC was ever aware, or

in any way critical, of the Fed’s lack of vigor in enforcing correc-

tive actions, even though the FDIC’s early warning models should

have identif‌ied SVB bank as a signif‌icant failure risk.

The FDIC’s report suggests that Signature bank’s failure owed

in signif‌icant part to staff‌ing shortages at the FDIC’s NY regional

off‌ice. The report suggests that it was more attractive for examin-

ers to take a job in DC and work from home during COVID than

to be a bank examiner in the New Yorkoff‌ice. We have yet to hear

the FDIC’s explanation for the failure of First Republic Bank.

Given the post-2008 changes in the way the Federal Reserve

implements monetary policy, the FDIC is perhaps the only party

with enough authority, at least in theory, to keep the Fed and the

OCC bank supervisors on the straight and narrow. But recent

events demonstrate the wisdom of a famous Yogi Berra-ism, “In

theory, there is no difference between theory and practice. In

practice, there is.”

The Fed’s adoption of a corridor monetary policy system and

QE have resulted in a situation where the Fed today pays interest

on an enormous amount of bank excess reserves. One unintended

and unfortunate victim of these Fed policies has been the indi-

rect oversight and discipline that was once provided by the federal

funds market. Before the corridor system and QE, banks used to

lend excess reserves amongst themselves. These uncollateralized

loans left banks at risk in the event a borrowing bank defaulted.

Consequently, banks used to monitor each other for signs of

weakness and distress.

Under this system, a bank’s inability to borrow federal funds

was an early warning, signaling distress to the bank supervisors,

often possibly alerting them to problems they had no inkling

of. But today’s central counterparty clearing and the demise of

a functioning federal funds market work in tandem with the Fed’s

monetary operating policy to greatly diminish bank incentives to

monitor the creditworthiness of other banks. Which means that

today, more than ever, we are relying on bank regulators to assess

the risk of banks.

Speaking of interest rate risk, it’s astonishing that the Federal

Reserve Board could be blind to interest rate risk in the banks it

supervises, when the Federal Reserve system itself has experienced

a $1 trillion loss—an unrealized loss, to be sure—on its held to

maturity portfolio because of an increase in interest rates. More-

over, the Fed is experiencing roughly $9 billion a month in actual

cash operating losses. Like some of the banks the Fed and FDIC

supervise, the Fed is paying a higher interest rate on the money

it borrows to f‌inance the $8.1 trillion worth of securities in its

portfolio than the yield it earns on the securities in that portfolio.

Federal bank examiners had plenty of warning about, and could

have used their extensive powers preemptively to reduce, what

now clearly seems to have been the reckless level of interest rate

risk at SVB. The same is true of the FDIC at First Republic and

Signature Bank. But for whatever reason, federal bank supervi-

sors did not exercise these powers. My experience suggests that

bank supervisors are often reluctant to impose sanctions before

they can point to evidence of actual realized losses. The losses in

these troubled banks were so-called “unrecognized losses,” mark-

to-market losses on their long-maturity f‌ixed-rate securities and

loan portfolios.

Because of their simultaneous failures, SVB and Signature

Bank sparked runs at other regional banks, many of which also

had large unrecognized mark-to-market losses on their long-

maturity f‌ixed-rate securities and mortgage loans. The Federal

Reserve Board, the FDIC board, and Secretary Yellen all agreed

to invoke a systemic risk exception for these two banks, and

to extend an FDIC blanket insurance guarantee on all deposits

in SVB and Signature Bank, regardless of deposit size. In addi-

tion, Secretary Yellen implied that the blanket deposit guarantee

would be extended to other banks if authorities deemed it

necessary.

Under normal rules, SVB and Signature Bank, could have

been resolved without any losses to the Federal Deposit Insurance

Fund. And let me repeat that: the outcome of these two failures

under FDICIA’s least-cost resolution mandate would have been

zero losses to the FDIC because the vast majority of deposits in

both banks were uninsured. The blanket deposit guarantee raised

the SVB resolution cost to at least $20 billion, and it cost the Sig-

nature Bank rescue something like $2 billion. The FDIC is now

debating how it will recoup these losses. For reasons that elude

me, they appear to be thinking large banks should pay for these

losses, even though well-managed large banks had nothing to do

with these two bank failures.