Financial and Monetary Systems

This is why (and how) banks are regulated

A review of the US bank's regulation and supervision is underway.

"The Collapse of a Bank," from 1881. A review of Silicon Valley Bank's regulation and supervision is underway. Image: Vladimir Makovsky/Public Domain

John Letzing
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Banking and Capital Markets

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  • The global impacts of Silicon Valley Bank's failure raise questions about current financial safeguards.
  • Overseeing the industry has become more challenging amid rising interest rates and pervasive social media use.
  • A review of the US bank's regulation and supervision is underway.

When I was working as a reporter in 2008, I had the pleasure of covering the failure of my own bank.

It’s still the biggest collapse in US history, though my account was unscathed. The second-biggest occurred earlier this month.

Silicon Valley Bank’s implosion may have people wondering how, not so long after the financial crisis triggered a raft of new safeguards, the demise of a lender many had never heard of could trigger speculation about yet another global contagion, or even a reshaping of capitalism as we know it.

The debacle points to the inherent difficulty in protecting people from an industry predicated on risk. That task may only be more difficult now, thanks to the inevitable uncertainty unleashed by sharply-rising interest rates.

Questions abound about whether the defenses currently in place are sufficient to eliminate fast-spreading danger from a surprisingly fragile and thoroughly global system; Silicon Valley Bank may have been just the 16th-biggest lender in the US, but its downfall impacted everything from start-ups in China to stock markets in Israel.

Have you read?

It also happened in an era when corrosive chatter about a bank’s health can spread at the speed of a tweet. The panicked run on Silicon Valley Bank that depleted it of essential deposits was probably the fastest in history.

The ensuing failure of another bank, the third-biggest in US history, further heightened scrutiny of the sector. A San Francisco-based lender proceeded to take a $30 billion rescue, and a benchmark index for US bank stocks fell sharply. So did a similar index in Europe, as Credit Suisse, one of the region’s biggest banks, submitted to a government-orchestrated takeover. Benchmarks in Asia faltered, recovered, and then fell again.

Proponents of tighter regulation reject the idea that most banks might actually be better off with a lighter touch, enabling them to do things like run their own stress tests as needed.
Proponents of tighter regulation reject the idea that most banks might actually be better off with a lighter touch, enabling them to do things like run their own stress tests as needed. Image: World Economic Forum

Silicon Valley Bank turned out to be uniquely vulnerable because it was so closely tied to business clients in the tech industry (it also made a uniquely unfortunate bet on bonds doomed to lose value in a world of rising interest rates). The role of big banks has certainly been questioned, should highly-specialized banks also draw particular scrutiny?

It’s not as if regulators didn’t have enough to consider already.

In the wake of the global financial crisis a decade and a half ago, these regulators tried to muster a collective response. The US expanded financial rules with the Dodd-Frank Act in 2010, which required big banks to undergo regular "stress tests" of their ability to absorb heavy losses (some elements were later rolled back).

The UK passed legislation requiring banks to “ring-fence” retail banking from more risky investment banking. The EU proposed simply breaking up big banks, by severing retail units from investment banking – an idea that was ultimately shelved.

At a more global level, the “Basel III” reforms set benchmarks for the protective capital that should be kept on hand relative to potentially-risky investments.

Policing the bank beat, calming the waters

The size and scope of problems that emerged during the crisis may have been new, but banking has worked pretty much the same way for a long time – minus a credit default swap here or a blockchain there. A run on imperial Rome’s banks a couple of millennia ago, for example, was followed by a familiar regulatory response: bailouts.

In 1825, a panic in Britain shuttered many small lenders that were in some ways precursors of Silicon Valley Bank; they also had relatively narrow access to capital from limited sources (think friends, family, and local farmers rather than tech start-ups). Regulatory reform enacted the following year enabled British banks to expand and diversify.

About a century later, more bad news was in store. More than 1,300 banks failed in the US alone in 1930, ushering in a global economic downturn. The government responded by insuring deposits up to a certain amount, and banning the mixture of taking deposits to make loans with more speculative banking activity, as part of the Glass-Steagall Act (in keeping with a recurring theme, the act was later mostly repealed).

The film “It’s a Wonderful Life” was released about a decade after Glass-Steagall, and somehow made a traumatic bank run a pivotal plot point in a holiday classic.

Several years after that, bank failures in India spurred that country to also start insuring deposits – something now taken for granted just about anywhere with a banking system.

No tweets necessary. The bank run scene in “Mary Poppins.” banking regulations
No tweets necessary. The bank run scene in “Mary Poppins.” Image: ABC Productions/YouTube

A bank account is a privilege. An estimated 1.4 billion adults still don’t have access to one, and the corresponding ability to gain some financial autonomy.

Some say that privilege should now be protected with more rigorous regulation. Soon after Silicon Valley Bank’s collapse, it was widely noted that 2018 rollbacks to the Dodd-Frank Act exempted the lender from related requirements, like regular stress tests. Others suggested its recent dash for loans from a system known as the “lender of next to last resort” should’ve been a clear warning sign.

As it turns out, regulators were aware of a number of issues at the bank. A review of its supervision and regulation is underway.

Proponents of tighter regulation reject the idea that most banks might actually be better off with a lighter touch, enabling them to do things like run their own stress tests as needed. “I taught school … and I did not let my students do their own testing,” US Senator Elizabeth Warren said recently.

As jitters continue to spread, however, the most important role for regulators right now might be to calm the waters. Because fear can be both contagious and self-defeating.

The bank run scene in “It’s a Wonderful Life” is a heart-warming illustration of the owner’s commitment to his community. But in truth, most of his customers actually brush aside his assurances about the positive things their deposits are being used for, like building their neighbors’ homes.

They just want their money back.

More reading on banks and regulation

For more context, here are links to further reading from the World Economic Forum's Strategic Intelligence platform:

  • One lesson learned recently, according to this analysis: the financial system is much more fragile than the public has been led to believe. (LSE Business Review)
  • What do Jane Austen and Silicon Valley Bank have in common? According to this piece, the regulatory response to troubled private banks in England and Wales in the early 19th century, including those owned by the novelist’s brother, holds lessons for the current situation. (The Conversation)
  • Ever wonder what your bank is investing in? This is a step-by-step guide to finding its balance sheet and assessing what it means in terms of risk. (Next City)
  • Rapidly rising interest rates were bound to claim victims, according to this piece, and the central bankers pushing them higher to fight inflation are “treading a narrow path.” (The Conversation)
  • “There [are] plenty of other banks, 186 to be precise, that sure look like they could be subject to a run.” A finance professor weighs in. (Kellogg School of Management)
  • “Regulators are supposed to grasp that they exist because bankers are always tempted to take risks.” This piece delves into the cycle of boom, bust, and bailout. (ProPublica)

On the Strategic Intelligence platform, you can find feeds of expert analysis related to Banking, Global Risks and hundreds of additional topics. You’ll need to register to view.

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