Several large US financial institutions collapsed in March—including Silicon Valley Bank on March 10—and the government took extraordinary steps to rescue them. For members of the public who lived through the chaos of fall 2008, this has been incredibly frustrating. You might be asking yourself: “Why didn’t we fix this back then? Are we doomed to have more of these events in the future?”

The answers to both of those questions are actually quite simple. The primary legislative response to the last crisis, the Dodd-Frank Act, was incomplete in one important way.

The bill did many good things, but it failed to account for the fact that the core problems that arose at AIG, Bear Stearns, and Lehman Brothers (to name a few cases) all came from funding stressors that were inherent in their business models. Unfortunately, the bill did not seek to mitigate the risks associated with business models that rely on funding that can quickly evaporate. Ironically, Barney Frank (the Frank in Dodd-Frank) was on the board of directors for Signature Bank, one of the banks that failed.

Funding structures

There are several current examples of where the incompleteness of Dodd-Frank leaves the financial system vulnerable. One comes from certain mutual funds that own corporate bonds that themselves are rarely traded, but the funds allow people to take their money out immediately at full value. Another example is some of the crypto assets, so-called stablecoins, that again promise people the ability to redeem their money at a constant price even when the underlying assets behind the coins fluctuate in value. If these or other emerging businesses that are built on flighty funding are not properly regulated, we are going to see a replay of the recent chaos.

Two winners of the latest Nobel Prize in Economic Sciences, Chicago Booth’s Douglas W. Diamond and Washington University in St. Louis’s Philip H. Dybvig, pointed out the problem with these arrangements 40 years ago. Whenever the decision by one investor to redeem funds (or not to roll funding over) raises the incentive of others to do the same, the banking structure is inherently unstable. In the case of SVB, uninsured depositors were assured that they could get money out at the promised value even though many of the assets the bank invested in would decline in value if interest rates rose. For small levels of withdrawals, SVB could offer redemptions by selling assets that held value, but at some point, it would need to start selling impaired assets, meaning that there would not be enough proceeds available to pay everyone fully. Everyone wanted to get out before that point was reached.

History teaches us that rapid changes often are a signal of a quickly developing risk. 

Overhauling the FSOC

The problem is that vulnerable funding structures keep appearing in different guises and the regulatory system is not nimble enough to keep up. The fact that crypto assets grew so quickly with so little oversight is just one example of the problem. We need a more fundamental reform of the existing regulatory system to deal with this, such as overhauling the Financial Stability Oversight Council, one of the institutions created by Dodd-Frank.

The FSOC is the forum that brings together all the major financial regulators in the United States, including the Federal Reserve, the Securities and Exchange Commission, the Federal Deposit Insurance Corporation, the Commodity Futures Trading Commission, and several others. Because the US regulatory system is so fragmented, there are 10 voting members and five nonvoting members on the FSOC, which is chaired by the secretary of the treasury. This creates too many cooks in the kitchen, as all the members not only must be convinced that a risk is present but also must agree on recommendations for addressing it. As a result, the annual report of the FSOC is reduced to talking vaguely about many issues while failing to make sharp recommendations about risks and remedies. For example, the latest report does not mention risks to banks that are reliant on funding from uninsured deposits.

It is time to take US regulatory fragmentation and turn it into an asset—not a liability. As explained in a recent task-force report on regulatory reform by the Hutchins Center on Fiscal and Monetary Policy at the Brookings Institution and the Chicago Booth Initiative on Global Markets (which I coauthored), this requires four changes:

1. Every member agency should have its charter adjusted to include a financial-stability objective and a division of the agency that pursues that objective. No member agencies should be able to duck responding to risks by saying they aren’t their concern.

2. The annual reports of the FSOC ought to be restructured and turned into the FSOC’s flagship product. The main section of the reports should be authored solely by the Treasury and should identify its main concerns regarding financial-stability threats and suggest its proposed remedies, whether those remedies involve new legislation or just more action by the existing regulators. This would allow the Treasury to present its views without compromising.

3. Each of the other FSOC members should be required to contribute their own annex to the main reports. The members could challenge the Treasury judgments or call out other risks, increasing the odds that these risks are attended to before they crystallize into a crisis. If a crisis were to occur, the revised structure and accountability would leave no doubt as to who failed to spot emerging risks. If Congress was alerted to a threat and then failed to act, that would be clear too.

4. Finally, the reports should pay special attention to rapidly growing products, markets, or institutions. History teaches us that rapid changes often are a signal of a quickly developing risk. The current system is slow to adapt. SVB is a perfect example of this: it quickly expanded its overall size and altered its funding to become more reliant on the Federal Home Loan Bank of San Francisco for financing. These changes should have been a red flag. Insisting that regulators pay closer attention to these emerging trends would be a major improvement over the current system.

Anil K Kashyap is the Stevens Distinguished Service Professor of Economics and Finance at Chicago Booth. This is an edited version of an essay that originally appeared on ProMarket, an online publication of Booth’s Stigler Center for the Study of the Economy and the State.

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