Banking’s existential crisis leaves us with unanswered questions

I was vacationing with family last week and paid little attention to flighty bank deposits or gyrating bank stocks. Fortunately, there were no new bank runs, but markets and regulators remain nervous about what’s to come. Up in the air: whether current bank troubles will cause a broader credit crunch that slows the economy.

But my question for the morning is this: Once the crisis is past, who will enforce discipline in the banking system? The likely candidates all seem to have disqualified themselves:

• Depositors. It was probably foolish to think that uninsured depositors would be a prime source of discipline for misbehaving banks, particularly in a case like Silicon Vally Bank, where customers were effectively required to hold deposits at the bank in return for loans and services. But by promising to bail out all the failed banks’ depositors, regulators have taken depositor discipline almost entirely off the table. (I say “almost” because regulators are still waffling on exactly who is covered by the deposit guarantee.)

• Investors. Kudos to the short sellers who saw this coming, and profited as a result. But their numbers were too small to be an effective police force against bank misbehavior.

• Regulators. We now know it was an error (if not an act of policy malpractice) to set $250 billion as the threshold for “systemically important” banks. The failed banks fell below that level but were declared systemically important all the same. Even more disturbing is the revelation that regulators probably wouldn’t have caught the problem anyway. Why? Because their “stress tests” didn’t deal with a rapidly rising interest rate scenario.

That last revelation is particularly disturbing. (You can read more about it in Shawn Tully’s excellent piece here.) We’ve known for over a decade that we were in a historically unprecedented era of low interest rates–and that a return to the norm would be likely, if not inevitable. So why would the Fed not “stress test” banks for the effects of higher rates? The Wall Street Journal attempts to explain the failure this weekend here. But it still boggles the mind.

Market failure is the best argument for imposing regulation. And regulatory failure is the best argument for imposing market discipline. But what happens when both fail? That’s the unanswered question.

More news below.

Alan Murray
@alansmurray

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This edition of CEO Daily was edited by Jackson Fordyce.