Texists here a centuries-old and deep relationship between finance and government. The great banking houses, such as the Medici of Florence, were lenders of last resort to rulers threatened with overthrow. The financiers had to avoid supporting losers who would be unable to repay their debts. Now it’s the banks that threaten to overthrow the state; a change that has led to increasing oversight by official bodies. With the intervention in the economic crisis a century ago, there was a drastic change. The global financial crisis of 2007-2009 reinforced this trend. The recent turmoil has pushed the banking system further down the road to government control.
On May 11, the Federal Deposit Insurance Corporation, an American regulator, announced that the country’s big banks will face a $16 billion bill for losses related to the failure of Silicon Valley Bank (svb) and Signature Bank. They’ll likely have to step in more to cover the case of First Republic, another lender. In America, Britain and Europe, officials are debating whether to offer more generous protections for bank deposits. Such moves are only the latest evidence that the power of the banks is declining and that of the state is increasing. In recent months, Leviathan has become increasingly prominent in areas ranging from deposit insurance to emergency lending to asset quality regulation.
Bankers and regulators are aware that changes introduced during turbulent times have a habit of sticking. Andrew Haldane, formerly of the Bank of England, has likened the safety net provided to banks to an “overstretched rubber band”. Once inflated, it never quite shrinks back to size. In addition, possible future expansions of government responsibilities can now be seen – possibly including significantly stricter rules on collateral or an unintended shift to a so-called narrow banking regime. How far will the state expand?
To understand the dynamics at play here, start with deposit insurance — the invention of which President Franklin Roosevelt is often credited. In fact, he opposed the measure’s introduction in 1934, fearing it would “lead to laxity in bank administration” since an insured depositor would not have to worry about safety. Although other countries feared the same and were slow to introduce such insurance, it nonetheless spread and was typically introduced in times of crisis. This spring, US regulators went further than ever before, protecting depositors retrospectively svb, Signature Bank and practically First Republic. The President, the Secretary of the Treasury and the Federal Reserve Chairman have all more or less said that all deposits in banks are safe.
Emergency lending is the next area where the government’s role is growing. Banks need a lender of last resort because they are inherently unstable. Deposits are refundable on demand; Loans are long-term. Therefore, no institution will have money on hand when depositors are clamoring for it en masse. Walter Bagehot, former editor of The economist, is credited with advising that, to avoid a crisis, central bankers should lend generously to solvent institutions, backed by good collateral and at a penalty rate. The Bank Term Funding Program recently introduced by the Fed refutes this dictum. It values long-term securities at face value, even when the market has heavily discounted them, and rarely charges penalties above the market rate.
The bigger the backstop, the more reason the government has to dictate what risks banks can take. Therein lies the third source of insidious government control: regulation of wealth quality. Banks everywhere are subject to rules that limit the risk of their assets and how much capital they must hold. The real risk arises when political preferences conflict with lending rules. In America, this is already happening in the mortgage market, which is dominated by two state-backed companies: Fannie Mae and Freddie Mac. Together, the two institutes now underwrite the credit risk for more than half of the mortgages. Their guarantees enable the 30-year fixed rate, early repayment mortgages that Americans have come to expect. They also help explain why the American financial system is more exposed to interest rate risk than Europe’s, where variable rate mortgages are common.
On the House
Since Fannie and Freddie assume the credit risk themselves, they charge mortgage lenders “points” (e.g. percentage points) that vary depending on a borrower’s creditworthiness and a property’s loan-to-value ratio. The system is arbitrary for borrowers, and those on the wrong side of the dividing lines get hammered. And sometimes arbitrariness is toyed with for reasons other than perceived risk. On May 1, the Federal Housing Finance Agency introduced new rules that increase costs for borrowers with high credit ratings and lower costs for borrowers with low credit ratings. The aim was to make it easier for poor people to buy their own home. Aside from the fact that overall easier lending does little to make housing affordable, the government has effectively decreed that these institutions should not be adequately compensated for the risk they take.
The banking system will look more and more like real estate financing. In the wake of the global financial crisis, regulators tightened the rules governing bank balance sheets enormously. Different assets entail different risk weights, meaning that a bank’s decision to invest in them affects its overall minimum capital requirements. As with any attempt to categorize complex things, these risk weights are often wrong. The First Republic loan book, which collapsed on May 1, contained mortgages for the wealthy that had low credit risk but were assigned a high risk weight by the rules. Probably for this reason, as part of the loan purchase, regulators promised to share loan losses with JPMorgan Chase, resulting in a lower risk weight. It’s not like anyone expects big losses. All the government had to do was circumvent their own misfire rule.
Where next for government intervention? In addition to expanding deposit insurance, regulators’ response to the recent turmoil is likely to be to tighten interest rate risk regulations. Today’s rules allow banks to count the face value of government bonds of any maturity as prime-quality liquidity (that is, funds available in a crisis). As many banks have learned in recent months, these bonds fall in value sharply when interest rates rise. The safest assets are both government-issued and short-term assets. But the more super-safe short-term government securities banks are expected to hold, the more the industry would move away from its core principle: that the purpose of banking is to convert short-term deposits into long-term assets.
For some, that would be a good thing. Narrow banking, which requires institutions to have sufficient liquid funds to cover all their deposits, was first proposed as the “Chicago Plan” in 1933 after the devastating effects of the Depression. Some parts of the system are already looking tight. In 2013, money market funds gained access to the Federal Reserve’s reverse repo facility, where they receive securities overnight for cash – a facility that was expanded during the Covid-19 pandemic. In fact, Americans can park cash in money market funds, which in turn park it directly with the Fed, bypassing the banking system entirely. Since then, money market funds have recorded inflows of around USD 435 billion svb failed, a cash flow contributing to the destabilization of the banks. The system could also tighten if the Fed or other major central banks introduce central bank digital currencies that serve as alternatives to bank accounts.
Such a world would bring its own problems. Deposits do not make sense when idle. The benefits of linking savers who prefer security and liquidity with borrowers who prefer flexibility and security are great. Joseph Schumpeter, an economist, wrote in the 1930s that “one of the most characteristic features of the financial side of capitalist development is to ‘mobilize’ all, even the longest maturities,” so that they would be financed by short-term borrowing. “It’s not just technology. This is part of the core of the capitalist process.” Banks liberate investment—an engine of Schumpeter’s creative destruction—from the savers’ “voluntary abstinence routine.”
An alternative path might be to conclude in a world of super-fast bank runs, like the scramble that led to the sinking svb, emergency support from central banks needs to become more frequent. Sir Paul Tucker, formerly of the Bank of England, who helped draft the rules introduced in the wake of the financial crisis, recently said: Financial Times that banks should be prepared to provide the central bank with enough collateral to fund emergency loans covering all their deposits so that they could survive a total collapse. This would reveal another way the state controls banks: the list of assets it considers as collateral for emergency loans. Banks could only use deposit funding to hold assets that have government approval.
Whichever path is chosen, the world is moving towards a larger role for government and a smaller one for private actors – a fact that should worry anyone who appreciates the role of the private sector in risk assessment. In China and Vietnam, state sanctions for credit creation are expressly provided for. The largest banks are majority-owned by the government, and state lenders are forced to support stagnant state-owned enterprises or boost growth when governments see fit. It’s becoming increasingly difficult to see the differences between the Chinese system of explicitly controlling lending and the Western system’s “social contract,” in which it imposes massive state-taking on risk and, in turn, imposes a slew of regulation imposed on banks do not abuse the insurance granted to them.
Moreover, the bedrock of many banking crises has been laid by misguided government intervention in banking, particularly policies that distort incentives or the pricing of risk, warns Gary Cohn, former deputy bank Goldman Sachs. It might be easier to sleep at night, knowing that the government has currently all but promised to protect all depositors, has generously lent to the banks and has funded the system through its resolution operations. But exactly such actions will cause sleepless nights in the future. ■
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