Anil Kashyap explains why the collapse of Silicon Valley Bank and Signature Bank are the result of the failure of the Dodd-Frank Act to adequately attend to funding risks from certain business models. Kashyap describes how to take the fragmented U.S. financial regulatory environment from liability to asset to prevent future failures.

Once again, several large U.S. financial institutions have collapsed and the government has taken extraordinary steps to rescue them. For members of the public that lived through the chaos of the fall of 2008, this must be incredibly frustrating. You might be asking yourself “Why didn’t we fix this back then? Are we doomed to have more of these events in the future?” 

The answers to both of those questions are actually quite simple. The primary legislative response to the last crisis, the Dodd-Frank Act, was incomplete in one very important way. The bill did many good things, but failed to account for the fact that the core problems that arose at Bear Stearns, Lehman Brothers and AIG (to name a few cases), all came from funding stressors that were inherent in their business models. Unfortunately, the bill did not seek mitigate the risks associated with business models that rely on funding that can quickly evaporate. Ironically, Barney Frank (the Frank in Dodd-Frank) was on the Board of Directors for Signature Bank, one of the two banks to fail over the weekend.

Funding Structures

There are several current examples of where the incompleteness of Dodd-Frank leaves the financial system vulnerable. One would be the mutual funds that hold corporate bonds that rarely trade, but allow people to take their money out immediately at full value. Another example is some of the crypto assets, so-called “stable coins,” that again promise people the ability to redeem their money at a constant price even when the underlying assets behind the coins fluctuate in value. If these, or other emerging businesses that are built on flighty funding are not properly regulated, we are going to see a replay of the chaos from last weekend.   

Two of the winners of this latest Nobel prize in economics, Doug Diamond and Philip Dybvig pointed out the problem with these arrangements forty years ago. Whenever the decision by one investor to redeem funds (or not to roll funding over) raises the incentive of others to do the same, then the structure is inherently unstable. In the case of Silicon Valley Bank (SVB), uninsured depositors were assured that they could get money out at the promised value even though many of the assets in which the bank invested would decline in value if interest rates rose. For small levels of withdrawals, SVB could offer redemptions by selling assets that held value, but at some point SVB would need to start selling impaired assets, meaning that there would not be enough proceeds available to pay everyone fully. Looking forward, everyone wanted to get out before that point was reached.  

Overhauling the FSOC

The problem is that vulnerable funding structures keep appearing in different guises and the regulatory system is not very nimble. The fact that crypto assets grew so quickly with so little oversight is just one example of the problem. We need a more fundamental reform of the existing regulatory system to deal with this. We should do this by overhauling the Financial Stability Oversight Council (FSOC) one of the apparatuses created in the Dodd-Frank legislation.  

The FSOC is the forum that brings together all the major financial regulators in the U.S. including the Federal Reserve, the SEC, the FDIC, the CFTC and several others. Because the U.S. regulatory system is so fragmented, there are 10 voting members and five non-voting members on the FSOC which is chaired by the secretary of the treasury. This creates too many cooks in the kitchen, as all the members must not only have to be convinced that a risk is present, but they must also agree on recommendations for addressing any risks. As a result, the annual report of the FSOC is reduced to talking vaguely about many issues while failing to make sharp recommendations about risks and remedies. For example, the last FSOC annual report does not mention risks to banks that are reliant on funding from uninsured deposits.  

It is time to take U.S. regulatory fragmentation and turn it into an asset— not a liability. As explained in a recent task force report by the Brookings Center and the Chicago Booth Initiative on Global Markets on regulatory reform, this requires four changes. First, every member agency should have its charter adjusted to include a financial stability objective and a division of the agency that pursues that objective. No member agency should be able to duck responding to risks by saying it isn’t their concern. 

Second, the annual report of the FSOC ought to be restructured and turned into the FSOC’s flagship product. The main section of the report should be authored solely by the Treasury. This would allow the Treasury to present its views without compromising. The Treasury’s section should identify its main concerns regarding financial stability threats and suggest its proposed remedies, whether those remedies involve new legislation or just more action by the existing regulators.

Third, each of the other FSOC members should be required to contribute their own annex to the main report. The members could challenge the Treasury judgments or call out other risks. This would mean that there would no longer be any doubt about who failed to spot emerging risks. If Congress was alerted to a threat and then failed to act, that would be clear too.

Finally, the report should pay special attention to rapidly growing products, markets or institutions. History teaches us that rapid changes often are a signal of a quickly developing risk. The current system is slow to adapt. SVB is a perfect example of this: It quickly expanded its overall size and altered its funding to become more reliant on the Federal Home Loan Bank of San Francisco for financing. These changes should have been a red flag. Insisting that the regulators pay closer attention to these emerging trends would be a major improvement over the current system.

Articles represent the opinions of their writers, not necessarily those of the University of Chicago, the Booth School of Business, or its faculty.