Want safer banks? Then prepare for slower growth

Underlying problem: A customer is escorted into the SVB headquarters in Santa Clara, California. The safest kind of banking would be no banking at all, at least not banking as it is currently understood. —Reuters

CONGRESS is asking the Federal Reserve and other financial regulators what went wrong at Silicon Valley Bank (SVB) and why they didn’t see it coming.

In due course, they’ll admit some mistakes, draw some lessons and tweak some rules.

But they won’t solve the underlying problem, because the underlying problem is insoluble: Financial stability and economic growth are fundamentally at odds.

Regulators can manage this trade-off, but they can’t repeal it.

Jon Danielsson and Charles Goodhart of the London School of Economics draw attention to what they call a trilemma of financial policy.

Governments want sustained growth, low inflation and financial stability – but can’t expect to secure all three for very long.

After the crash of 2008, loose monetary policy and high asset prices supported growth, but financial stability rested on the assumption that interest rates would stay low.

The longer rates stayed at zero, the bigger the financial risks grew.

When high inflation demanded monetary tightening, the outlook for growth worsened and financial fragilities surfaced.

The safest kind of banking would be no banking at all, at least not banking as it is currently understood.

This is the solution advocated by supporters of the Chicago Plan and its equivalents.

“Narrow banks” would back all deposits available for withdrawal on demand with reserves at the central bank. This would make them run-proof.

Loans and other forms of credit would be extended by other institutions – in effect, by investment trusts backed by equity.

These could collapse if they invested unwisely, but losses would be borne entirely by their investors.A standard objection to narrow banking is that risk would shift from the banks to more lightly regulated lenders.

This might be true of efforts confined to one part of the system, but it misses the larger point: The amount of overall risk in the system is not fixed.

If you squeeze it in one place, it doesn’t necessarily spring up somewhere else.

A sufficiently comprehensive safety-first regimen could indeed diminish risk across the financial sector.

That’s what the pure Chicago Plan (narrow banks plus investment trusts) would aim to do.

It would be a genuinely safer setup, with much less leverage and much more loss-absorbing capital – but it would also make financial intermediation harder and more expensive, especially for the small and medium enterprises that currently rely on bank credit.

There’d be less investment and less growth.

Other policies to discourage leverage could likewise promote safety: much tougher capital and liquidity requirements for “shadow banks” as well as banks, for example, or the elimination of tax preferences for debt (mortgage interest is tax deductible, after all; why should corporate borrowers be able to deduct interest payments but not dividends?).

An economy with less leverage would be safer – but would grow more slowly.

Granted, the SVB debacle does point to some surprisingly simple errors of judgment.

Correcting them might improve the terms of the trade-off, even if the essential trilemma remains.

Regulators were wrong to think only the biggest banks can pose systemic risks.

Smaller banks such as SVB can destabilise the whole financial system by drawing attention to weaknesses that might be widespread.

This can change the prevailing narrative from “everything’s fine” to “we’re in trouble,” roiling asset prices and risk assessments, putting other institutions under pressure, and so on.

Managers and regulators were also wrong to treat long-term government bonds as “safe” – they aren’t, despite zero credit risk.

When interest rates rise, the bonds’ value falls, which can be problematic if the assets need to be sold sooner than planned.

As countless similar episodes have shown, a flight to liquidity can force a lender to sell assets, turning technical insolvency into actual insolvency in no time flat.

(In this case, a “fire sale” didn’t drive asset prices down; they were already down, thanks to the Fed’s monetary policy.)

Regulators have now acknowledged the systemic significance of banks such as SVB.

“I anticipate the need to strengthen capital and liquidity standards” for banks with assets of more than US$100bil (RM442.3bil), the Fed’s vice chair for supervision told the Senate Banking Committee on Tuesday.

From now on, regulators will also take interest-rate risk more seriously.

The likely remedy for their broken risk-weights will be to give total leverage (the ratio of assets to equity, regardless of estimated asset-specific risk) a more prominent role.

No doubt they’ll also debate the scope of deposit insurance and bank executives’ exposure to profit and loss.

All this will be progress if it buys a bit more safety at modest cost in forgone growth – but let’s be clear about the limits.

Making finance “safe” requires either crippling its ability to promote investment and growth, or tolerating the inflation needed to make leverage sustainable.

In the end, learning to manage financial collapses might be more productive than trying to prevent them outright. — Bloomberg

Clive Crook is a Bloomberg Opinion columnist. The views expressed here are the writer’s own.

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