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US financial regulatory system still broken
When a bank fails in the United States, questions about who is to blame are often directed at many different regulatory agencies, because the system is complex and hard for outsiders to understand. In the wake of the collapse of Silicon Valley Bank, the case for an overhaul could not be stronger
Howard Davies 25 Mar 2023

When a bank fails, attention inevitably turns to its regulators. Who was asleep at the wheel? Who failed to spot the warning signs? The failure of Silicon Valley Bank (SVB) is no exception.

In the United States, these questions are often directed at many different agencies, since the system is complex and hard for outsiders to understand. So, the conclusion is often an inverted form of John F. Kennedy’s famous observation after the Bay of Pigs fiasco, to the effect that “success has many fathers, but failure is an orphan”. American bank failures often have several fathers – all disclaiming paternity.

Congress will get its teeth into the SVB collapse before too long, and we will learn more. In the meantime, a few facts are clear. SVB was exempted by the Trump-era Regulatory Relief Act from enhanced supervision. This means that it did not have to submit to stress tests, for example, which should have exposed its vulnerability to a sharp rise in interest rates. The United Kingdom’s stress test includes a five-point rise in interest rates, which would have revealed – and perhaps prevented – SVB’s maturity mismatch. Moreover, a five-year exemption from the Volcker rule, which prohibits proprietary trading by banks, allowed SVB to invest in venture capital funds. As its website proudly proclaimed: “There are many ways to describe us. Bank is just one.”

SVB’s main regulators were the US Federal Reserve Board, acting through the Federal Reserve Bank of San Francisco, the Federal Deposit Insurance Corporation (FDIC), and, as a state-chartered bank, the California Department of Financial Protection and Innovation, whose name hints at a problematic mix of oversight and promotion. The department’s commissioner is a lawyer with a background in sports organizations.

We know two other possibly relevant facts. When SVB acquired Boston Private Bank in June 2021, the Fed predicted that the merged entity “would not pose significant risks to the financial system in the event of financial distress.” Clearly something had changed since then. And the San Francisco Fed had good insight into SVB’s affairs, since SVB’s CEO was on its board until the bank failed.

Of course, it would be simplistic to claim a causal link between the oddities of the US regulatory system and the problems of any individual bank. But it is instructive to look at what the main actors in the last financial meltdown thought about the regulatory structure through which they were obliged to work.

In his memoir, “Stress Test: Reflections on Financial Crises”, Timothy Geithner, who was president of the New York Fed and later US treasury secretary, noted that “our current oversight regime, with its competing fiefdoms and perverse incentives encouraging firms to shop around for friendly regulation, was an archaic mess”. In his own reflections on that turbulent period, Hank Paulson, Geithner’s predecessor as treasury secretary, argued that the US needed “a better framework that featured less duplication and that restricted the ability of financial firms to pick and choose their own, generally less strict, regulators in a practice known as regulatory arbitrage”. Here was a rare example of bipartisan agreement.

The Dodd-Frank financial reforms, enacted in the wake of the 2008 crisis, did very little to address these structural problems. The Office of Thrift Supervision was merged into the Office of the Comptroller of the Currency, and a new Consumer Financial Protection Bureau was created – adding a further acronym to the alphabet soup. But the rest of the system so disliked by Geithner and Paulson was left intact.

Former Fed chair Paul Volcker continued the fight for simplification until his death at the end of 2019. In 2015, the non-profit Volcker Alliance published a searing indictment of the system and drew up an outline of a more coherent structure.

The key elements were straightforward. The Fed would have beefed-up overarching responsibility for financial stability, and the Financial Stability Oversight Council, which has rapidly rotating membership from all the assorted bodies involved in financial regulation across the country, would be cut back sharply and put under the Fed’s control. And the Securities and Exchange Commission (SEC) and the Commodity Futures Trading Commission (CFTC) would be merged in that restructuring. (The US is the only country where cash securities and their derivatives are regulated by different entities.)

The Volcker Alliance also recommended establishing a new Prudential Supervisory Authority, an independent agency which would incorporate all the prudential functions now carried out by the Fed, the Office of the Comptroller of the Currency, the FDIC, and the SEC and CFTC, which currently oversee broker dealers and indeed money market funds. The result would be “a simpler, clearer, more adaptive, and more resilient regime that would have a mandate to deal with the financial system as it exists now and would be capable of keeping pace with the evolving financial landscape”.

Sadly, Volcker is no longer with us and able to push for reform. But, wherever he is, he may be allowing himself a sad smile about recent events. They amount to further proof that the US system is dysfunctional. The US authorities currently are fire-fighting, and we must all hope they succeed. But, when the short-term crisis is over, they might dust off Volcker’s report. Its analysis reads well today and the recommendations are clear and workable, as one would expect from someone who oversaw the current regulatory thicket for a dozen years. The system still doesn’t work well, and it needs to be fixed before it reveals its shortcomings again.

Howard Davies is the chairman of NatWest Group and a former first chairman of the United Kingdom’s Financial Services Authority, director of the London School of Economics, deputy governor of the Bank of England and director-general of the Confederation of British Industry.

Copyright: Project Syndicate

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