This Is the One Banking Regulation That Could Have Prevented This Year's Bank Failures

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KEY POINTS

  • The collapse of Silicon Valley Bank triggered a banking crisis that is still impacting American banks.
  • Increased regulatory scrutiny of small- and medium-sized banks could have prevented the recent banking failures.
  • Regulations often get introduced following a crisis and then rolled back in the years afterward.

Bank runs are scary. They happen when lots of people lose confidence in a bank and try to withdraw their money all at once. They were more common in the Great Depression of the 1930s, which saw thousands of banks collapse and wiped out millions of Americans' savings. The banking regulations that were introduced back then to restore confidence set the framework for many of the rules and protections that exist today.

Unfortunately, no regulation is perfect -- in part because it's hard to regulate against unexpected events as they are, by definition, unpredictable. Added to which, strict regulations tend to get passed after a crisis and then relaxed when times are better.

If we look at the collapse of Silicon Valley Bank (SVB), which triggered the current crisis, both factors played a role.

  • The unexpected: Ultimately, a combination of events caused SVB's failure. But a simplified version hinges on risk management and the changing value of bonds. SVB held large quantities of long-term bonds, which dropped in value as interest rates rose. When customers got nervous, SVB couldn't sell enough bonds without taking massive losses. Nervousness became panic, and panic triggered a bank run.
  • Relaxed regulation: There are a few parts of the Dodd-Frank Act, passed after the 2008 crisis and relaxed a decade later, that might have made a difference today. It's hard to know if they'd have outright prevented the SVB collapse, but they'd certainly have minimized some of the damage and raised red flags earlier.

Moving the goalposts

Banking regulations are often complex and multi-layered, but the drive behind them is simple: to protect the economy and consumers. As such, there's some logic to the argument that smaller banks pose less risk to the financial system and therefore require less stringent regulation.

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If a massive bank that holds assets over a certain threshold fails, it could do significant damage, so it follows that they have to follow tighter rules. However, what we saw with SVB is that even medium-sized banks can threaten the economy. Moreover, consumers could lose their savings if they collapse. Therefore, if one single banking regulation could have prevented these failures, it is this: a lower threshold for stronger supervision.

A lower threshold means the Federal Reserve would be able to apply stress tests, liquidity reviews, and increase its oversight of small- and medium-sized banks, just as it does for the big players. Indeed, When Dodd-Frank was first passed, the threshold for closer Fed scrutiny was $50 billion. This threshold was increased in 2018, so it didn't apply to SVB.

Had it still existed, SVB would have had to:

  • Undergo annual stress tests: Stress tests essentially explore how banks would perform in various scenarios such as recession or other market shocks. There's a requirement that banks have to have enough liquid assets on hand to cover extreme conditions. In plain language, they need enough capital to cover unexpected losses.
  • Create a "living will": Also known as a resolution plan, this sets out how the bank might manage its failure in a way that doesn't damage the wider financial system.

There's some debate about whether SVB's implosion could have been prevented by implementing existing regulations and following up on certain red flags more promptly. That's understandable. But the failure of three major banks so far this year highlights that the current system is not working. Without getting too far into the weeds, increased regulation and improved implementation are both necessary.

What to do if you're worried about your money

The White House is already talking about changing banking regulations in the wake of the recent bank failures. However, changing regulations can be a slow process. Plus, it's too soon to say whether the banking crisis is over. The hope is that JPMorgan's acquisition of First Republic will be an end to it, but many on Wall Street are not convinced.

If you're worried about the cash in your bank account, the most important thing to know is that customers have not yet lost any deposits. FDIC insurance covers deposits of $250,000 per customer, per bank, per account ownership category. SVB and Signature both had large sums of uninsured deposits, but authorities still made them whole to try to prevent further panic.

Even so, if you have a lot of money in your savings and checking accounts combined, it's a good idea to learn more about FDIC insurance and its limits. If you have more than $250,000 in deposits, here are just two of the ways you can increase your protection:

  • Open a new bank account: FDIC insurance applies $250,000 per depositor, per insured bank, for each account ownership category. As such, moving funds to a new account with an FDIC-insured bank would give you another $250,000 of coverage.
  • Open a joint account: There are two ways a joint account can change your insurance limit. Firstly, each person on the joint account is covered for up to $250,000. Secondly, this is a different ownership category, so if you have $250,000 in your name and another $250,000 in a joint account, both sums will be covered.

Bottom line

There's a good chance the recent banking failures will lead to increased regulation, including changes to consumer protection and additional oversight for small- and medium-sized banks. In the meantime, make sure your money is deposited with an FDIC-insured bank and try not to panic. There are lots of protections in place to make sure Americans do not lose their savings, and so far, they have done their job.

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