Banks: The Weak Spot in a Strong Recovery

The larger problem is feeble and captured regulation, resulting in multiple intra–executive branch fights.

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As the economic recovery proves much more solid than expected thanks to President Biden’s public-investment programs and the private investment and job creation they stimulated (and no thanks to the Federal Reserve’s continual raising of interest rates, which fortunately fiscal policy has counteracted and which could finally be coming to an end), the economy does have one Achilles’ heel. Banks continue to take excessive risks, and undermine or sidestep necessary regulations for their safety and soundness. And the same Federal Reserve that overstates inflation is either complicit or insufficiently vigilant about these real risks.

This spring, several banks went under, including First Republic and Silicon Valley Bank (SVB). Regulators allowed First Republic to be acquired by JPMorgan Chase in a sweetheart deal that allowed America’s largest bank to get even bigger.

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SVB went bust because it was undercapitalized, hadn’t hedged interest-rate risk, and had pursued very rapid growth by accepting large deposits far in excess of the FDIC deposit insurance limit of $250,000. At year-end 2022, 88 percent of its deposits were uninsured. When customers began doubting its viability and started withdrawing funds, the government had the lousy choice of either bailing it out, brokering a shotgun merger, or violating the $250,000 limit. In the SVB case, it pursued a combination of all three.

As the Prospect has reported, examiners and officials of the San Francisco Fed had warned of the bank’s problems early on. But the higher-ups at the Fed Board of Governors in Washington did nothing.

Now it turns out that other banks have been trying to play some of the same games. Last Monday, the FDIC, which is a much better regulator than the Fed, sent a stern letter to U.S. banks warning them to stop misstating their exposure to uninsured deposits. Large banks, including Bank of America, had been cooking their numbers in regulatory filings known as call reports by claiming that uninsured deposits were collateralized by other pledged assets.

“This is incorrect because in and of itself, the existence of collateral has no bearing on the portion of a deposit that is covered by federal deposit insurance,” the FDIC said Monday in a letter on its website. In addition, said the Fed, some banks were improperly counting assets of affiliates.

When it comes to capital standards, the FDIC, whose deposit funds are at risk, is the strong regulator and Fed chair Jerome Powell is the weak one.

The near-term reason for this is that the FDIC was about to assess monetary charges on banks with large amounts of uninsured deposits, to replenish the insurance fund. But this cat-and-mouse game is part of a larger effort by at least some regulators to head off serious problems by ensuring that banks are well capitalized. That way, when losses occur, the bank has adequate reserves to cover them, rather than adding risks to the system and running to the government for bailouts because it is “too big to fail.”

And this conflict occurs not just between bankers and their regulators, but between strong regulators and weak ones that are overly friendly to banks. When it comes to capital standards, the FDIC, whose deposit funds are at risk, is the strong regulator and Fed chair Jerome Powell is the weak one—but with a twist. The Fed vice chair for supervision, Michael Barr, one of President Biden’s appointees, has been pushing for stronger capital standards, as in this July 10 speech. Powell has internally criticized Barr for pushing too hard.

New draft rules, requiring modestly higher capital standards for banks larger than $100 billion, were issued for comment by the Fed and the FDIC July 27. According to FDIC chair Martin Gruenberg, the rules would “increase tier 1 capital requirements by 16 percent for holding companies and 9 percent for insured banks.”

But even before they saw the rules, influential bankers were complaining that they would cut into profits and benefit rival non-bank financial companies not subject to the same rules. “This is great news for hedge funds, private equity, private credit, Apollo, Blackstone,” Jamie Dimon, head of JPMorgan Chase, said sarcastically.

“We think the capital increases are excessive and it puts pressure on returns,” said JPMorgan CFO Jeremy Barnum on the same earnings call July 19. “That obviously puts pressure on us to increase prices where we can. That is generally a bad thing for the real economy.”

This is of course self-serving nonsense. Banks already increase prices as much as they can. And it’s not as if banks and hedge funds or private equity companies are necessarily rivals.

Last week, Banc of California announced its intent to acquire PacWest, which reported a loss of $197 million for the second quarter. The only outside sources of capital for the deal are two private equity firms, Warburg Pincus and Centerbridge, which will get ownership of 19 percent of the bank.

Another factional fight within the Biden administration will determine the outcome of this merger. The Treasury Department, led by former Fed chair Janet Yellen, and her allies want to see more mergers, which they feel will bring stability to struggling large regional banks. Anti-monopoly reformers like Consumer Financial Protection Bureau director Rohit Chopra and Justice Department Antitrust Division head Jonathan Kanter believe that banking giants extract wealth from customers and make the entire system unstable. The PacWest/Banc of California deal is a key test case.

So is the fight over capital requirements. Politico reported last week that dissension on Fed vice chair Barr’s proposal rises even to the level of chair Powell, who expressed “reservations” about it. “While there could be benefits of still higher capital, as always we must also consider the potential costs,” Powell said in a statement. The chair is undermining his own vice chair of supervision and acting in concert with the big banks.

The entire financial system is overly concentrated and inadequately regulated. The rest of the economy is in recovery. As Deep Throat would have said, follow the money (men).

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