What went wrong at First Republic Bank

 

By James Surowiecki

 

When the FDIC seized regional bank First Republic this morning and put it into receivership before selling its assets to JPMorgan Chase, it marked the third failure of a regional bank in the past two months, following the collapse of Silicon Valley Bank and Signature Bank in March. These represent three of the four biggest bank failures in U.S. history, and in all of these cases, the FDIC and other government regulators have ensured that none of the depositors in these banks would lose any money (even though FDIC deposit protection applies only to accounts of $250,000 or less).

 

That tells us that something went terribly wrong with bank regulation in the past few years. And a new report published by the Federal Reserve last week shows in great detail that bank regulators treated big regional banks with a light touch, letting them grow too big and take foolish risks, while doing little to rein them in. 

It wasn’t supposed to be this way. Under Dodd-Frank, the bank-regulation bill passed in the wake of the financial crisis, any bank with more than $50 billion in assets was subject to a tougher regulatory regime than small banks were. These banks—which would have included SVB, Signature, and First Republic, since they all had more than $100 billion in assets when they failed—had to run periodic stress tests that would test how they would perform under various scenarios. They were subject to tougher capital and liquidity rules—meaning that they had to keep more capital on their balance sheets, and had to keep enough liquid assets to be able to cover 21 days of withdrawals. And they had to submit so-called living wills, resolution plans in the event of their demise.

These regulations were important, since the stress tests gave both banks and regulators a more realistic portrait of how resilient banks would be in the event of a crisis, while the enhanced capital and liquidity requirements reduced the risk of bank runs by bolstering banks’ balance sheets. But beyond that, applying these rules to regional banks also implicitly sent a message to regulators that these banks were important in the system, and that they should be monitored closely, just as megabanks (like Citigroup, JPMorgan Chase, and Bank of America) were.

 

If the rules Dodd-Frank put in place for regional banks were still in place, it’s very unlikely that we would be talking about bank runs today. But in 2018, thanks to fervent lobbying from the banking industry, Congress enacted a law that significantly weakened government oversight. It raised the threshold for those tougher requirements from $50 billion to $250 billion. And though it allowed the Federal Reserve to put regulations back in place for banks that had between $100 and $250 billion of assets if the Fed thought those rules were necessary, the message to the Fed was clear: Use a lighter touch on regional banks. Not surprisingly, the Fed did not put those regulations back in place.

The impact of the 2018 changes wasn’t just practical: It also translated into bank regulators taking more of a hands-off approach to their supervisory role. Last week, the Federal Reserve published a 100-page postmortem on what happened to Silicon Valley Bank, and the biggest takeaway is that while bank management did an abysmal job of managing risk, the regulators who were supposed to be in charge of supervising the bank didn’t actually do much real supervising. In other words, it wasn’t just that the regulations had been weakened. The Fed’s enforcement of the regulations that were still in place was lax and lacked any bite. 

The most obvious example of this is that when Silicon Valley Bank went under, it had 31 unaddressed citations, which is roughly three times as many as its peer institutions. So, as the report says, “When supervisors did identify vulnerabilities, they did not take sufficient steps to ensure that [the bank] fixed those problems quickly enough.”

 

Some of this could have been solved had Dodd-Frank’s regulations been left in place. If Silicon Valley Bank had been required to maintain the kind of liquidity that megabanks are required to have, it would have limited how much risk-taking it could have done. But even then, we would have needed regulators to step up and enforce the rules.

The lack of enforcement was especially damaging because when you have regulations in place, you create an illusion of safety, one that makes both the institutions themselves and the people lending money to those institutions (including depositors) think they’re better off than they actually are. If there were no FDIC, and no bank regulators, then people would be far more skeptical of banks, and much less likely to give them money. But once you put a regulatory regime in place, you’re sending the message that it’s safe to go in the water. 

But in order for that to work, you need to actually do the regulating. Otherwise, you end up with what we’ve seen over the past two years: depositors flooding banks with cash that the banks didn’t really have any use for and ended up taking bad gambles with, leading in turn to their eventual failure and government-orchestrated bailouts for depositors.

 

The conclusion is, at this point, obvious: If a bank is important enough to the system that the federal government needs to get involved in rescuing all of its depositors, then that bank is important enough to be subject to tougher regulatory requirements and supervision, requirements like those the so-called megabanks are subject to. The catch is that, as the Fed report notes, putting new rules in place  will likely take a while (and probably longer than it should). In the meantime, the Fed has to hope that the contagion that’s taken down these banks doesn’t spread further, and that First Republic turns out to be the last bank failure. Of course, that’s exactly what was said after Silicon Valley Bank and Signature went under.

Fast Company

(12)