How to prevent bank runs? Here’s a simple plan that banks will hate

To avoid the bank runs that led to the failures of Silicon Valley Bank, Signature Bank, and First Republic Bank, some economists, myself included, recommend that banks pool their capital and maintain sufficient short-term safe liquid assets (T-bills). to cover any potential bank runs. Although sound in economic theory, this proposal will be politically difficult to implement in practice.

So lawmakers and regulators should discuss other policies, especially proposals to increase bank transparency and thus allow the public to better assess bank solvency. In particular, banks must mark all securities and loans to market. They should not be allowed to continue the common practice of carrying these assets at face value by declaring that they will hold them to maturity. The hold-to-maturity loophole is an accounting abomination that violates basic accounting and finance principles. Instead, timely information on capital ratios based on market values ​​should be readily available to depositors.

Even with greater transparency, the playing field will remain uneven between the large, systemically important (“too big to fail”) banks and all other banks. The FDIC’s systemic risk exception effectively subsidizes large banks designated by the FSOC as systemically important through implicit deposit guarantees that are not available to smaller banks. And the FDIC is funding recent losses at regional banks with money raised through bank assessments that ultimately lower the rates depositors receive on their money.

The simplest and perhaps the most politically expedient way to avoid bank runs is to require all banks to have more capital. This solution involves the least amount of regulatory effort, is solidly grounded in economic theory and evidence, and eliminates the level playing field on which large and small banks compete, and on which all banks compete with non-bank lenders.

But lawmakers actually have four policy alternatives to address these inequalities in the banking system.

The first would be to stop guaranteeing any deposit. This alternative is not politically viable and, in practice, regulators will not stick with it when the big banks fail.

The second would be to guarantee all deposits. But such guarantees create moral hazard, because banks often take more risk when their deposits are guaranteed. They reap all the rewards when their investments are profitable, but share the losses with the guarantor when they fail. These regional banks failed due to moral hazard. When Treasury bill rates fell to near zero levels, the only potentially profitable strategy available to them was to roll the dice on long-term interest rates. If rates did not rise, there would have been no bank runs and the banks would have benefited. Yet rates rose, banks failed, and the FDIC eventually picked up the losses.

Consequently, deposit guarantors must regulate banks to control these moral hazards. But regulation is costly and often ineffective, as recent bank runs show. Too often, regulatory control has failed to prevent bank runs, and no evidence suggests that it will be more successful in the future. Deposit insurance also unfairly subsidizes bank financing by making cheaper money available to banks, while non-bank lenders operate at a disadvantage. Consequently, guaranteeing all bank deposits is an unfair political solution.

A third possibility is to require banks to hold enough short-term liquid safe assets to cover any potential bank runs. This proposal is attractive because the implementation is operationally easy. But it also faces significant political obstacles. Banks will claim that they must raise interest rates on bank loans if they cannot lend their depositors’ funds. However, any such increase would be due to the removal of the subsidy implicit in deposit insurance and government guarantees. This subsidy distorts capital allocation decisions and is unfair to all other financial institutions and people who lend money.

The fourth policy alternative is to require banks to hold so much capital that deposit guarantees do not influence their risk-taking behaviour. Under this proposal, the FDIC could guarantee all deposits because the guarantees would create little moral hazard. But the banks will not like this proposal either. They will claim that increasing the required capital ratios will decrease the money available for borrowing. But this argument is misleading. Banks can raise more capital to finance loans that are sound investments. In addition, well-accepted financial theory and evidence indicates that average capital costs fall when firms have more capital relative to the risk they take; that is, investors accept lower rates of return when their investments are safer.

Actually, there are three reasons why banks don’t want to hold more capital. First, the expected return on capital falls when banks have more capital for a given level of risk because the benefits of successful bank investments (mainly loans) are spread over more capital. But more capital also means that any losses are shared more widely, making capital less risky and therefore more attractive to most investors. Investors looking for higher expected returns can buy bank stocks on margin to gain more risk for a given dollar investment.

Second, the lower expected capital returns and volatilities associated with higher capital ratios lower the values ​​of executive compensation stock options. Consequently, bank executives prefer lower capital ratios.

Finally, and perhaps most importantly, high capital ratios reduce the moral hazard associated with deposit insurance. When banks are sufficiently capitalized, shareholders, not the FDIC, bear the losses associated with malinvestments.

The banking system’s excessive reliance on deposit insurance to prevent bank runs has created a game of heads I win, tails you lose, with the public playing the wrong side. These banking problems must end to facilitate long-term stable growth.

Larry Harris is a professor of finance and business economics at the University of Southern California Marshall School of Business. He was chief economist for the Securities and Exchange Commission from 2002 to 2004.

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