Beyond the First Republic’s Failings: A Deep Dive into the Compromised Banking System

Not only the First Republic fell short. The entire banking system is involved.

U.S. financial markets are still in chaos. The government was forced to take over First Republic Bank, making it the third big bank to fail this year. As customers and investors abandoned the bank, its stock price plummeted to less than $4 per share on Friday from about $150 in February. This disaster is unfolding very gradually. There will most likely be further repercussions.

At least larger financial institutions came in to buy First Republic over the weekend. There were supposedly numerous bidders, but JPMorgan Chase ultimately prevailed. This means the largest bank in the country is getting even more extensive, making it not just too big for survival but too vast to fail as well. However, the terms of the contract were as favorable as could be expected. The FDIC did not have to rescue uninsured depositors, which is good news, but some FDIC funds were still required to sweeten the deal (about $13 billion). More than $35 billion has been spent by the FDIC so far to save these banks. This shows again how much better it is to prevent lousy banking practices before a crisis happens rather than trying to fix things after the fact.

Poor management, low regulations, and even laxer monitoring of medium-sized financial institutions contributed to this regional banking catastrophe. The quick increase in interest rates generated a hailstorm in the banking industry, but it was the kind of weather that bankers and regulators should have been ready for. Social media accelerated what would have taken days (or weeks) earlier, such as a bank run, at the first failed bank, Silicon Valley Bank.

Congress and the Federal Reserve Board had loosened regulations and oversight of midsize banks before the collapse of Silicon Valley Bank. The most detrimental omission was a mandate for adequate capital reserves (like those imposed on major financial institutions). The argument put out was that these medium-sized institutions didn’t warrant consideration. The American public and the rest of the world can now see how wrong they were in their first assumption. While not as severe as the 2008 financial collapse, this crisis has nonetheless acted as a drag on the economy. Now, it’s more challenging to secure a loan.

The top priority at the moment is stopping any further bank failures. In an awful precedent, regulators bailed out all Silicon Valley Bank depositors, including those with accounts worth far more than $250,000. (Deposits above that amount are often not insured by the FDIC.) The banks pay into an FDIC insurance fund, where the bailout money comes from. However, this cost is indirectly paid by all customers who deposit funds into a bank account. Understandably, Congress would be suspicious of a ‘blank cheque’ assurance of all deposits. It would be silly to do that. But if the strategy were more precise, the country could avoid a similar chaos. Significant companies should have their payroll accounts formally insured by the FDIC, but no more. In a study, the Federal Deposit Insurance Corporation (FDIC) suggested “targeted coverage” on Monday.

The second objective is to improve the supervision of financial institutions. In a 114-page study published on Friday, the Federal Reserve criticized its shortcomings that caused the collapse of Silicon Valley Bank. The Fed’s honesty in admitting its blunders is refreshing; it admitted to “slow recognition of risks and slow pace of supervisor action.” The Fed’s culture needs to change. Fed Vice Chair for Supervision Michael Barr assumed office in July and has been working to increase regulation. It is concerning that concerns that frontline Fed employees did identify were not resolved.

There is still a crisis going on. At the end of 2022, banks had unrealized losses of almost $620 billion, primarily due to interest rate hikes.

So, what are we to do? The Failed Bank Executives Clawback measure, introduced in Congress by bipartisan supporters, would be an excellent place to start. If a bank were to fail, the step would allow regulators to take back pay for bank executives from the five years before the failure.

However, clawbacks aren’t activated until after the fact. Executive compensation could be required to put long-term performance ahead of short-term gains if authorities want to discourage dangerous behavior. In addition, new regulations may make it harder for bank executives to “take the money and run” by mandating that they save considerable amounts of stock and options until retirement.

The latest Fed analysis on the causes of the collapse of Silicon Valley Bank suggests as much. Leaders “were underpaid to manage the bank’s risk,” according to the 102-page study, which calls for stricter stress testing, more significant liquidity requirements, and tighter limitations on executive compensation.

Those are encouraging developments as well, albeit not enough. Financial instability would persist if banks and bank executives weren’t motivated to consider the system as a whole rather than just their shareholders.