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What was the question you wanted to address when you started your series of essays?

When Silicon Valley Bank failed, it was the first big bank failure since the Global Financial Crisis of 2007-09.

The two factors that coincided for Silicon Valley Bank and really caused the runs were its extraordinary overreliance on uninsured deposits, on the one hand, and the significant amount of unrealized losses the bank had on long-term securities, on the other.

When people started to focus on those unrealized losses on SVB’s books, depositors who weren’t insured by the Federal Deposit Insurance Corporation—the FDIC—began to worry that their money was at risk. It helped create the run. So, the question became, with the benefit of hindsight, what could the bank and its regulators have done to prevent it from becoming such an outlier in both of those categories?

One of the hot topics of discussion was whether regulation or deregulation had been a part of the problem. I thought it would be useful to focus on a specific and answerable question, which is: if specific regulations had been in place and enforced, would they have made a difference?

I’ve looked at three rules so far. Two of them applied to the largest banks but didn’t apply to Silicon Valley under the Federal Reserve’s so-called “tailoring rule,” which implemented a 2018 law passed by Congress. The third was a Basel standard on interest-rate risk that the U.S. never implemented.

The first rule was the liquidity coverage ratio, an important measure that was introduced after the Global Financial Crisis, which says that a bank should have enough very liquid assets to be able to manage outflows under a stress scenario. Essentially, if you experience a really bad 30-day period where you’ve had heightened withdrawals and heightened concerns about your bank, do you have enough assets that you could sell or raise cash off of to meet those demands?

When I ran the calculation for SVB, the number I came up with was 75%. Silicon Valley would’ve had a significant shortfall in that measure if it had applied to the bank.

It’s like an alternate history. You go back and you say, “Imagine if this rule had still applied to Silicon Valley Bank.”

Exactly. And I should add that the Fed’s review of the bank’s failure, the so-called Barr Report, later confirmed that the bank would have had an LCR shortfall. Their estimate for the end of 2022, using confidential data that is not publicly available, was 91%.

So, they wouldn’t have met the threshold. What would’ve happened then? What steps could have been taken?

There are strict requirements if a bank falls out of compliance. There’s an expectation that the bank will get into compliance as soon as possible. Of course, it’s impossible to know exactly what would have happened between the regulators and the bank management, how it would have gotten into compliance, but the U.S. banks that are subject to the rule now average around 125% coverage. When you’re subject to the rule, some combination of risk management, pressure from the regulators, and the fact that you have to release information publicly results in higher liquidity ratios and a better ability to survive market stress.

Still, the bank could have easily boosted its LCR without fixing the problem on its balance sheet, as I noted in the blog. If they had identified the issue early enough, they could have simply transferred assets from long-term mortgage-backed securities to long-term Treasuries to raise the bank’s LCR. But they then would have been just as vulnerable to mark-to-market losses—assets that have lost value and would incur a loss if sold—when interest rates rose.

So there are still a number of issues with the LCR as it stands now. The rules would have to be different to disincentivize banks from holding long-term securities that could fall in value, even if they are high-quality liquid assets. One way is to treat high-quality liquid assets that have long durations differently from those with short durations. So right now, high-quality liquid assets could include a 30-year Treasury bond, which is very, very subject to interest-rate risk, or a four-week Treasury. The rule treats them the same, but they carry very different risks. For Silicon Valley Bank, that was the difference between having billions of dollars of losses or not.

It’s also worth taking a fresh look at the treatment of uninsured deposits in the LCR rule. The runs at SVB greatly exceeded the LCR’s drawdown rates. I suggested in the blog that a revised rule could penalize highly concentrated uninsured deposits. Maybe require banks to hold a portion of their high-quality liquid assets in reserve balances or short-term Treasuries if they have concentrations in uninsured deposits. Like all rule changes, that would require further analysis and, if put in place, a suitable transition.

What was the next measure you looked at?

I looked at the net stable funding ratio. Instead of asking whether you have enough liquid assets to cover outflows, this measure asks whether your liabilities—including deposits—are stable enough to back your assets. In other words, how likely are you to lose your deposits and need to replace them with new sources of funding? In this case, Silicon Valley Bank ended up passing very easily.

However, the fact that it passed, to me, doesn’t mean that they were in good shape, because they were really out on the curve compared to all other banks when it comes to managing their assets and liabilities. It really suggests there’s something wrong with the rule.

Again, this has to do with the treatment of uninsured deposits and held-to-maturity securities. I suggested some penalty for securities with unrealized losses—in other words, a requirement that they have more stable funding. I also suggested an aging effect where if you have a big increase in your uninsured deposits over a short period, you wouldn’t get full credit for those deposits until they had aged. That would be an automatic way to address risks in fast-growing banks. Not to take undue credit, I should note I got this idea from a friend who manages assets at a large financial institution.

The third topic I covered was interest-rate risk. If anything, that should have been the first topic, because everybody agrees that interest-rate risk was what got SVB in trouble. It’s the biggest focus in the Barr Report. What we pointed out in the essay was that there actually is a Basel standard, an international banking standard, that goes back 20 years and was reinforced in 2016, that accounts for the impact rapidly rising or falling interest rates can have on the value of a bank. SVB would have been way out of compliance with this standard. The standard would have required the bank to raise capital or take other actions to reduce its interest-rate risk. But U.S. regulators never implemented it.

I imagine it’s a challenge in trying to understand crises and how to prevent them that you just don’t know if a rule is adequate until something fails.

One reaction that some folks had was that no liquidity rule is good enough when a bank is facing a run. I think that’s the wrong way of looking at it. I mean, if you had a strong enough balance sheet to convince folks that their money was safe, then you wouldn’t have a run. There’s a feedback loop. At some point, if you have a lot of liquidity in your books and you can prove that, then you’re just not going to be the first bank depositors will run.

This work got picked up pretty widely. What’s your sense of why people were interested in it, and why the White House referenced it in calling for stronger safeguards and supervision for large regional banks?

I think that it was good to get the meat on the bone on this argument about whether the old regulations would have made any difference. The Barr Report focused on what supervisors did wrong. They did speak a little about how regulations need to be improved, but they saved the specifics for later.

A lot of people get these two concepts mixed up. Regulation is what’s written down—if it’s a rule, you have to follow it; if it’s guidance, you ought to follow it. Supervision is where the rubber meets the road, where the examiner is meeting the bank and deciding whether the bank is operating in a safe and sound manner. They’re both very important and they feed off of each other; if you don’t have strong enough rules, it makes it harder for examiners to challenge a bank.

In this case, whether you believe that the supervisors had no clue or you believe that they really understood what was going on but were unable to act quickly enough, it seems to me that a rule with clear consequences would have made a difference either way. That is, a rule that said, “this bank passed a threshold; it’s one of 5 or 10 outliers in the whole banking system based on this standard; and here are the consequences—raise capital, or change your asset mix.” There would have been a presumption to take action.

What’s it been like having this unfolding case study of what you’ve been studying in so many different ways for years now?

It feels like the work that we do at YPFS, that we’ve been doing for many years now to prepare to provide advice during crises, is really relevant in times like this. We should try to apply that. We should try to apply what we’ve learned.

How relevant is what you studied at Silicon Valley Bank for the other banks that we’ve seen get in trouble?

That’s really the key question. As soon as one bank fails, the market, quite reasonably, starts looking for the next bank on the list. There was a quickly circulated chart that showed uninsured deposits on one axis and held-to-maturity losses on the other axis. Silicon Valley was up in the upper right as an outlier in both categories across the whole banking sector. There were other dots going down to the left.

It certainly doesn’t suggest that the issues facing Silicon Valley Bank were common. If anything, there’s only a handful of banks in a similar situation. The market’s already focusing on them.

This reinforces the need to reconsider some of these rules. If a bank is managing itself so badly, the repercussions should be fairly automatic. The GAO’s report on the recent bank failures suggested that the regulators consider new prompt corrective action triggers based on various measures of bank health. Prompt corrective action means early, forceful regulatory actions to address specific unsafe banking practices. Today, prompt corrective action only has capital triggers, which are a bit lagging.

Do you think SVB was a systemic risk before the Fed acted?

It was a very large bank. But it didn’t share many of the other characteristics that regulators have used since the crisis to measure systemic importance. It wasn’t particularly interconnected or involved in complex financial activities. The factors, other than size, that made it a systemic risk on that particular weekend were not foreseeable. The risk was systemic because of the fear that other large banks might have the same toxic mix of uninsured deposits and unrealized losses. That suggests that these basic rules around liquidity and interest-rate risk management should be applied pretty broadly for regional banks, not just for banks that you decide are systemic based on some theory or formula.

The banks that are failing now, hopefully, are just the remaining few banks that have really poor interest-rate risk management and the markets will calm down, but I’m not predicting the future.

So you can’t say for sure that we’re out of the woods?

The medium-term concern right now is that, as long as interest rates are high, banks’ profit margins are going to be constrained. The cost of deposits is going up, and a lot of banks are stuck with lower-earning assets. Profitability is going to get worse and worse as long as rates are high. Also, you’ve got growing concerns about commercial real estate. It seems like a long-delayed effect from COVID, but it’s starting to hit the books. That’s a concern especially about the smaller banks. It’s a potential systemic issue that really looks more like the savings and loan and banking crises of the 1980s and 1990s than the Global Financial Crisis.