The aftershocks of the collapse of Silicon Valley Bank (SVB), while seemingly fading, are still reverberating around the world. Although Federal Reserve officials have taken pains to assure the public that the US banking system is sound, it is unclear why anyone should believe them. After all, Fed Chair Jerome Powell told Congress the same thing just days before SVB's collapse in March.

In the weeks since then, it was reported that the vaunted stress tests established by the 2010 Dodd-Frank financial reforms did not foresee the drop in value of government bonds caused by the Fed's aggressive interest-rate hikes. A recent study by Erica Jiang and her co-authors found that "marked-to-market bank assets have declined by an average of 10 percent across all the banks" following the Fed's rate increases, "with the bottom 5th percentile experiencing a decline of 20 percent."

While US President Joe Biden has promised to hold accountable those responsible for SVB's collapse, such promises, too, should be greeted with a healthy dose of scepticism. After all, the Obama administration, in which Biden served as vice president, never held any bankers responsible for the 2008 financial crisis.

The fact is that regulators – including the Fed – have failed to keep the banking system safe. Banks depend on trust: depositors need to be confident that they can withdraw their money whenever they want. That has always been true. What has changed is the ease with which billions can be withdrawn in a nano-second online.

Even a whiff of danger that they will not be able to get their money back is enough to cause rational people to withdraw uninsured funds, and even insured amounts, if there is a risk of delay. The result is that when a bank fails, the people left holding the bag are those who have not been paying attention or, like many elderly customers, do not use digital banking services.

The current status quo – under which sophisticated depositors use intermediaries to engage in regulatory arbitrage and guarantee that all of their deposits are insured, or are prepared to withdraw funds above the insured amount at a moment's notice – is no way to run a banking system. To stabilise the sector, policymakers must establish comprehensive deposit insurance, paid for by depositors based on the benefits they derive and the systemic risks they pose. Until that is done, the banking system will remain fragile.

As the head of the government agency responsible for supervising SVB, Powell bears responsibility for the oversight failures that precipitated its collapse. Unlike the massive mortgage-lending fraud that caused the 2008 financial crisis (the extent of which became clear only years later, following numerous lawsuits and other legal actions), SVB's lending seemed sound.

To be sure, even good lending can turn sour in the midst of a significant downturn, and suspicions of dubious activity inevitably arise when so much money is being held in uninsured low-interest accounts. But SVB's problems were more prosaic, and any banking regulator worth their salt should have acted, especially when the regulator was the one creating the risk.

Banks always engage in maturity transformation, turning short-term deposits into long-term investments. While this process is inherently risky, banks are often tempted to gamble their depositors' money if taxpayers directly or indirectly bear the downside risk. This is what SVB did: it invested some customer deposits in long-term, ostensibly safe securities, betting that long-term interest rates would not increase. Supervisors should not allow this to happen, and they should make it a central part of stress testing when it does.

Yet the Fed allowed it to happen, and by neglecting the role of interest-rate hikes in triggering financial-sector fragility, it undermined the efficacy of its own stress tests. In addition to these supervisory errors, SVB's collapse was preceded by regulatory failures, as the Fed under Powell relaxed regulations on banks like SVB, which it considered to be of regional economic significance but not systemically important.

Most people do not have the ability, resources, or access to information needed to assess the soundness of banks. Such assessments are a fundamental public good and, as such, the government's responsibility. If a bank can accept the public's money, the public should have confidence that it can repay it. The US government, particularly the Fed, has failed in that regard.

The Fed, like other independent central banks, jealously guards its credibility. The risk of losing it has been cited as the reason for the Fed's interest-rate hikes of the past year, which went far beyond normalising the ultra-low rates that characterised the post-2008 era. But by failing to recognise the risks posed by its rapid rate increases, and how more than a decade of near-zero interest rates had exacerbated these risks, the Fed undermined its own credibility – precisely the outcome it sought to avoid.

Worse, the rate increases reflect the Fed's misdiagnosis of the source of inflation, which is largely driven by supply-side shocks and demand shifts related to the Covid-19 pandemic and the war in Ukraine. Moreover, short of causing a sharp economic downturn, rising interest rates might actually make inflation worse. A major contributor to increases in the consumer price index is rising rental rates stemming from housing shortages, which higher interest rates exacerbate. Meanwhile, the Fed's disinflation strategy could cause youth unemployment among African-Americans to jump over 20 percent, leaving long-lasting scars on a highly unequal country.

As matters stand, the Fed and its chair have lost credibility on every front. The current crisis has exposed the Fed's failure to address the governance issues that contributed to the 2008 crisis. The fact that SVB CEO Greg Becker sat on the board of the regional Fed that was supposed to supervise his bank is a case in point.

It remains to be seen whether the still-simmering financial turmoil triggered by SVB's collapse will boil over into a deeper crisis, but investors and depositors have no reason to trust the Fed's assurances that it will not. Only meaningful reforms of deposit insurance, governance, regulatory structure, and supervision can restore confidence in banks and the Fed's credibility.

Joseph E Stiglitz, a Nobel laureate in economics, is University Professor at Columbia University and a member of the Independent Commission for the Reform of International Corporate Taxation.

Copyright: Project Syndicate, 2023.
www.project-syndicate.org

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