Failed regulation and even worse enforcement characterize the US banking system – 03/18/2023 – Samuel Pessôa

Failed regulation and even worse enforcement characterize the US banking system – 03/18/2023 – Samuel Pessôa

In the 2008 crisis, the American central bank, known as the Fed, rescued the banks. The Fed bought the mortgage securities that financial institutions held. That is, in the assets of banks, instead of mortgages, there was liquidity. The banks did nothing with this liquidity. Fiscal policy was lacking. Recovery after the crisis was slow, and inflation did not come.

In the pandemic, things turned out very differently. The US government transferred resources to families. Fiscal policy gave an air of grace. These resources turned into deposits from the non-banking private sector in banks.

As interest rates were very low, many banks invested these resources in US Treasury debt securities and long-term mortgage-backed securities. These papers pay interest higher than the remuneration of deposits. That’s how the bank made money.

A long-term bond pays, with a certain periodicity, a certain amount, both established in the contract. At maturity, the issuer buys back the security for a certain price, also established in the contract. When the bond is issued, the acquisition price will be given by the market according to the interest rates in effect at that time: the investor can buy the bond or leave the money yielding on the market. The price paid will be the one that balances the two options (controlled by the risk of the different options).

The bank that went bankrupt two weeks ago, Silicon Valley Bank (SVB), had demand deposits as obligations. His investments were in long-term bonds. Treasury and mortgage-backed securities are highly liquid. If a depositor wants to withdraw funds, the bonds are sold.

In the pandemic crisis, inflation came. And it came strong. Interest rates went up.

It is worth remembering: the price of a long-term bond is that value that generates in the market, given the prevailing interest rates at a given moment in time, an income stream equivalent to the bond payments as established by the contract. If interest rates rise, considering that the bond’s payment flow is given, its price will fall: the higher market interest rates will cause a smaller amount of resources to generate an income stream equivalent to the contractual ones.

The rise in US interest rates has greatly reduced the value of SVB’s assets. A significant portion of SVB’s deposits exceeded US$ 250,000, the limit guaranteed by the deposit insurance. The bank’s fragility, even having invested the resources in papers with no risk of default, that is, safe papers, generated a bank run.

Recent work has documented that the exposure of American banks to this problem corresponds to 3% of GDP. The government has already secured the deposits and, through this channel, the bank run must be stopped.

Evidently, we are still in the middle of the process and it is not possible to know its full extent.

However, it is possible to assure that American banking regulation is very flawed.

After the 2008 crisis, the US Congress approved, in 2010, the Dodd-Frank Act. In 2018, Congress loosened some regulatory limits of the 2010 law, mainly for banks whose assets ranged from US$ 50 billion to US$ 250 billion, exactly the case of SVB.

In particular, banks in this asset range were exempted from participating in the annual stress test.

The problem is even worse. In February 2022, the Fed conducted a stress test for banks with assets above $250 billion. However, the test would not present problems for the SVB if it participated: in the worst case scenario, the Fed considered that interest rates would not exceed 3.25% per annum.

I can’t move forward here. Nobody could explain to me how the Fed, in February 2022, considered that the worst possible scenario imaginable would be interest rates at 3.25%!

Very difficult to run a banking system if the regulation is flawed and the execution is even worse.

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