Preventing Bailouts Is Simple, but It Isn’t Easy

The Fed could simply stop blocking run-proof banks from emerging. But that would take political will.

By John H. Cochrane and Amit Seru. Excerpts:

"Silicon Valley Bank and a few others suffered runs in early 2023. SVB took large uninsured deposits and invested them in long-term Treasury securities. No subprime mortgages, no collateralized loan obligations, no toxic derivatives, no special-purpose vehicles. SVB’s only risk was that higher interest rates would reduce the market value of its assets. When that happened, depositors ran. The army of regulators missed this simplest interest-rate risk. The Federal Deposit Insurance Corp. quickly guaranteed all deposits, of any size. Markets now expect that guarantee.

In March 2023, Credit Suisse was teetering. Its troubles were clearly isolated, with no “contagion” to worry about. Finally, here was a chance to use the big-bank reforms. Instead, the Swiss government orchestrated a weekend sale to UBS with an infusion of government money.

Our basic financial regulatory architecture allows a fragile and highly leveraged financial system but counts on regulators and complex rules to spot and contain risk. That basic architecture has suffered an institutional failure. And nobody has the decency to apologize, to investigate, to talk about constraining incentives, or even to promise “never again.” The institutions pat themselves on the back for saving the world. They want to expand the complex rule book with the “Basel 3 endgame” having nothing to do with recent failures, regulate a fanciful “climate risk to the financial system,” and bail out even more next time."

"The solution is straightforward. Risky bank investments must be financed by equity and long-term debt, as they are in the private credit market. Deposits must be funneled narrowly to reserves or short-term Treasurys. Then banks can’t fail or suffer runs. All of this can be done without government regulation to assess asset risk. We’ve understood this system for a century. The standard objections have been answered. The Fed could simply stop blocking run-proof institutions from emerging, as it did with its recent denial of the Narrow Bank’s request for a master account."