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Kartik B Athreya

Learning from (Banking) Failure

headshot of Kartik Athreya
Oct. 4, 2023

Kartik Athreya

Executive Vice President and Director of Research

Economics Club at Iowa State University

Thank you for the kind invitation to this great event; it is truly a pleasure.

Let me start with what I was asked to comment on: Bank failures in the spring led some observers to claim that regulatory failure was responsible, whether due to lax rules or insufficient enforcement of existing regulations. With several large regional banks being downgraded, what should the regulatory role be going forward? Is there systemic risk that threatens banks due to rising inflation and interest rates, and to what extent is the Federal Reserve able or willing to address those risks? Did the 100 percent insurance of bank deposits over $250,000 create or ease risks of bank failure?

These are all deeply relevant questions, and some have been addressed more formally recently — and I'd direct you to the Barr report as a start. In that context, I want to use my time tonight to offer some personal thinking about the broader issues raised in these questions. And I do mean personal! The views I'll express are solely my own and do not represent those of the Federal Reserve Bank of Richmond or those of the Federal Reserve System.

I want to make three points: First, the fight in banking is, as the Talking Heads might say, "same as it ever was." Second, contra those amazing mechanical marvels, the Transformers, when it comes to the events of Spring 2023, there may be less than meets the eye. Third, beware the ratchet.

Point 1: Same as it ever was. The events of the spring and since represent punches thrown in the most recent round of a financial intermediation boxing match that has been going for about 200 years or more in the U.S., and elsewhere in the world for longer. The fact that both fighters — the regulators and the regulated — are still standing and trading blows (typically courteous ones, to be clear) indicates a mild form of success: Stalemates sometimes just represent a yin and yang tension balancing benefits and costs.

We've had deposit insurance for about 100 years, and now banks fail only once in a while. The FDIC cleans things up quickly, usually over a weekend, and we move on. Sometimes, banks fail spectacularly, or banks and nonbanks-doing-banking fail en masse, and we wring our hands about what to do. Some say more regulation and oversight is key, especially if a nondepository is quacking like one. Some will urge us to require more capital for all — or place related restrictions on the liabilities of banks, such as using longer-term debt to fund longer-term assets, or allowing banks to sometimes suspend withdrawal requests, and so on. Others will tell us that such moves will throttle financial intermediation, increase the cost of funding, and hurt American economic dynamism. Some will argue for the extension of deposit insurance to scotch the ability of rumors and fears to kill an otherwise healthy entity. Others will counter with the point that this will mean more moral hazard as neither bank management nor depositors have skin in the game. Some will say that regulations intended to prevent large failures raise red tape and costs for smaller banks disproportionately. And so on.

Here's the thing: Everyone has a point. Each solution carries benefits and costs, usually uneven in impact. Yet when I look at where we are, I see a system doing something not too badly given the incredible complexity and variety of the American banking landscape — our 4,000-plus banks, of essentially every size, scope, and complexity, being unique in advanced economies.

That noted, for regulators like the Fed, it is no doubt healthy to ask if our own supervisory efforts were up to even our own standards. The phrase "lessons learned" pops up. Of course, this asks us to establish what we should have seen before in real time were it not for our processes and behaviors. Yet, those processes and behavior were hardly arbitrary: They surely reflected a balancing of risks and hence of the puts and takes I mention above. Just because you missed a flight doesn't mean you should change when you usually get to the airport. So, there perhaps is a bias to reaction that we need to keep in mind.1

Point 2: Silicon Valley Bank (SVB) and the rest: less than meets the eye? Yes, it is true that SVB, among the others that failed, had a lot of uninsured deposits, more than 90 percent, at peak. Yes, it's true that some had a few giant funders. Yes, extreme maturity mismatch seemed clear. So far, so bad, we might say.

But the economics is not entirely obvious. One facet of banking is that management needs oversight — with market discipline being one source. Banking at its best is about information-intensive lending and may thus be open to gaps in information between those running it and those funding it. Classic papers have shown us how uninsured deposits and the threat of a run might actually discipline bank management. This is important because it at least starts with the data: We see bank depositors forgoing the comfort of deposit insurance, and now we have a possible reason — even outside feeling implicitly protected by the taxpayer.

Next, consider asset-liability mismatch. Start with the good news — SVB, among many, held almost only the safest kinds of assets when it comes to credit risk: Treasuries and agency MBS. So, you might say they were not running a full-blown casino.

Add to all this the unprecedented speed of interest rate normalization by the Fed, and it's not hard to tell a story where the kind of inattention that prevailed following a decade of placid times, followed by a booming recovery from the pandemic, would have left a lot of parties — bank management, depositors, and regulators among them — not quite sure of how well, or maladapted, their business models really were. Think back to January 2022: If we said to any bank, you need to be prepared for a 450 bps-plus rise in rates within 12 months. As Richmond Fed work has documented — this was an extremely quick normalization of policy.

How about the asset side of the entities? Well, as I noted, those were pretty gold plated and, held to maturity, would deliver the goods. Only in a run would they need to be sold at the now-much-lower market prices that prevailed. But if the deposit base was concentrated, and known to management and each other, why would one suspect a run even once mark-to-market value was lost?

Still, it seems undeniable that SVB and the others that failed did take on risk: long-term assets, large uninsured deposits, a concentrated customer base, which likely would open the door to correlated reaction and (even) needs. So, the assets look fine, but the combo was in a clear sense risky.

What about the siren of "narrow banking"? Well, SVB already had one part of that locked down: They held a lot of very (very!) safe assets. But this leaves maturity mismatch — their assets were long maturity. An answer here comes from the most recent Nobel Prize winners Doug Diamond and Philip Dybvig, and it is that narrow banking misses out on something socially valuable. Namely, banking can be viewed as a brilliant social invention to provide society with liquidity insurance while letting it benefit from long-gestation investment. So yes, we could make banking safer (at least inside the regulated sphere, which is a point I won't develop further) via insisting on less maturity mismatch. But Diamond and Dybvig tell us that we'd be missing out on the "maturity transformation" that is at the core of the value proposition banking brings us.2

Point 3: Beware the ratchet. Let's now consider the view that banking is in need of really serious beefing up of capital, of regulation, and maybe also of permanently expanded deposit insurance. Our colleagues at the FDIC and elsewhere are thinking about these matters right now, so I don't want to speak confidently ahead of their effort. But I do want to highlight a longer-running dynamic in U.S. banking that almost certainly cannot deliver a long-term solution. And that is to expand forever what is publicly insured and bring ever more into the regulatory remit. Following each blow-up, this proves attractive. And perhaps accounts in part for the extensive safety net, implicit and explicit, we now have.3

This said, we surely need to favor always learning and adapting to improve whatever we are doing; that would be good. Those runs happened very fast, for example — and electronic communication may indeed raise risk of coordinated flight. Also, maybe business is changing, and we do need those payroll accounts to be insured. Maybe 250K is outdated, just because it is not easy to update those numbers unless something happens. All things to sift through and better understand.

As for rescues of failing entities or of the system more generally, a (or the?) rationale for not taking any chances and doing emergency lending (BTFP most recently) is that we prevent contagion and spillovers, most of all from fire sales of the assets of those in trouble. Indeed, absent fire sales, it's harder to think of a reason to save a banking entity, FDIC insured or not.

An alternative exists: It is to ensure that for large or highly interlinked entities especially, the specter of fire sales is reduced. And the way to do this is to ensure that all entities can be "failed" (verb) in an orderly manner. This requires, first of all, a real effort to ensure living wills are serious and credible, even when executed at scale in a major crisis. Work at the Richmond Fed has long championed this path as a valuable part of the toolkit. It requires banking organizations to have a lot of clarity on their own operations, utilize funding sources that are more equity like in crisis — to avoid having to sell assets in a mass rush for the exits, and so on. If you sense the value of greater bank capital here, you're right. But it may be of a contingent kind.

So, as we look back to look ahead, I personally hope our moves as banking and regulatory communities can be ones that acknowledge the state of rough balance I think exists, to learn lessons patiently, and to push for maximally credible "safe-failure" mechanisms.

Thank you.


These remarks were prepared prior to a speech by Governor Miki Bowman, delivered on Monday, Oct. 2, which I would recommend for a view on the same set of issues, here from a member of the Fed's senior-most leadership.


See this Richmond Fed podcast for more explanation on the value of banking as mismatched maturities, and this Richmond Fed essay on the roots of, and mitigants of, banking instability.


At the Richmond Fed, we used to regularly compute a "Bailout Barometer" even!

I thank Huberto Ennis, Zhu Wang, and Lisa White for assisting me with this speech.

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