Over the course of one week, the Federal Reserve board’s reputation sank from hero to goat.
On March 6, S&P Global Market Intelligence announced that “the once-dormant belief that the Federal Reserve can tame inflation without decimating the U.S. economy is gaining new traction.” Inflation was coming down and unemployment was at a 50-year low.
As late as March 10, The Washington Post’s Catherine Rampell observed that economic performance was well ahead of expectations. Alan Blinder, Princeton economist and former Fed vice chairman, published an essay arguing that “soft landings” after Fed interest-rate hikes were more common than everybody supposes. The implication was that Jerome Powell’s Fed just might pull one off.
Inflation, now 6.4 percent, is still falling on an annualized basis, and unemployment, though up slightly, is still a very low 3.6 percent. Yet somehow we’ve stumbled into a banking crisis, and much of the blame resides with the very same Fed that seemed to be doing so very well.
You may ask: How could the Fed have known there’d be a run on Silicon Valley Bank that spread quickly to Signature Bank, and that both banks would collapse? Or that the apparently unrelated financial troubles at Credit Suisse, which required the bank to borrow up to $53.7 billion from the Swiss Central Bank to shore up its balance sheet, would so spook stockholders at First Republic Bank that it would start to wobble too?
Mea culpa: I didn’t anticipate any of this either. Last week I wrote that the failures of Silicon Valley Bank and Signature Bank “don’t pose much threat to the broader economy.” Today that looks more like a wish than an assertion of objective fact. But I’m just a schmuck journalist. I count on the Fed to be much smarter than I am, and you should too.
The Fed should have known trouble was brewing because it was warned in advance. One messenger was Kenneth Rogoff, a Harvard economist and co-author, with Carmen M. Reinhart, of This Time Is Different: Eight Centuries of Financial Folly (2011), an essential textbook for understanding the 2007–9 recession. On January 2, Rogoff wrote a newspaper column with the prescient headline, “The Looming Financial Contagion.” Rogoff said it was “a miracle” that we got through 2022 without a systemic financial crisis, and that “with public and private debt having risen to record levels during the now-bygone era of ultra-low interest rates, and recession risks high, the global financial system faces a huge stress test.” Rogoff was thinking more about Japan and Italy than the United States and Switzerland, but his diagnosis identified the very problem that brought down Silicon Valley Bank, i.e., overinvestment in long-term, low-interest government bonds that lost value as the Fed pushed up interest rates. Bankers call this “duration risk.”
Please note that I am not faulting the Fed for hiking interest rates. With inflation surging, it really had no alternative. But the Fed was inattentive to the stress these rate hikes placed on U.S. banks.
As I noted last week, a major reason for this inattention was the 2018 bank-deregulation law passed by Congress, which raised the threshold for banks that received special Fed scrutiny from $50 billion to $250 billion. (Silicon Valley’s and Signature Bank’s assets were $209 billion and $110 billion, respectively.) At a Senate hearing last week, Treasury Secretary Janet Yellen said that the law, in exempting Silicon Valley Bank and Signature Bank from certain “stress tests,” did not contribute to Silicon Valley’s and Signature Bank’s failures. But the law also allowed the Fed to exempt banks like Silicon Valley and Signature, with $100 billion to $150 billion in assets, from strict requirements on liquidity—and that, Yellen conceded, proved relevant to the failures at both banks. (Todd Phillips of the Roosevelt Institute, a former attorney for the Federal Deposit Insurance Corporation, or FDIC, argues that other provisions in the 2018 deregulation law came into play as well.)
In 2019 the Fed took Congress’s hint and, after consultation with the FDIC and the Comptroller of the Currency, eliminated strict liquidity requirements for midsize banks. Lael Brainard, then the board’s sole Democratic-appointed governor, voted against this change. In a strongly worded dissent, Brainard wrote that it went “beyond what is required by law and weaken[s] the safeguards at the core of the system before they have been tested through a full cycle.” Brainard noted that during the financial crisis of 2008, liquidity problems at two unnamed midsize banks “in the $100 to $250 billion size range” had “necessitated distress acquisitions.” Now, as Brainard moves over from the Fed to become chairman of Biden’s National Economic Council, or NEC, it’s happening again.
(By the way: Why does it always fall to women to call foul on fatefully bad economic policy decisions made by men? In the late 1990s, Brooksley Born, chair of the Commodity Futures Trading Commission, got condescended to by Larry Summers, Alan Greenspan, and Bob Rubin, a.k.a. Time magazine’s “Committee To Save the World,” when she proposed CFTC oversight of the derivatives that helped cause the economy to implode in 2008. In 2006, it was FDIC Chair Sheila Bair whom the big boys ignored when she warned about subprime mortgage bonds, which also played a starring role in the 2008 financial crisis. In 2019, it was Brainard. Let’s be grateful that, at this perilous moment, Biden has penis-free personnel running the NEC and Treasury.)
The 2018 law and the 2019 regulation established that the Fed was no longer required to apply special scrutiny to midsize banks. But they didn’t bar the Fed from doing so as circumstances warranted. That’s where Aaron Klein of the Brookings Institution, a former deputy assistant secretary at the Treasury Department under President Barack Obama, finds fault. Klein assigns blame specifically to the San Francisco Federal Reserve Bank, on whose board sat Greg Becker, chief executive of Silicon Valley Bank.
Klein identifies four red flags that the San Francisco Fed should have spotted. The first was the quadrupling of Silicon Valley Bank’s assets between 2019 and 2022. That alone should have drawn early scrutiny, but there were more signs. Fully 97 percent of Silicon Valley’s deposits were from customers who exceeded the $250,000 limit for FDIC insurance. “Uninsured depositors are more likely to run,” Klein points out. Also, in 2019–2021, the bank purchased more than $100 billion in mortgage-backed securities. Unlike in 2006, the problem here wasn’t the soundness of the securities themselves so much as that they carried low interest rates and were unmatched by investments that hedged against the Fed raising interest rates. You would think that the Fed, in carrying out its duties as bank regulator, would, in its capacity as an inflation-fighter, have some sense that betting too heavily on low interest rates was reckless. The fourth sign of trouble was that the Silicon Valley Bank was borrowing more cash than any other bank from the San Francisco Federal Home Loan Bank. (Close behind was First Republic.)
According to a March 17 Bloomberg report, the problem wasn’t that the San Francisco Fed failed to assign a team to scrutinize Silicon Valley Bank; it did. According to The New York Times, it issued six citations. The problem was that the Fed didn’t move early enough or fast enough or aggressively enough to alter the result. The final red flag was that Becker sold off $3.3 million in Silicon Valley stock starting in January. On the Friday that Silicon Valley Bank collapsed, Becker pushed out bonuses ranging from a reported $12,000 to $140,000 before the government took over. On that same Friday, Becker was finally relieved of his seat on the San Francisco Fed.
Where was the bank’s senior risk officer when the ship was going down? Well, actually, she stopped doing the job in April 2022. A replacement was finally installed in December, but, as Yahoo! Finance reported, she was based in New York, 3,000 miles from headquarters.
Powell, who two weeks ago was smelling like a rose, now carries the stink of incompetence and maybe even corruption. The New York Times reported on March 16 that Powell held up a joint statement by the Fed, the Treasury Department, and the FDIC announcing the government’s depositor bailout at Silicon Valley and Signature until a phrase mentioning regulatory failures was removed at his insistence. David Dayen of The American Prospect later reported that Powell initially persuaded Biden to soft-pedal these failures in a White House statement. That is very bad behavior. If Powell hadn’t been reconfirmed by the Senate as Fed chair until 2026, and were the Fed’s independence not so highly prized, Biden would have to fire him. The law says a president can fire a Fed chairman only “for cause.” Maybe it’s time to consider whether that circumstance applies here.