Recent failures revive questions of moral hazard and TBTF

Ho Hum. Just another gathering of academicians to hash out the latest tweaks in rulemaking for banks and their regulators. Well, not quite. This was no yawner..The occasion was a public forum, convened by the University of Minnesota's Heller-Hurwicz Economics Institute and billed as "Here we go again: Silicon Valley Bank and the current banking crisis." Just three weeks earlier, the bank and New York City's Signature Bank had collapsed. Barely more than a month later, First Republic Bank in San Francisco failed. Ranked by assets unadjusted for inflation, these were three of the four largest bank failures in U.S. history..The forum's participants were economists — panelists V.V. Chari and Christopher Phelan from the University of Minnesota and moderator Terry Fitzgerald, recently retired from a top position at the Federal Reserve Bank of Minneapolis. Chari and Phelan were emotional at times — frustrated, resigned, angry — about the financial regulatory system's apparent indifference to the problem of moral hazard..That's the idea that individuals or institutions are less incentivized to care about the risks managers are taking in deploying their assets when they know these resources will be fully protected against losses. Analyzing and raising concerns about moral hazard has been at or near the top of the Minneapolis Fed's agenda for many years..At Silicon Valley Bank, 96 percent of the deposits were not covered by the FDIC as of Dec. 31. Regulators, fearing the bank's troubles could spread, decided two days after the SVB and Signature failures to extend deposit insurance to cover all uninsured depositors at both banks. "They just guaranteed everything," Phelan told the audience. "There's no way we're ever going to be able to convince anyone, for the next 20 or 30 years, that [if you put your money in a U.S. bank] you should look at what the managers are doing with that money … no way.".Such frustration by moral hazard critics has only grown since the Heller-Hurwicz meeting, as pressures to raise or even eliminate the caps on deposit insurance have increased. Citing the new bank failures, FDIC chair Martin Gruenberg floated a proposal to allow higher or unlimited deposit coverage of business accounts. Days later, iconic investor Warren Buffett took the occasion of his Berkshire Hathaway annual meeting to declare that bank runs would have been "catastrophic" throughout the financial system but for the regulators' intervention to cover all of the deposits at the Silicon Valley and Signature Banks..The 16th largest U.S. bank by assets at the time of its failure, SVB was a complex institution with close ties to the nation's largest and most influential venture capital and technology firms. An investigation led by the Fed's vice chair for supervision concluded that staffers from the San Francisco Fed, the bank's primary regulator, should have acted more aggressively to fix the problems at the bank. Chari was unsparingly harsh. "This is extraordinary incompetence by the San Francisco Fed," he told the audience..SVB's travails mounted after its officers seriously bungled interest rate risk. News of its shaky condition spread rapidly, spurring uninsured depositors to rush to the bank to get their money out in the country's first "Twitter bank run." Once the run on the bank began, Chari said, it was too late for regulators to act in a measured way; "regulatory panic" quickly set in..Noah Wilcox, 2020-21 chair of the Independent Community Bankers of America, feels there are too many cooks in the regulatory kitchen and sees the eased regulations on smaller banks in 2019 as minimal relief. But he agrees with the Minneapolis Fed's concern about the risks at larger banks. "The big banks are chock full of moral hazard," said Wilcox, who heads the $400 million Wilcox Bancshares in Grand Rapids, Minn..The Heller-Hurwicz meeting was mindful of the seasoned alliance of economists at the University and the Minneapolis Fed. For decades, they have been on the leading edge of research and recommendations about how to curb moral hazard in financial regulation and to end the related problem of banks deemed too big or complicated to fail. This work won renewed attention in 2016 when Neel Kashkari, who had just been named president of the Minneapolis Fed, staged a series of splashy "Ending Too Big To Fail" symposiums that featured big-name economists including former Fed chair Ben Bernanke..The result was the "Minneapolis Plan," which proposed to reduce sharply the risks of bailouts and financial contagion by ending regulators' designations of large and complicated banks as too big to fail. To reach that goal, the plan lessened the likelihood of too much risk at large banks by requiring those with more than $250 billion in assets to boost their equity levels to 23 percent of their risk-weighted assets — substantially more than their equity was then or is now..The plan also proposed taxing the debt held by "shadow banks" — hedge and private equity funds, asset managers and other financial entities that don't face bank-like supervision and regulation. The argument for this levy was that if regulators make it harder for traditional banks to get bailouts, their riskiest activities will move to the less regulated shadow bank sector unless that sector is taxed..The Minneapolis Plan required congressional approval, but a bill was never introduced in Congress. By the time the plan was released, at the end of 2017, proposals for deregulation were picking up steam..Louis Johnston, an economist at the College of St. Benedict and St. John's University in Collegeville, Minn., has backed the Minneapolis Plan's recommendation that the largest banks be required to hold much more capital. He said many other economists also support higher capital requirements for these banks..Johnston thinks the Minneapolis Plan failed to win broad support partly because the regulatory community is dominated by lawyers who often favor complex rules-based regulations that can take years to draft. A better alternative would be a principles-based philosophy that stresses regulation based on standards such as understandability, readability and relevance. He points to the work of Richard Bookstaber, a risk management expert whose 2007 book "A Demon of Our Own Design" foreshadowed the financial crisis. "Risk management regulation in the U.S. is a failure," Bookstaber told Financial Times readers in an op-ed the day after First Republic failed..Gary Stern, the now-retired Minneapolis Fed president who led the bank from 1985 until 2009, was in the audience at the Heller-Hurwicz gathering. Later, in an interview for this story, Stern was asked why the plan didn't win more support. He speculated that large banks "pushed very hard against it" but added that there can be honest disagreement about how much equity capital large banks should be required to hold..Stern echoed the concerns of Chari and Phelan about moral hazard and shared their criticism of the San Francisco Fed for failing to intervene earlier at the SVB. "The regulators saw the problems," Stern said. "They didn't insist that the bank's managers address them. It's ridiculous.".Many economists warn that the current regulatory system remains vulnerable to instability that can shake the financial system and imperil the economy. They cite recurring crises: the Continental Illinois Bank failure in 1984; the failure of more than 1,000 savings & loan associations in the late 1980s and early 1990s, and the contagion that led to the bailouts and deep recession that came with the 2008-09 financial crisis..In 2004, Gary Stern and Ron Feldman, now the Minneapolis Fed's chief operating officer, wrote a book aptly titled "Too Big to Fail." They suggested "systemic focused supervision" to identify, contain and fix problems at large, complicated and intertwined financial institutions before their troubles threaten the entire system..Stern said the move to guarantee all of the deposits at the Silicon Valley Bank suggests that the concern about moral hazard will become more difficult to address in days to come than when his book came out. He agreed with Phelan that the FDIC's practice of covering only the first $250,000 of deposits has become meaningless. "As far as I can tell, our book fell on deaf ears," Stern said..Building regional research partnerships.The Federal Reserve Bank of Minneapolis has become a center for the study of moral hazard, banks designated as too big to fail and rational expectations theory. The Fed's other regional banks also built up specialized research. But decentralizing this capacity for research took decades..Art Rolnick, the Minneapolis Fed's research director from 1985 until he retired in 2010, said leaders at the central bank's headquarters in Washington did not welcome independent research at the regional affiliates when he joined the bank in 1970..Rolnick said the St. Louis Federal Reserve Bank led this shift, becoming one of the first of the Fed's affiliates to establish a research department with ties to academia. In the 1970s, the other regional banks began building partnerships with university economists. In New York, the Fed paired up with various Ivy League schools; in Boston, with Harvard and MIT; in Chicago, with the University of Chicago and Northwestern..The Minneapolis Fed's partnership with the University of Minnesota became one of the earliest and eventually strongest of these alliances. Nine of the university's 22 Nobel laureates came from the school's economics department. Many economists shuttled between the campus and the Minneapolis Fed..The alliance provided fertile ground for work on moral hazard. In the late 1970s, economists Neil Wallace and John Kareken began studying the deposit insurance system. Their work, and that of others later, helped to pave the way for adjustments to the system. Then came the research on the Too Big to Fail problem, and later work on a smorgasbord of other topics, including economic disparities, taxation, early childhood education, sovereign debt crises, taxation and fiscal and monetary policy..Rolnick said the idea has always been that economic research should influence economic policy, and vice versa..Dave Beal is a longtime business columnist and former business editor for the St. Paul, Minn., Pioneer Press.