Were Recent Bank Failures the Result of Lax Regulation? In a Word, No

With the recent collapse of Silicon Valley Bank and Signature Bank, financial markets all around the world are on edge. Despite promises from the Federal Reserve that a “soft landing” of the economy is on the way, all signs point to an imminent “crash landing”! While the full consequences of these bank failures are yet to fully play out, a prized and popular scapegoat has already been trotted out to explain the current crisis: deregulation of financial markets.

According to proponents of this view, the partial rollback of the famous Dodd-Frank Act that took place in 2018 enabled banks to engage in overly risky behavior that has now become those banks’ undoing. This perspective has even started to gain traction in Washington, DC, as well. On March 14, Senators Elizabeth Warren and Katie Porter introduced a bill that would undo the partial rollback of Dodd-Frank. In a statement released the same day, Warren writes, “In 2018, I rang the alarm bell about what would happen if Congress rolled back critical Dodd-Frank protections: banks would load up on risk to boost their profits and collapse, threatening our entire economy—and that is precisely what happened.”

This is hardly the first time that deregulation has been blamed for a financial crisis. Both popular consciousness and the economics profession has always pinned deregulation as one of the major factors leading to the 2008 financial meltdown (even though this is not supported by the data). If the current crisis continues to evolve into a full-blown recession, then fingers will doubtless be pointed once more at deregulation as a main cause.

But is this really the case? Was it truly because of deregulation that Silicon Valley Bank and Signature Bank went under? To evaluate these claims, we have to know more about the specific regulation involved—in this case, the Dodd-Frank Act. What are the contents of this bill, and what portions of it were allegedly rolled back by the Trump administration?

The Dodd-Frank Wall Street Reform and Consumer Protection Act (colloquially known as Dodd-Frank) was a landmark piece of legislation passed in 2010 in response to the 2008 financial crisis. The idea behind the bill was that financial markets were in need of greater regulation, especially the largest banks. The bill resulted in the creation of:

• the Financial Stability Oversight Council, which is tasked with overseeing the financial stability of the largest banking firms and ensuring that none of them are “too big to fail”;
• the Consumer Financial Protection Bureau, which ensures that mortgage lending and other consumer loans are nonpredatory and understood by customers;
• the Volcker rule, which prevents banking institutions from engaging in short-term trading of securities or derivatives, the purpose of which is to further separate the activities of an investment firm from those of a bank.

In 2018, the Trump administration loosened the requirements of Dodd-Frank specifically on small- and medium-sized banks. The justification for doing so was that the restrictions that Dodd-Frank had placed on the banking industry, especially the “stress tests” and capital requirements, had crippled the lending ability of these smaller banks. Because of their smaller size, they had much less freedom of action under the requirements of Dodd-Frank as opposed to their larger counterparts. Dodd-Frank’s regulatory framework had applied to all banks with a capitalization of over $50 billion, which the Trump administration raised to $250 billion—a number which effectively excludes all but the largest banks in the country.

Fast-forward to present day. On March 10, Silicon Valley Bank (SVB) was taken over by the Federal Deposit Insurance Corporation (FDIC) after it was declared insolvent due to its inability to pay out depositors. On the same day, Signature Bank was also taken over by the FDIC over concerns about depositor withdrawals in the wake of SVB’s collapse. While both of these banks were large in their own right—with capitalizations of $212 billion and $88 billion, respectively—they were both under the $250 billion requirements to be under the full weight of Dodd-Frank. If they had both been subjected to the same regulatory scrutiny of the largest banks, would they have still failed?

Despite the protestations of Elizabeth Warren, the answer is yes. While the deregulation of these smaller banks might imply that they were eager to engage in very risky, casinoesque financial gambling, this was not the case. SVB had been dealing with a steady stream of deposit withdrawals for months as Silicon Valley more broadly has suffered financially.

Much of SVB’s portfolio was held in US Treasury bonds, which they purchased near the start of the covid-19 pandemic—a point when bond prices were very high because interest rates were low. As interest rates have risen in recent months, bond prices have correspondingly fallen. Because SVB was forced to liquidate its assets to pay depositors, it had to sell these bonds at a loss. When the news of these sales reached investors and depositors, more panic ensued which resulted in the eventual bank run that followed.

In the case of Signature Bank, its closure can be largely attributed to the failure of SVB. The contagion from its failure had spooked Signature’s depositors into withdrawing funds from their accounts. To help stave off a total run on the bank, as had happened with SVB, the FDIC stepped in and closed the bank to prevent any further drawdown of reserves.

In neither case would the Dodd-Frank regulations have prevented the bank from failing. US Treasury bonds are commonly viewed as the safest asset that one can buy, meaning that SVB’s portfolio would have likely passed any “stress tests” that regulators would have thrown at it. Signature closed its doors as a result of a good old-fashioned bank run, which Dodd-Frank—nor any other regulation—could ever truly prevent. This fact was attested to by Barney Frank himself, who was on the board of directors at Signature! As convenient an explanation as it might be, the exemption of these banks from Dodd-Frank had nothing to do with their ignominious collapse.

If regulation was not the cause, then what or who is the guilty party? The true culprit is something much more insidious: bad monetary policy. For years, the Federal Reserve has maintained artificially low interest rates—far lower than what would otherwise have been set by unhampered markets. The result is that financial institutions were misled into believing that there were far more savings in the economy than was actually the case. As a result, they were more willing to purchase bonds and make other investments based on this assumption.

However, these artificially low rates cannot last forever. As the Fed has raised interest rates in response to rising inflation, the investment decisions made by these banks were revealed to be mistakes. Because SVB’s depositors came looking for their money, they had to realize these losses and close their doors, which also led to Signature’s demise. It remains to be seen the effect that these malinvestments will have on the broader financial system, but the outlook is murky at best.

The full implications of the Fed’s malicious monetary policy are yet to fully manifested, but one point is already clear. If we are to prevent these or other crises in the future, the problem must be pulled out by its roots: the cheap-money policies of the Fed must be ended once and for all.

While centralized control over interest rates and the money supply persists, we can expect continued recessions and crises into the future. Dodd-Frank—or any similar legislation, for that matter—misunderstands the problem entirely. The solution to financial distress is not in regulating markets but in removing interference in them. No regulation, large or small, can save us from the consequences of bad monetary policy and economic illiteracy.