It's financial sector greed again

US and European regulators ignored basic risk management. But why do regulators allow financial sector firms to gamble with depositors' money?

On March 27, the Silicon Valley Bank (SVB) was taken over by the First Citizens Bank (FCB), backed by considerable financial support from the US Federal Deposit Insurance Corporation (FDIC). A college friend asked me about what had led to the collapse of the SVB. The subtext of his question was that following the North-Atlantic financial Armageddon in 2008-2009, the additional US regulatory controls should have made such a bank failure impossible.
 

A summary explanation is that over the past several years regulatory red lines have been blurred in the US. For instance, the July 2010 Dodd-Frank Wall Street Reform and Consumer Protection Act was diluted by the passing of the Economic Growth, Regulatory Relief, and Consumer Protection Act in May 2018. However, the SVB meltdown was not due to any sophisticated chicanery as in the case of Lehman Brothers. SVB had large stocks of long maturity bond and loan portfolios funded by short-term borrowings. Further, around 90 per cent of SVB’s individual deposits were more than the $250,000 insurance cap of the FDIC. In short, highly risky bets were taken by SVB and other mid-sized US banks, which involved maturity mismatches between liabilities and assets.
 

According to media reports, about 4,700 US banks with assets amounting to $10.5 trillion may be facing solvency or liquidity risk due to similar practices. The Federal Reserve is providing loans to such banks at the face value of their long-term assets, rather than at the much lower mark-to-market values.
 

The now defunct Zurich-headquartered Credit Suisse was set up in 1856 to help fund construction of railways. In recent years, Credit Suisse was hurt repeatedly by straying too far from its core competence of wealth management into investment banking. Finally, on March 19, 2023, at the Swiss government’s prodding, UBS bought out Credit Suisse for a sum of $3.2 billion. Additionally, the Swiss government has reportedly agreed to provide $9 billion to UBS. Indicating the seriousness with which the collapse of Credit Suisse was viewed, the US Federal Reserve, the Bank of England and other G7 central banks coordinated their efforts to increase the supply of US dollars in international financial markets.
 

Even basic MBA finance courses teach that modified duration (effectively maturity) matching between assets and liabilities is an elementary risk management measure. It has always been tempting for banks to fund higher fixed interest rate assets with lower floating interest rate borrowings, taking advantage of upward sloping yield curves. The SVB did just that and its borrowings repriced at higher interest rates as the Federal Reserve, the European Central Bank and the Bank of England raised benchmark interest rates sharply in the past 12 months.
 

Why are financial sector firms, including banks, allowed to take such risks with depositors’ money by regulators? The only rational conclusion is as Gordon Gekko, played brilliantly by Michael Douglas in a movie called Wall Street, announced with self-satisfied flair that in the financial sector “greed is good.” In a sequel called Wall Street 2, the same character Gekko declared that now “greed is legal.” Despite such flippant mockery, by and large that is what aptly describes the behaviour of many financial sector big-wigs in the US and West-Europe.
 

A pertinent question is whether senior managers in India’s private or public financial sector institutions should follow suit? The instances of wrong-doing by, for example, the heads of the Industrial Development Bank of India (IDBI), YES and ICICI banks were driven by individual greed and are too well-known to need recounting. The Unit Trust of India (UTI) and the National Stock Exchange (NSE), were set up with the funding support of majority government-owned financial institutions such as the Life Insurance Corporation of India (LIC) and public sector banks (PSBs). The UTI Asset Management Company (AMC) and the NSE have gradually acquired a private sector aura with their top managers paid Rs  5-8 crore per annum. The heads of the much larger and more systemically important financial institutions such as State Bank of India and LIC are paid a fraction of what the heads of UTI AMC and NSE earn. While it is a fact that India’s PSBs had to be recapitalised by taxpayers on several occasions, the borrowers who defaulted to PSBs were invariably large private sector companies, and fingers are usually not pointed at them as being sources of systemic risk. Unfortunately, it appears that the Insolvency and Bankruptcy Code is being incrementally diluted by private sector borrowers and by the incompetence, complicity or shortage of judges. Somehow a belief has gathered weight that listed private sector financial institutions are less likely to make mistakes driven by greed because the discipline of stock markets would rein in excessive risk taking. Well, we have the example of the Adani companies of just how much the markets can get the pricing of stocks wrong.  
 

A New York Times report dated March 21, on the SVB collapse mentions that “Michael Barr, who President Biden appointed as the Federal Reserve Bank’s Vice Chair for supervision, was carrying out a holistic review of bank oversight even before the failures.” Please note that word “holistic” again. According to Peter Conti-Brown, associate professor of financial regulation at the Wharton School, “There’s a lot of buck passing.” The only way to reduce irresponsible financial sector risk-taking is to reduce monetary compensation in this profession such that no one earns enough for several generations in merely three-four years. As Karl Marx had remarked, history repeats itself, the first time as a tragedy and then as a farce. It is amusing that this comment from a 19th century champion of the proletariat is so piquantly appropriate to the recurring financial sector meltdowns in the 21st century, invariably caused by the obscene avarice of its chieftains.

j.bhagwati@gmail.com. The writer is a former Indian ambassador and head of corporate finance at the World Bank, and currently a distinguished fellow at the Centre for Social and Economic Progress