Predictably, Bank Regulators Have Flunked The Moral Hazard Test Yet Again

Originally published at AmericanBanker.com

Still reeling from the Silicon Valley Bank failure, America’s banking system is in a state of flux unseen since the Great Recession.

For the first 24 hours after the federal government shut down Silicon Valley Bank, it seemed like regulators were doing the right thing—pay off the insured depositors and liquidate assets to pay the uninsured ones (an estimated 90 cents on the dollar), with the bank’s lenders and shareholders most likely losing everything.

As the former president and CEO of LaSalle National Bank (later sold to Bank of America), I was disappointed but not surprised when, within 48 hours, regulators reversed course and provided a full bailout of all depositors up front. In doing so, they failed the test.

By “test,” I mean the concept of moral hazard. For centuries, human beings have known the perils of moral hazard—the lack of incentive to guard against risk when protected from its consequences—and yet, for centuries, we have failed to put our common understanding into practice. When banks, depositors, and shareholders assume they will be bailed out even for exceptionally risky behavior (“heads they win, tails taxpayers lose”), then deposits and lending will grow faster at banks that can earn more—and pay more for deposits—by taking on riskier assets.

It is well understood that, if lenders to banks, shareholders, and large depositors (who are also “first-in-line lenders”) know they are at risk, then they will impose what is called “market discipline.” In other words, it will be in their best interest to understand the level of risk that the bank is assuming in order to serve as a monitoring, moderating force.

This is all well and good, but it ignores the political and bureaucratic incentives for regulators to step in as “rescuers,” in part to protect their own jobs but also constituencies important to them. They argue, as was the case with Silicon Valley Bank, that the stability of the entire banking system requires them to act. But, through bailouts and other regulatory actions, individuals other than those who reap the rewards for risky behavior end up paying the price. The losers are always American taxpayers and the customers of better-run banks. 

Of course, in extreme cases, a certain level of regulatory intervention is necessary. In 2007 and 2008, the mortgage meltdown created “systemic risk” for all of us. Democrats and Republicans agreed that the mortgage crisis required federal action.

But government intervention is not the best approach during all crises. To the contrary, moral hazard is a more serious problem in most cases. “Solutions” like bailouts become problems in themselves, making the ultimate problem of moral hazard worse in the long run.

I harken back to a conversation of mine with a governor of the Bank of England in 1974. I was a young banker, posted to our London office across Threadneedle Street from the Bank of England. At the time, we were meeting with several officials to discuss a potential acquisition. We were also a year into the global recession that lasted from 1973 to 1975.

With the panache emblematic of employment at a financial institution that has dealt with banking crises since the beginning of the British Empire, this particular governor told me that the Bank of England knew the right answer to the test dating back centuries. The Bank recognized the downsides of moral hazard, and yet decided to intervene time and time again. To convince the U.K. market that the Bank would no longer intervene, its governors helped enact a law “forbidding” them from bailing out failing banks, while protecting their shareholders and depositors.

Then, this governor laughed and said, which I remember to this day, “But of course, the next time a banking crisis hit, we went back and got the law suspended.” 

Recognizing that bailouts fly in the face of market discipline, U.S. financial regulators created the concept of “Systemically Important Financial Institutions” (SIFIs)—a handful of banks deemed too big to fail. At the time of Silicon Valley Bank’s failure, there were 30 SIFIs around the world.

Do you know which bank didn’t even come close to making the SIFI list as “too big to fail”? Silicon Valley Bank. 

When the next banking crisis hits the United States, let’s hope that we pass the test. But, if history is any indication, Americans can expect a failing grade.