The abrupt failures of Silicon Valley Bank and Signature Bank and subsequent concerns about the stability of other banks have reignited a fierce debate among lawmakers, the financial industry, the Biden administration and former government officials about an array of banking reforms and regulatory changes.
The ideas floated within a month of Silicon Valley Bank’s collapse on March 10, 2023, range from calls to tweak banking regulations to a major overhaul of the government’s oversight of the banking system.
I’m a finance professor who previously worked for two major banks and was an economist at the Federal Reserve. Based on what I’ve learned from the banking crises that have occurred in the past 40 years, I’d put all the banking reform proposals under consideration into five categories.
1. Stronger supervision
Silicon Valley Bank reportedly ignored six separate warnings from the Federal Reserve Bank of San Francisco that it had too little cash on hand and was engaging in risky practices. So calls for stronger bank supervision and regulation should come as no surprise.
Any such reforms would at least, in part, reverse changes from a law Congress passed in 2018 that loosened some banking regulations.
Previously, the government had to pay especially close attention to banks with at least US$50 billion in assets. Among other things, it needed to subject them to stress tests – in which the authorities assess whether banks have the ability to respond to hypothetical economic shocks – by having enough cash on hand to meet relatively strict capital requirements.
The 2018 law raised the cutoff for what counts as a “systemically important” bank to $250 billion in assets, thus allowing many banks, including SVB, to avoid these more stringent regulations.
The White House has already called for new rules similar to what’s listed above for mid-sized banks — those with $100 billion to $250 billion in assets. SVB, which had about $210 billion in assets, fell in this category before its demise.
Sen. Elizabeth Warren of Massachusetts and Rep. Katie Porter of California have introduced legislation in the Senate and the House of Representatives that would simply repeal the 2018 law, returning the threshold to $50 billion.
Major banking trade groups, such as the Bank Policy Institute, which advocates on behalf of its large-bank members, have argued that the 2018 law was not a major factor in the failures of SVB and Signature Bank.
2. Higher deposit insurance threshold
The role that deposit insurance plays in staving off and alleviating banking crises could also change.
The Federal Deposit Insurance Corp. was only supposed to insure accounts of up to $100,000 during the 2008 financial crisis. But instead, it covered nearly all depositors, uninsured as well as insured, in most bank failures that occurred at that time.
The government subsequently raised that limit to $250,000 in October 2008. But the FDIC once again broke with its official mandate when it protected depositors from losses in excess of that ceiling during the March 2023 bank failures.
Some lawmakers have suggested raising the $250,000 cap on deposit insurance.
Rep. Maxine Waters, the highest-ranking Democrat on the House Financial Services Committee, says she supports that step. And Warren has suggested that she might support new limits that are in the millions of dollars rather than the hundreds of thousands.
“Is it $2 million? Is it $5 million? Is it 10 million?” she said in a television interview.
But those lawmakers have so far stopped short of calling for the FDIC to commit to always fully covering all losses among customers who experience losses when bank failures cause their deposits to vanish – rather than doing so on a case by case basis.
FDIC Chair Martin J. Gruenberg told the Senate Banking Committee during a recent hearing that the insurer plans to release its own proposals on May 1.
3. ‘Modified deposit payoff’
Other proposals go further.
For example, William Isaac, who chaired the FDIC from 1978 to 1986, is calling for the government to insure all non-interest-bearing checking accounts, regardless of size. But he also has a recommendation that might potentially discipline banks that run into trouble.
Isaac distinguishes between deposits that are essentially investments, such as certificates of deposit that people use for long-term savings purposes, and, say, a checking account a customer maintains primarily for basic transactions.
Investors with large sums of money held in CDs are generally wealthy individuals who can either assess financial risks on their own or with input from a paid adviser. People with CDs also have an incentive to leave them with the bank, because withdrawing the money tied up in them before maturity can mean paying a penalty or forfeiting the high interest rates that make them attractive investments.
Isaac also advocates returning to the way uninsured deposits – currently, those above the $250,000 mark – were treated in the 1980s. He calls this the “modified deposit payoff” model.
In resolving a bank failure, the FDIC would cover the full cost of compensating customers with uninsured deposits that don’t pay any interest, yet give uninsured depositors certificates worth 80% of their uninsured funds.
If the government were to recover at least 80% of its cost of covering the uninsured deposits, often by selling failed banks to financial institutions, investors with large deposits at a failed bank would get paid more, Isaac explained in a Wall Street Journal op-ed.
“This reform would protect business accounts that are essential to keeping the economy moving and would reduce substantially the risk of panics,” he wrote.
The most comprehensive proposals that call for restructuring the banking system would use what’s known as a “ring fence” model.
Ring-fencing segregates a portion of bank assets and liabilities from the rest. The United Kingdom already follows this approach.
Since 2019, British banks have had to segregate their retail banking activities from their presumably riskier investment banking and international lending.
The most radical of these proposals would lodge all insured deposits in “narrow banks” which would be allowed to hold only cash and U.S. Treasury securities.
All bank lending activity would occur outside of narrow banks, perhaps in finance companylike firms funded with uninsured borrowing and capital instruments such as stocks and bonds.
Economist Robert Litan wrote a book about narrow-banking in the 1980s, but the idea can be traced back to Milton Friedman – the late University of Chicago economist and Nobel Prize winner.
Banks are typically required to set aside a portion of their deposits as reserves held either as cash or deposits at their local Federal Reserve bank. However, the Fed reduced that share to zero in March 2020 – effectively eliminating the requirement altogether.
Some experts question whether ring-fencing, by preventing the transfer of capital among bank subdivisions, might make banks less flexible in responding to financial shocks – and therefore riskier.
Critics of the narrow-bank model point out that this approach would drastically reduce the amount of money banks could lend. As a result, systemic risks would shift from real banks into “shadow banks” – securities firms, hedge funds and other credit intermediaries that face less regulation and supervision. Shadow banks contributed to the 2007-2009 global financial crisis, according to the International Monetary Fund.
5. Compensation clawbacks
At the heart of the debate about banking reform is “moral hazard.” That’s a concept regarding how insurance can create an incentive to take bigger risks when people, institutions and even countries realize they won’t bear the full cost of that risk.
One way to reduce risks in this context is to make bank executives bear some of the costs when the banks they run fail.
A bipartisan group of senators have introduced a bill to do just that. It would require regulators to claw back compensation, including the bonuses and stock awards paid to bank executives in the five years preceding a failure.
In my view, it’s too early to tell whether policymakers will make minor adjustments or opt for more significant reforms.
One thing that I hope all policymakers will keep in mind is that there are trade-offs between the financial stability of banks and market discipline. Offering too much government support – such as insuring all liabilities in the event of a bank failure – creates incentives for banks and their customers to ignore risks or to engage in risky behavior.
This article was updated to clarify Robert Litan’s contributions to the debate over banking reform.