Investigate the Bank Failures

I want to concur with Luigi Zingales’s obseraations at City Journal that there needs to be an investigation of the bank failures:

Resilient institutions cannot be brought down by the failure of just one individual, even the CEO. In fact, banks have a number of important gatekeepers. The failure of these banks suggests that all these gatekeepers failed together. If we want to restore trust in the system, we need to understand why. Only an authoritative presidential commission can do so.

The first gatekeepers to be investigated are the boards of SVB and Signature Bank, which are responsible for ensuring that bank risks are properly managed. They were not. In June 2019, Delaware’s supreme court held that the board members of Blue Bell Creameries should be personally liable for losses the company suffered following a deadly listeria outbreak because they did not create a board-level process to oversee mission-critical risks for the company. Why should the same not happen to bank board members when the bank they supervise fails to adopt such basic risk-management techniques as hedging interest-rate risk?

The second gatekeeper to be investigated should be the auditors. On February 24, KPMG signed the audit report of Silicon Valley Bank. On March 1, it signed the audit report for Signature Bank. By law, auditors must state whether they have any doubt about a company’s ability to survive over the next year. In both cases, KPMG expressed no doubts. Within two weeks, both banks failed. If auditors are unable to detect fraud or risk, what are they paid for?

The last and most important gatekeeper to be investigated is the Fed. The knee-jerk reaction of many liberal commentators was to blame former president Donald Trump for these bank failures. Under Trump’s administration, midsize banks like SVB were exempted from the duty to conduct a stress test. If this relaxation did not occur, the claim goes, SVB’s risk would have been identified much sooner. This claim is false, however. As Nobel laureate Douglas Diamond clearly stated in the latest episode of Capitalisn’t, a podcast that I co-host, SVB would have passed the stress test with flying colors. The 2022 stress test did not evaluate banks’ exposure to the possibility of significant interest-rate increases. If the Fed did not fail in its role as regulator for lack of instruments, then why did it fail?

to which Aaron Klein at Brookings adds:

I count at least four classic red flags of the bank’s conduct that should have sent the alarm bells ringing, which the Fed appears to have slept through.

1. Explosive asset growth.…
2. Hyper reliance on uninsured deposits.…
3. Huge interest rate risk. …
4. Dash for cash to the Federal Home Loan Bank.…

Each of these red flags should have triggered greater scrutiny from the Federal Reserve. Combined, they become a red laser beam screaming for greater scrutiny. After all, SVB is not a Main Street bank and never was. Regional banks of its size ($200B) have around 1,000 branches: SVB had 16. This does not even include more potential red flags about the relationship between SVB’s venture capital arm and the bank’s customer base, a potential red flag the Fed’s regulation of the bank holding company should have analyzed.

He characterizes the Fed as “asleep at the switch”. That seems to be happening a lot lately. Allowing the Federal Reserve to investigate itself is insufficient. There needs to be a Congressional if not White House level investigation.

Not only is it important that the interests and responsibilities of bank management, boards of directors, the banks’ auditors, and the Federal Reserve need to be consistent and aligned, so do the interests and responsibilities of shareholders and stockholders in the banks.

There’s a sort of Spiderman rule here: with great covering of uninsured deposits comes great oversight.