SVB’s Execs Were Rats, But They Were Just Navigating the Regulatory Maze to the Government Cheese

A brief follow-up on SVB (which kinds of sounds like a venereal disease, which is kind of apropos I guess).

During the GFC I wrote about how bank capital requirements were like price controls. A regulator can never set the “right” prices–in this case, the shadow costs of assets with different risks. It will underprice some risks, and overprice others. Banks will hold too many of the assets where risk is underpriced, and too little of the assets where the risk is overpriced.

Bank capital requirements focus primarily on credit risk, rather than interest rate risk. SVB incurred very little if any capital charge to hold Treasuries and agency debt, because they are viewed as “safe” from a credit risk perspective. But they did allow SVB (and other banks) to take on interest rate risk.

Very low or zero capital charges on Treasuries fall into the there-are-no-coincidences-comrade category. The government wants to encourage holding of Treasuries and agencies. Big deficits to finance, after all. As Niall Ferguson, Charlie Calomiris, and others have pointed out, governments regulate and structure banking systems first and foremost to facilitate government finance, not private capital markets.

Related to this is the issue of stress tests. The relaxation of regulation passed in 2018 meant that banks of SVB’s size no longer had to undergo stress tests. But the recent government stress tests would not have really stressed SVB: they only tested for a 200 basis point increase in interest rates, not the 400+ increase we have experienced. So SVB would have passed anyways.

In the immediate aftermath of the GFC I expressed skepticism about stress tests. I called the Tinker Bell Economics–“We believe! We believe!” That is, they are intended to assure everyone about the safety of the banking system, rather than to actually test the safety of the banking system.

The unstressful interest rate stress scenarios also plays into the idea that the Fed and Treasury don’t want to do anything to dampen banks’ appetite for government bonds.

One last comment. Many historical banking system crises are the result of yield chasing in low interest rate environments. Low yields (a) allows banks to borrow cheap, and (b) induces banks to chase yield by taking on more risk.

We obviously operated for years in a low rate environment, courtesy of the Fed. Yield chasing was an inevitable. SVB chased yield.

In sum, yes, SVB’s execs were rats. But the government designed the maze (capital requirements, low interest rates) and baited it with cheese. So when the government says that they are going to fix the problem, don’t believe them. But believe this: especially given the United States’ huge debt and deficits, any “fixes” will be rigged to protect the Treasury market, and the devil take the hindmost. Which would be you.