Former Fed officials: Liquidity tweaks needed to prevent next SVB

Michael Nagle/Bloomberg

Revised liquidity standards are the key to preventing future bank runs like the one that toppled Silicon Valley Bank last year, according to a paper by former Federal Reserve officials.

Former Fed Govs. Dan Tarullo and Jeremy Stein are among the co-authors of a paper released late Wednesday that explores last year's bank failures and the evolution of the banking sector in recent decades. 

In it, they call for lowering the asset threshold at which banks are subject to the full liquidity coverage ratio — which requires banks to maintain enough high-quality liquid assets to withstand 30 days of significant deposit outflows — from $250 billion to $100 billion. They also say banks should be required to have enough assets pledged as collateral to the Fed's last-resort lending facility to offset uninsured deposits. 

"The concept is that the liquidity situation of the bank would be substantially enhanced, precisely because it had ready access to the discount window, collateral that was pre-positioned, and thus the Fed was in a position to provide the liquidity immediately to a bank, should it suffer a run on its deposits," said Tarullo, who served as the Fed's top regulatory official after the subprime lending crisis and through the implementation of the Dodd-Frank Act.

The suggestion comes as regulators in Washington prepare to put forth their own liquidity reforms at some point this year. 

Fed Chair Jerome Powell and Vice Chair for Supervision Michael Barr have stated that liquidity reforms are in the works, while acting Comptroller of the Currency Michael Hsu has already floated a set of potential changes: mandatory asset pre-positioning at the Fed's discount window and a five-delay liquidity requirement for certain banks.

The new paper, titled "The Evolution of Banking in the 21st Century: Evidence and Regulatory Implications," explores the implications of two potential sets of reforms: expanding insurance coverage to all deposits in the banking system and requiring banks to have full liquidity coverage capabilities. The paper was compiled for the Brookings Papers on Economic Activity, a semiannual conference hosted by the Brookings Institution, a Washington-based think tank.

In the paper, the Harvard-based research team — which also includes Samuel G. Hanson, Victoria Ivashina, Laura Nicolae and Adi Sunderam — noted that broad expansion of deposit insurance, aside from being politically nonviable, would also present "moral hazard" by incentivizing distressed banks to take on greater risks. 

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But, the report notes, the matter is complicated by the fact that banks' deposit bases are growing at a faster rate than their ability to deploy funds into new loans. Stein said this is driven by several factors including the Fed's own balance-sheet expansion and a preference for higher balances by depositors, as well as greater competition from nonbank lenders.

"It's not like people have great lending opportunities and are raising deposits for them," Stein said. "Rather, they have a lot of deposits incoming, and if you have too many deposits, it outstrips your natural loan opportunities, and the rest ends up in securities … mostly longer-term treasuries and mortgages."

The challenge in expanding liquidity requirements, the researchers note, is tilting banks more toward amassing securities and away from making loans. 

Tarullo said the solution lies in the treatment of high-quality liquid assets, or HQLA, within the liquidity coverage ratio, or LCR, as well as the collateral that banks can pledge to the discount window. He urges regulators to "harmonize treatment of collateral for LCR HQLA purposes with what's required for the backing of uninsured deposits."

The paper does not call for a dollar-for-dollar match of pre-positioned assets at the Fed's discount window to deposits beyond the $250,000 deposit insurance cap. Tarullo said he and his co-authors did not suggest a specific ratio because they felt they lacked the necessary information about deposits in the banking system to make such a determination.

But, he noted, that the suggested framework could go a long way toward reducing the stigma associated with discount window borrowing, a factor that regulatory officials and financial scholars say has long dissuaded banks from turning to the lending facility until it is too late. He said the framework would complement the current effort by Fed officials to encourage discount window readiness.

"My expectation is that [our proposal] would almost inevitably reduce the stigma associated with it, precisely because [the discount window is] incorporated into the regulatory system and wasn't just available as a kind of lender of last resort," Tarullo said. "I don't know that will get you all the way, but I think in combination with the hortatory efforts of the Board of Governors, the kind of thing that we're talking about should move us further in that direction."

Stein added that the discount window does not need to cure all the issues facing troubled banks to be an effective tool.

"I don't think we're necessarily under the illusion that all problems can be solved with discount window lending," he said. "But, even for a bank that is ultimately going to fail, having it happen in a slightly more orderly fashion and say, the discount window can buy you a week or 10 days … to have the failure happened in a more orderly way, maybe you're able to find somebody to sell the bank to rather than having to invoke a systemic risk exemption. That alone is a virtue."