Smaller banks operating locally understand their communities in a way large banks cannot. Small and medium-size businesses rely on smaller banks for loans to buy property and equipment and services, including making payroll, paying suppliers and extending credit to customers. Smaller banks help people in their communities buy homes and cars and pay for higher education. For large banks, the costs of acquiring local knowledge necessary to make many of these loans are too high, and the benefits of making smaller loans are insufficient.
While large and small banks are different, we must recognize that they are both subject to risk, because risk is fundamental to their operations. There is credit risk, also called asset quality: the question of whether their borrowers will pay back their loans or whether the bank’s investments will perform. There is market risk, one of the risks that played a role in Silicon Valley Bank’s downfall. For example, if mortgage rates go up, the mortgages banks already own that were issued at lower rates decline in value. Finally, there is liquidity risk, the other risk involved in the S.V.B. crisis. Depositors can withdraw their money at any time, but banks cannot require loans to be repaid at any time.
So how do we regulate a multifaceted, socially important industry where risk taking is an essential function? The history of banking regulation is the result of our episodic answers to this question, from the Federal Reserve Act of 1913 to the Dodd-Frank Act of 2010. By and large, we have done a good job, particularly because we have recognized that our economy is ever changing and some risks are the responsibility of the government to manage.
Today we have expansive regulation for our largest banks. The cost of operating large banks has almost doubled since the Dodd-Frank Act. Banks are required to hold capital against their loans and other assets, maintain high levels of liquidity and continuously monitor a wide array of risks. They are subject to constant supervision, including having federal regulators on site with free access to management and information. The costs of compliance personnel and systems stretch into the tens or even hundreds of millions of dollars annually.
But regulation also increased the resiliency of large banks. That resiliency was crucial in allowing the Federal Reserve and Congress to respond swiftly to alleviate the economic effects of the Covid-19 lockdowns.
The events of the past week have proved that smaller bank oversight, regulation or both should be improved. Clearly, risk-management functions, on-site supervision and the qualifications and role of boards of directors should be evaluated. The $250,000 limit on deposit insurance should be raised, perhaps substantially, to at least $2 million or as much as $5 million or even $10 million. This step reflects the reality that depositors cannot be expected to monitor the financial condition of banks as if they were sophisticated investors.
But we must be realistic. Smaller banks cannot afford anything close to what the large banks must do, as the latter are able to spread the costs over their huge global operations, including large deposit bases. Calls for increased capital and liquidity, appealing in their simplicity, inevitably follow bank failures, but Silicon Valley Bank had plenty of both. If we impose large bank regulation on small banks, the small banks would be forced out of business, in many cases landing in the hands of larger banks.