Current Bank Failures, Regulation, and the Business Cycle
Was deregulation responsible for the most recent bank failures and how does regulation affect the business cycle?
By J.W. Rich
With the recent collapse of Silicon Valley Bank (SVB) and Signature Bank, the long-standing debate over financial regulation in the United States has begun anew. The resolution? Whether or not the collapse of these banks was the result of de-regulation. Many throughout the media and academia have lined up to argue in the affirmative. Shortly after SVB and Signature’s collapse, Vox published an article with the headline, “A 2018 Banking Law Paved the Way for Silicon Valley Bank’s Collapse”. Bloomberg, while more modest in its claims, still ran the headline, “Deregulation Gets Some Blame for the SVB Blowup”. Elizabeth Warren has joined with the chorus of other voices calling for increased regulation as well, even going so far as to introduce legislation to impose additional regulation on the banking sector.
First, what exactly is the alleged de-regulation that these and other advocates blame for SVB and Signature’s demise? To explain this, some backstory on financial regulation is needed. In the aftermath of the 2008 Financial Crisis, Congress passed the Dodd-Frank Wall Street Reform and Consumer Protection Act, colloquially known as Dodd-Frank. The main purpose of this legislation was to ensure that banks, especially the largest banks, were not engaging in overly risky behavior that could put the entire financial system in jeopardy. For instance, one of the provisions of Dodd-Frank was that banks would be subject to “stress tests” to hypothesize how their asset portfolios would perform under various economic circumstances.
However, in 2018 the standards that determined how broadly Dodd-Frank would apply were altered by the Trump Administration. The rationale they gave for this move was that Dodd-Frank, which had been written with large banks in mind, was also levied against many small and mid-sized banks as well. The result was that their lending abilities were being suffocated under Dodd-Frank's restrictions, which could be ameliorated if they were instead exempted from the bill altogether. Thus, the total capital value for a bank to comply with Dodd-Frank was raised from the original $50 million to $250 million.
According to regulation advocates, it was precisely this move that would lead to the ignominious fates of SVB and Signature. With the post-2018 changes, they were both under the new capital requirements for Dodd-Frank to apply, thus making them both outside of any of its controls. While hindsight is 20/20, would the Dodd-Frank protections have prevented SVB and Signature from collapsing?
The simple answer is: almost certainly not. Contrary to the wailings of regulation advocates, SVB and Signature were not engaged in risky, casino-style investments. SVB held a very large portion of its assets in US bonds - the safest assets under the sun. Ditto for Signature Bank as well. More than anything, these banks were just the victims of good, old-fashioned bank runs (if you recall, George Bailey had a safe asset portfolio as well). Even stress tests would only have tested for lowering interest rates and shrinking inflation, not the rising interest rates and increasing inflation that actually prevailed. Thus, any claims that Dodd-Frank would have saved SVB and Signature are specious at best.
However, the broader question still remains: can regulation prevent financial distress and bank failures? This is especially important within the context of economic depressions and the bust of the business cycle. Even if Dodd-Frank would not have saved SVB and Signature, would more regulation of a different sort possibly prevent further bank failures and financial crises in the future?
In order to answer this, we have to first understand the oft-misunderstood business cycle. The business cycle is marked by two phases: the boom and the bust. During the boom, the economy writ large seems to be doing very well. Profits are up, wages are increasing, and demand is strong. However, it is not to last. Eventually, the bust comes along and all the good sentiments built up during the boom are ignominiously shattered. Businesses fail, employees are laid off, and stock prices tank. Eventually, the economy slowly starts to recover, and things slowly start returning to normal.
There are a few core aspects of the process of the business cycle we could key in on, but the element most important for our interests is the “cluster of entrepreneurial errors”. In other words, when the bust comes along, many investments that entrepreneurs believed to have been profitable ventures are revealed to be mistakes. When those revelations manifest themselves, the result is economic pain, as these losses have to be incurred. Some firms are able to take the hit, but others cannot and are forced to close their doors. The million-dollar question is: why? Entrepreneurs make individual mistakes all the time, but why would the business cycle result in a cluster of these errors being made all at once? In other words, why are there systematic, not individual, mistakes being made?
These malinvestments come about because of falsified price signals, specifically, a falsification in the interest rate (which can be seen as the price of buying present resources in exchange for future resources). In an unhampered market, the interest rate would result from the supply of savings and the demand for those savings. However, in our modern day, interest rates are set (or more accurately, heavily influenced) by central banks. This presents a problem, however. If a central bank decides to set the interest rate too low - at a rate which would imply that more savings exist than actually do - then entrepreneurs will jump on the opportunity to borrow money and invest. However, because these lower interest rates are unnaturally low, the savings to fund these investments does not actually exist. Whenever the artificially low interest rates are eventually returned to their normal levels, the lack of savings is revealed and the investments revealed to be mistakes. It is this revelation that constitutes the cluster of errors - comprising failed investment decisions - that characterize the bust phase of the business cycle.
The question of regulation, then, is essentially a question of whether or not regulation could prevent the malinvestment decisions that the entrepreneurs erroneously embark upon. From all appearances, the answer is no. For regulation to be effective in this scenario (assuming flawless implementation and the absence of unintended side effects - neither or which are realistic assumptions), there must be some way to discern between safe and unsafe investment opportunities. But that’s the catch. It is precisely because these investment opportunities look appealing - particularly in the light of lower interest rates - that they are pursued in the first place. These investments do look safe, and at least for a time, they are successful. It is only ex post, not ex ante, that these investments are revealed to have been mistakes.
Ludwig von Mises used a metaphor for the business cycle in Human Action that may be of assistance here. He viewed the economy as being a builder who is in the process of building a house. He has a plan for how he is going to build this house, given the number of bricks he has available to him. However, he has been deceived about the number of bricks at his disposal. He will not have enough to complete the house as planned. By the time he makes this discovery, he will have to tear the partially completed house down, re-evaluate his plan, and start over again. In this metaphor, the builder is the entrepreneur, and his mistaken belief about the bricks is analogous to the artificial lowering of interest rates. The tearing down of the house and restarting is a parallel to the bust phase of the business cycle.
Using this analogy, regulation would have the role of an examiner who checks the plans of the builder to ensure that they are not overly risky or ambitious, given the bricks at his disposal. However, the plans themselves are not the problem. The problem is found in the assumptions the plans are built upon - i.e. the number of bricks available. If the number of bricks was accurate - or to move out of the analogy, the amount of real savings in the economy - then the plans would be executed without any issues. It is because of the assumptions of the plans, not the plans themselves, that the builder is forced to tear down his partially-completed house and restart the building process.
Similarly, the most any regulatory body can do is to examine the plans of a business to judge their relative risk and danger to the system as a whole. But just as in the case of the builder, the economic devil is in the economic details. The plans themselves are not at fault, but the assumptions they are built upon. The newly-lowered interest rate induces businessmen to invest, and they create their plans with this rate in mind. For a while, their investment decisions will seem to be wise as their “houses” are being built. However, once these interest rates are revealed as illusory, then the unprofitability of these houses is revealed. Regardless, a regulatory body would have approved these plans all the same. It is not because of a foreseeable risk or unsustainable business strategy that the cluster of errors occurs, but rather, because of misleading price signals in the interest rate. The businesses and the businessmen are not at fault, but the manipulations in the market that led them to falter.
Regulation, then, cannot prevent financial crises or economic crashes. It is not because entrepreneurs systematically take on too much risk that financial crises occur. Rather, it is because they are misled about the risk that they are incurring in the first place. The root of these misleading price signals can be found in central banking and its nefarious control over interest rates. To end the business cycle once and for all, central banking’s tampering with interest rates must be suspended once and for all. If not, then we can expect plenty more firms following the example of SVB and Signature Bank in the future.
About the Author
J.W. Rich is an independent writer whose upcoming book is titled Praxeological Ethics. He is also the host of the Marginal Investigations Podcast. Rich’s long form writings can found here.