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Did a 2018 Regulation Rollback Lead to Bank Failures?

The people who attribute every problem in the economy to deregulation have come up with an explanation for the failure of Silicon Valley and Signature Bank. To my great surprise, it's deregulation.


Watchdog, whatever that is.

President Joe Biden, March 13 press conference: "The last administration rolled back [Dodd Frank] requirements designed to make sure 2008 would never happen again."

Native American population spokeswoman

Guy who collects $40,000 speaking fees plus accommodation for railing against Capitalism

This excerpt from the New York Times summarizes the argument nicely.

"Some banking experts on Friday pointed out that a bank as large as Silicon Valley Bank might have managed its interest rate risks better had parts of the Dodd-Frank financial-regulatory package, put in place after the 2008 crisis, not been rolled back under President Trump.

In 2018, Mr. Trump signed a bill that lessened regulatory scrutiny for many regional banks. Silicon Valley Bank’s chief executive, Greg Becker, was a strong supporter of the change, which reduced how frequently banks with assets between $100 billion and $250 billion had to submit to stress tests by the Fed."

Dodd Frank is an 848 page Obama-era law, which has created 27,278 restrictions on financial activities since its passage in 2010, ostensibly designed to prevent a 2008-style banking crisis. One of its features is the introduction of periodic Stress Testing to be conducted by the Federal Reserve. Dodd-Frank also increased bank capital requirements under the international central bank accord BASEL III. The first iteration of that was BASEL I, which went into effect in 1984.

The argument here is that if SVB had been subjected to more frequent stress testing, they "might have" managed their interest rate risk better. While we're here, I don't find the phrase "might have" to be compelling, it's as if the people offering the explanation are themselves not very confident in it. I've searched high and low, and so far, no one has made an effort to even show which part of the Fed's stress tests would've affected SVB's interest rate exposure, or how Dodd Frank rules would've mitigated it. So, I'm doing all the heavy lifting here while the PhD's who inform the New York Times get to blindly speculate.

How does a Stress Test work? The regulators at the Fed put together a simulation of abnormally large economic shock factors, using a host of macroeconomic and financial market variables. The banks under examination must then use statistical modeling to determine the impact of those variables on their ability to fund their operations and continue lending. Here's an example.

In 2021 the stress test simulated a scenario where the US economy underwent a two-year long recession with a 38 percent drop in home prices. Economic variables include the growth rate of Gross Domestic Product (GDP growth), disposable income growth, and the inflation rate. Financial variables include the 3 month Treasury bond rate, 10 year Treasury bond rate, and the interest rate on BBB rated corporate bonds.

After banks have simulated the effects of these economic shocks on their business, the results are reviewed by the Fed. The Fed then assigns additional capital requirements specific to each bank based on the results. This additional requirement is called a Capital Buffer, and is a minimum of 2.5 percent for all banks, whether they are stress tested or not. It may be increased based on the results of the stress test.

Capital requirements are a bit complicated, but hopefully this example will make them make sense. The first of these requirements is the Common Equity Tier 1 ratio. Common Equity is the total amount that all common shareholders have invested in the bank. The minimum ratio for all banks is 7 percent (a 4.5 percent minimum plus that 2.5 percent buffer I mention above).

The ratio defines how much Common Equity the bank must have as a percentage of its assets. What makes it complicated is that different types of assets are all weighted differently, but suppose for a moment that all assets have a weight of 1. If a bank has $100 billion of assets, its total Common Equity must add up to at least $7 billion to satisfy the capital rules (7 percent).

The Fed publishes the required Common Equity ratios for individual banks after the stress tests. For example, in 2022 the Fed assigned Bank of America a Capital Buffer of 3.4 percent, higher than the minimum of 2.5. BofA also has an additional 2.5 percent requirement for being a "Global Systemically Important Bank" (GSIB). Add those all together, and Bank of America's required Common Equity Ratio is 10.4 percent. Without accounting for weights, for every $100 in assets BofA has, they must have $10.40 in Common Equity.

Source: Federal Reserve Board 2022 Stress Scenario

Would a Stress Test have prevented SVB's failure?

The highest Common Equity Ratio assigned after the latest stress test was 13.5 percent. That requirement was given to Credit Suisse, which has a bit of a reputation for being a riskier bank.

Silicon Valley Bank's CE ratio was already higher than that: 15.29 percent as of December 2022.

Source: Silicon Valley Bank Q4 2022 Results

But even if the Fed slapped them with 50 percent Common Equity requirement, it's important to understand that no amount of Common Equity against assets will save a bank from a run. If a mass of depositors starts to pull funding, the only way that the bank survives is by having enough cold, hard, cash to pay them with. Fractional reserve banks, by the very nature of their business, never have enough cash laying around to pay out a significant number of depositors. Thursday's run of $42 billion was 22 percent of the deposit base. It's delusional to think the banks that get stress tested would've been able to take that in stride.

SVB actually had more cash than average, about $12.5 billion, which is about 7 percent of their total deposits, and 7 percent more than they're required to have by law. Yes, the Fed dropped reserve requirements to zero in 2020. Now back to stress tests…

According to the experts who inform the New York Times, stress testing would've pushed SVB to better manage its interest rate risk. Did recent stress tests even include rising interest rates as a variable? No, check it out.

In the 2022 stress scenario, the 3 month Treasury Rate, which usually hovers within a quarter percent of the Fed Funds rate, stays at 0.1 percent for three consecutive years. The current 3 month Treasury rate is 4.85 percent. The 30 year mortgage rate doesn't even breach 4 percent in this scenario. Right now it is 6.73.

The Fed wasn't preparing anyone for rising interest rates.

Regardless of the particular scenarios in the tests, what everyone needs to understand about this process is that it does not work. After 2020, it is completely ludicrous to think that these things have contributed anything whatsoever to the stability of the banking system.

Stress testing, like the rest of Dodd Frank, was designed to prevent a 2008 style banking crisis from ever happening again. But that type of crisis did happen again in March 2020. After 27,278 new regulatory restrictions on financial institutions, and 9 years of stress testing, the money market and bond market still ground to a halt in the face of economic instability from COVID-19. In response, the Fed re-launched almost all of its 2008 funding facilities for banks (so that none of them would fail), cut the short interest rate to zero, and bought about $5 trillion of bonds. They even went one step further than 2008 and bought investment funds made up of corporate bonds.

I also can't leave out the fact that former House Financial Services Committee Chair, Barney Frank, who cosponsored the Dodd-Frank Act, told Bloomberg he doesn't think the 2018 "rollback" was a factor in the recent failures at all:

"I don’t think that had any effect… I don’t think there was any laxity on the part of regulators in regulating the banks in that category, from $50 billion to $250 billion." Bloomberg

In summary, the business of fractional reserve banking leaves banks inherently exposed to the risk of failure through a run. It wouldn't have mattered if SVB and Signature Bank had been stress tested 48 times and had a 50 percent ratio of Common Equity to assets. Without a bigger cash buffer than most banks have kept for the last century, they weren't going to survive a sudden, mass outflow of depositors.

Despite what Elizabeth Warren and Robert Reich would have us believe, there's no magical clause of Dodd-Frank that says banks can't severely expose themselves to shifting interest rates. There's also nothing in Dodd-Frank that says fractional reserve banks can't be fractional reserve banks. The correct response to someone who says that "deregulation" was a causal factor in the recent bank failures is laughter.


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