Peter Morici: Cracking down on banks now only makes them sitting ducks for next big hit

The drama surrounding Silicon Valley Bank, Republic Bank, PacWest Bancorp and other regional banks is provoking tough talk about implementing tighter banking regulations. Those could do more harm than good and won’t avert another crisis.

Apparently both the White House and Federal Reserve want to reimpose on mid-sized banks stricter Dodd-Frank standards rolled back during the Trump administration. Federal regulators appear inclined toward new rules for liquidity, liability structures and capital.

Households and businesses deposit money in banks for safekeeping and to facilitate transactions. To finance these services and earn profits on shareholder capital, commercial banks mostly make loans and hold Treasury securities, federally backed mortgage securities and other safe assets.

Other than near-dated bonds and loans, those assets are often illiquid, as their immediate market values can change abruptly. Consistent with accounting rules, banks minimize the impacts on the balance sheet by valuing bonds at par — their value at redemption.

That is reasonable if banks have adequate reserves to meet depositor withdrawals and can hold bonds to maturity. However, reserve requirements can rise with interest rates. Business conditions may compel depositors to more rapidly withdraw funds to meet expenses. The Fed boosting interest rates, for example, prompts depositors to invest in short-term securities and money market funds.

No bank is safe if depositors believe it is insolvent and withdraw their funds en masse. Nowadays this can happen with lightning speed, thanks to social media and online banking.

Dodd-Frank encourages all banks to apply more careful lending standards, and banks are relying more on government securities for income. Bank holdings of Treasurys and federally backed mortgage bonds increased to 20% of assets in 2022 from 12% in 2007 (before Dodd-Frank) .

SVB and some other banks went much further. At the end of 2022, SVB had assets of $212 billion and from January to early March 2023, depositors withdrew $68 billion — $42 on its final day of operation. Holding enough reserves and extremely short-dated securities to handle a run, and what may have followed had not the FDIC seized control, would have made the bank unprofitable or at least not profitable enough to justify shareholder investments.

Researchers at Stanford University estimate that as a share of assets, 11% of all U.S. banks took paper losses greater than SVB as interest rates rose in 2022. The entire banking sector lost almost 30% on long-dated securities that will be recouped if those bonds were held to maturity.

Regulators cannot possibly set liquidity requirements high enough to avert short-term liquidity squeezes without rendering small- and medium-sized banks unprofitable, unless banks charge much higher rates for loans. This would encourage disintermediation through money-market funds, commercial credit brokers, fintech and private equity, where ordinary consumers and businesses face less safety.

Capital ideas

Regulators at the Fed are excessively bureaucratic and were slow to act on liquidity issues and encourage remediation at both SVB and Republic. The agency’s ability to execute needs to be improved.

The FDIC adjusts the rates it charges banks on deposits according to risks in their asset profiles, and liquidity is one factor considered. Getting premiums right on illiquidity would be a useful step toward discouraging banks from overloading on long-dated securities and loans.

Higher capital requirements would reduce the losses the FDIC endures when banks fail, but those would similarly reduce bank profitability and drive deposits and lending outside the regulated banking sector.

Instead, Congress should enable the Federal Reserve to make permanent the temporary facility, created in the wake of the SVB collapse, that lends to banks against Treasurys, federally sponsored mortgage securities and other quality assets.

Had SVB and other banks had access to such a facility as interest rates rose in 2022, liquidity squeezes and solvency fears could have been prevented.

Limiting deposit insurance to $250,000 per account does little to discourage moral hazard. It’s unrealistic and counterproductive to expect individual depositors to have the technical expertise or time to evaluate the liquidity and solvency of banks.

Insuring virtually all deposits would require raising the basic FDIC assessment on deposits from 0.05% to 0.1%. That should be manageable for even the smallest banks.

The next punch

Still, these changes will not likely avoid the next major challenge facing banks and federal regulators: commercial real estate. Work-from-home lessens the demand for office space in major cities. As leases expire, tenants are purchasing less space and landlord defaults are rising. Aggravating the situation, commercial construction and renovations have long lead times and projects initiated before the pandemic are adding to inventory.

Small- and medium sized banks account for 38% of all outstanding loans, and commercial property accounts for 67% of their portfolios. A wave of defaults could precipitate a recession no matter what the Fed does. That was not much mentioned at the recent congressional hearings focusing on SVB and bank regulation.

Peter Morici is an economist and emeritus business professor at the University of Maryland.