Global Courant 2023-05-02 15:24:32
Bank of the First Republic became the second largest bank failure in US history after the lender was seized by the Federal Deposit Insurance Corp. and was sold to JPMorgan Chase on May 1, 2023. First Republic is the latest victim of the panic that has rocked small and medium-sized banks since the bankruptcy of Silicon Valley Bank in March 2023.
The collapse of SVB and now First Republic underscores how the impact of risky decisions at one bank can quickly spread to the wider financial system. It should also provide an impetus for policymakers and regulators to address a systemic problem that has plagued the banking industry since its inception. savings and credit crisis of the 1980s to the financial crisis of 2008 to the recent unrest after the death of the SVB: incentive structures that encourage excessive risk-taking.
The Federal Reserve’s top regulator seems to agree. On April 28, the vice president of the central bank for supervision delivered a compelling report about the collapse of Silicon Valley Bank, blaming the failures on its weak risk management, as well as oversight missteps.
We are professors of economy who study and teach the history of financial crises. In each of the financial upheavals since the 1980s, risk has been the common denominator. Banks created incentives that encouraged executives to take big risks to increase profits, with little consequence if their bets went bad. In other words, all carrots and no sticks.
One question we are now wrestling with is what can be done to prevent history from repeating itself and threatening the banking system, the economy and the jobs of ordinary people.
The S&L crisis sets the tone
The precursor to the banking crisis of the 21st century was the savings and credit crisis of the 1980s.
The so-called S&L crisis, such as the collapse of the SVB, started in a rapidly changing interest rate environment. Savings and loan banks, also known as savings banks, provided home loans at attractive interest rates.
When the Federal Reserve under Chairman Paul Volcker aggressively raised interest rates in the late 1970s to combat raging inflation, S&Ls suddenly earned less on fixed-rate mortgages while having to pay higher interest rates to attract depositors. At some point their losses exceeded $100 billion.
Paul Volcker in an archive photo. Image: Twitter
To help the failing banks, the federal government the recycling industry deregulated, allowing S&Ls to expand from home loans to commercial real estate. S&L executives were often paid based on the size of their institutions’ assetsand they lent aggressively to commercial real estate projects, taking on riskier loans to rapidly grow their loan portfolios.
In the late 1980s, the commercial real estate boom turned. S&Ls, weighed down by bad loans, failed en masse, forcing the federal government to take over banks and overdue commercial properties and sell the assets to recover money paid to insured depositors. Ultimately, the The bailout cost taxpayers more than $100 billion.
Short-term incentives
The 2008 crisis is another clear example of incentive structures encouraging risky strategies.
At all levels of mortgage financing — from Main Street lenders to Wall Street investment firms — executives thrived by taking excessive risk and handing it over to someone else. Lenders provided mortgages made for people who couldn’t afford them on Wall Street companies, which in turn bundled them into securities to sell to investors. It all came crashing down when the housing bubble burst, followed by a wave of bankruptcies.
Incentives rewarded short-term performance and executives responded taking greater risks for immediate gains. At Wall Street investment banks Bear Stearns and Lehman Brothers, profits soared as the companies bundled increasingly risky loans into mortgage-backed securities to sell, buy and hold.
As bankruptcies spread, the value of these securities plummeted and Bear Stearns collapsed in early 2008, sparking the financial crisis. Lehman failed in September of that year, paralyzing the global financial system and collapsing the US economy worst recession since the Great Depression.
However, executives at the banks had already cashed in, and no one was held responsible. Harvard University researchers estimate that top executive teams at Bear Stearns and Lehman pocketed a total of $2.4 billion in cash bonuses and stock sales from 2000 to 2008.
A famous ring
Which brings us back to Silicon Valley Bank.
Executives tied up the bank’s assets in long-dated government bonds and mortgage-backed securities, failing to hedge against rising interest rates that would undermine the value of these assets. The interest rate risk was particularly acute for SVB, as a a large portion of the savers were startupswhose finances depend on investors’ access to cheap money.
When the Fed started raising interest rates last year, SVB was exposed twice. As startup fundraising slowed, they took in money forced SVB to sell long-term participations at a loss to cover the recordings. As the magnitude of SVB’s losses became known, savers lost confidence, leading to a run that ended with SVB’s collapse.
Silicon Valley Bank’s problems may be the tip of the iceberg for US banks. Image: Screengrab/Twitter/TechCrunch
For executives, however, there was little downside when discounting or even ignoring the risk of rising rates. The cash bonus of SVB CEO Greg Becker more than doubled to $3 million in 2021 from $1.4 million in 2017, bringing its total revenue to $10 million, up 60% from four years earlier. Becker also sold nearly $30 million in stock in the past two years, including some $3.6 million in the days leading up to his bank’s bankruptcy.
The impact of the malfunction was not limited to the SVB. Share prices of many medium-sized banks collapsed. Another American bank, Signature, collapsed days after SVB did.
First Republic survived the initial panic in the following March was rescued by a consortium of major banks led by JPMorgan Chase, but the damage was already done. First Republic reported this recently savers withdrew more than $100 billion in the six weeks following the collapse of the SVB, and on May 1, the FDIC seized control of the bank and secured a sale to JPMorgan Chase.
The crisis is not over yet. Banks had more than $620 billion of unrealized losses at the end of 2022, largely due to rapidly rising interest rates.
The big picture
So, what to do?
We believe the bipartisan bill recently introduced in Congress, the Failed Bank Executives Clawback, would be a good start. In the event of a bank failure, the legislation would allow regulators to back down compensation received by bank executives in the five-year period prior to bankruptcy.
However, clawbacks only take effect afterwards. To prevent risky behavior, regulators can require compensation from directors prioritize long-term performance over short-term gains. And new rules could limit bank executives’ ability to take the money and run, including requiring executives to hold significant portions of their stocks and options until they retire.
The Fed’s new report on the causes of the SVB’s failure points in that direction. The 102-page report recommends new caps on executive pay, saying leaders “were not compensated to manage the bank’s risk,” as well as stricter stress testing and increased liquidity requirements.
The bottom line is this: financial crises are less likely if banks and bank executives consider the interests of the entire banking system, not just themselves, their institutions and shareholders.
Alexandra Digby is Adjunct Assistant Professor of Economics, University of Rochester; Dolly Davis is deputy dean of the faculty, Minerva UniversityAnd Robson Hiroshi Hatsukami Morgan is Assistant Professor of Social Sciences, Minerva University
This article has been republished from The conversation under a Creative Commons license. Read the original article.
Similar:
Loading…
