Blog: The Flaws In Financial Regulation Seen Through The Downfall Of … – Eurasia Review

By Wei Hongxu*

Silicon Valley Bank (SVB) set a new record by collapsing just 48 hours after announcing its losses. Despite the efforts of U.S. financial regulatory bodies such as the Federal Reserve, the panic in the market has not been fully contained, leading to the collapse of several small and medium-sized banks and a sharp decline in the stock prices of the U.S. banking industry.

Against the backdrop of continued interest rate hikes by the Fed and high inflation in the US, many are worried that the collapse of SVB may trigger a new financial crisis domino effect. Several research institutions and market professionals are evaluating and analyzing the impact of the bank’s collapse on the financial sector, and most believe that the systemic risk caused by it is still controllable. They point out that although it does have an impact on the U.S. financial system and markets, the spillover effects will not be strong. However, the collapse of SVB does raise multiple issues for financial regulation that are worth further examining and researching.

The rapid collapse of SVB raises concerns about regulatory gaps. Financial regulation involves more than just post-lending supervision, it also requires a series of policies and rules that match capital and risk, and achieve proactive regulation to prevent the spread of financial risks. Since the global financial crisis of 2008, the U.S. has taken measures to address the blind spots and loopholes in financial regulation. It has strengthened the regulation of financial institutions, including banks, through standardized transactions and increased capital supplementation. However, it only took two days from the announcement on March 8 that SVB sought to raise more than USD 2 billion to fill the loopholes on its balance sheet, to the Federal Deposit Insurance Corporation (FDIC) announcing the bankruptcy of SVB on March 10. Many market professionals are puzzled as to why the deterioration of SVB’s assets was not detected by prior monitoring. Was there communication between SVB’s capital supplementation and regulatory agencies? Did the regulatory agency take over SVB too hastily or too late? These questions currently do not have definite answers, but the regulatory gaps do contribute to the factor of market panic caused by SVB’s collapse.

Secondly, many attribute the collapse of SVB to the Federal Reserve’s monetary policy of rapidly raising interest rates, resulting in asset losses. This is of course a major factor, making some banks with weak risk tolerance take the lead in problems. As the Fed continues to raise interest rates, researchers at ANBOUND note that there will be more institutions due to difficulty in bearing the pressure resulting in problems that emerge one after another, which is also the reason for the market panic. However, another problem is the effectiveness of financial supervision under the condition of a tightening financial environment. Although financial leverage has been restrained since the global financial crisis in 2008, many financial institutions have not really been able to grasp the risk prevention and control issues in a tightening environment of long-term low-interest rates and low inflation. This, as it stands, is also a long-term challenge for financial regulation.

Although SVB holds a large amount of tradable liquid assets, these assets are mainly low-risk U.S. Treasury bonds and asset-backed bonds, which have floating losses primarily due to the Fed’s interest rate hike. If held to maturity, no loss would have occurred. This raises the issue of risk measurement. It was SVB’s desire to replenish capital that triggered a run, making the liquidity risk problem uncontrollable. Therefore, there is still a lot of room for discussion and improvement in how to measure and manage these risks. According to some researchers, regulators understand that unrealized losses in bank securities portfolios can be problematic, but they have not taken any concrete steps to address the issue. The risk management of these liquid assets by regulatory authorities should be considered and dealt with from a broader and systematic perspective, rather than simply supplementing capital. As a result, the current predicament has emerged.

There is another conflicting focus on the coverage and handling of the deposit insurance system. One of the reasons for the run on SVB is that a large number of its deposits are not covered by federal deposit insurance. On the one hand, most of its customers are start-ups and relatively high-net-worth customers, which makes their deposits higher than the insurance limit of USD 250,000. This is the main factor causing the run. Some scholars believe that regulatory agencies may re-examine liquidity regulations and adjust the requirements for banks with funding sources far beyond small deposits to hold high-quality liquid assets. However, the regulatory authorities have agreed to pay depositors’ deposits in full, considering the chain reaction caused by the freezing of corporate deposits. This measure has been effective in preventing risk spillovers, but it has also put the deposit insurance system, which is designed to protect the interests of depositors, in an awkward position. It can neither restrain banks nor benefit the participants. In fact, some small and medium-sized banks that have current problems have similar problems, making this system face ethical risk and lose its effectiveness.

Another issue worth noting is the timing of financial regulatory intervention. In the early stages of the run on SVB, U.S. Treasury Secretary Janet Yellen stated that the bank would not be bailed out, but instead would be treated according to the “standard” crisis handling procedures of the deposit insurance system. However, several hours later, the U.S. financial regulatory authorities changed their stance after realizing the panic-inducing consequences of the run, announcing that they would take over SVB and fully pay out depositors’ funds, while the Fed would increase special liquidity support to prevent similar problems from occurring in other banks due to market panic. This approach did not calm market sentiment but instead made the market more worried that regulatory authorities were concealing larger problems, leading to more runs on small and medium-sized banks and a sharp drop in bank stock prices. This means that while the U.S. financial regulatory authorities have been able to intervene promptly, the flip-flopping of their policies has exacerbated the market panic they originally intended to avoid. For experienced institutions like the Fed and other financial regulatory authorities, their grasp of timing and market psychology still appears to be inadequate and lacks sensitivity to the signs of systemic risk.

Managing risk in complex environments is considered the instinct of financial institutions to compete and establish themselves in the financial market. Additionally, it reflects the professional and regulatory capabilities of financial regulatory authorities. Although financial institutions and regulatory agencies have taken measures to improve and make up for their shortcomings after various financial crises, the events surrounding SVB exposed numerous problems and shortcomings that financial regulation still faces. Financial regulation is not static; it needs to keep up with market developments, address new loopholes, and maintain a systemic approach while balancing the long-term and short-term needs and the market and individual interests.

Final analysis conclusion:

The sudden collapse of Silicon Valley Bank not only caught the financial market off guard but also exposed some flaws and issues in the financial regulatory system and its methods. These problems amplified and spilled over liquidity risks for small and medium-sized banks, causing panic in the market. Therefore, in terms of financial regulation, there are still many areas for reflection and research in the process of SVB’s downfall.

Wei Hongxu is a researcher at ANBOUND

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