First Republic’s failure shows we are fighting an unwinnable war

When Silicon Valley Bank was busy imploding earlier this year, and depositors were pulling their money out of shaky lenders to put it in safer-looking banks, the joke was that everyone was going to end up banking with JP Morgan. Now that the US uber-lender has agreed to acquire most of First Republic, another stricken bank, the gag is even less funny.

Make no mistake, this is yet another bailout. First Republic – like SVB and Signature Bank before it – was seized by the Federal Deposit Insurance Corporation (FDIC) before the sale was hastily arranged. The regulator has agreed to share the burden of any losses, which are expected to cost the FDIC something in the order of $13bn.

Jamie Dimon, JP Morgan’s chief executive, wanted to make it crystal clear whose idea this all was: “Our government invited us and others to step up, and we did.” The bank’s finance chief double underlined the point on a call after the acquisition was announced: “We did not seek out this deal.”

How did it come to this? Just under two months ago we passed the 15-year anniversary of the investment bank Bear Stearns being rescued from collapse by JP Morgan amid the global financial crisis. One of the key lessons then was that many banks had become “too big to fail”.

Getting the biggest lenders to swallow up smaller rivals was therefore seen as somewhat perverse at best and positively counterproductive at worst.

Over the subsequent decade and a half, global financial regulators have had countless meetings in airless rooms trying to figure out how banks could be safely wound down in other ways without jeopardising the wider economy.

Lenders are undoubtedly far better capitalised than they were in the lead up to the financial crisis. Nevertheless, as we saw with the collapse of Credit Suisse, strong capital and liquidity ratios offer meagre protection if depositors and investors take fright.

Regulators have also introduced new forms of debt that can be written off in a crisis and should – in theory – protect depositors in the event of even pretty large losses. Thanks to lobbying by many mid-sized US banks, this only applied to the largest lenders. And so, Dimon has been asked to ride to the rescue once again.

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We may have only suspected it before the wobbles of the last few months but now we know for sure: following almost 15 years of intense effort, the authorities remain concerned that, when push comes to shove, even quite small lenders would make too much of a mess were they to be allowed to die a natural death.

Financial regulators are often accused of fighting the last war. There are elements of truth in that. For example, derivatives fell out of favour following the financial crisis while government debt was considered a safe haven. But part of SVB’s problem was that it held too much government debt. This lost value as interest rates rose. Ideally, the bank’s management team should have hedged some of that risk with, you guessed it, derivatives.

But at times it seems like regulators are actually fighting an unwinnable war. Banks use liquid liabilities (deposits) to fund relatively illiquid assets that are hard to value (everything from mortgages to derivatives). This is simultaneously both their raison d’etre and their fatal flaw. It means banks are inherently unstable and prone to failure; you can make lenders safer but never completely safe.

Charles Goodhart of the London School of Economics recently highlighted what he called the trilemma of financial policy. Everybody wants sustained growth, low inflation and financial stability. The trouble is, it’s almost impossible to maintain all three for long.

Following the financial crisis, loose monetary policy helped to boost growth. But financial stability was maintained less by new regulations than the fact that interest rates were so low. When central banks were blindsided by high inflation they started to increase rates, financial fragilities started bubbling to the surface.

The recent travails of banks on both sides of the Atlantic augur for a period of tighter regulation as policy makers double down on their current approach. But this has big downsides. It may calm the markets for a time but it will also increase the cost of lending, especially to SMEs, and may even push the economy into a recession. “It is, at best, only a very short-term solution and will increase systemic risk in the longer term,” says Goodhart.

Policymakers are always trying to strike a balance: tighten the rules and slow economic growth or loosen constraints and deal with more frequent crises. This calculation is complicated because it’s not binary: tighten the rules too much and the risk might spill out into the less regulated shadow banking system and cause who-knows-what problems.

So what’s the alternative? The first step, according to Goodhart, is for regulators to stop kidding themselves that they can identify and measure – much less manage – all the risks in an infinitely complex financial system. This is the flawed thinking that underpins post-2008 regulatory policy and is the reason why – as we have seen with SVB, Credit Suisse and now First Republic – it has failed.

Such an approach essentially means almost all banks are protecting themselves against the same risks in the same ways. Stress testing, for example, looks at whether banks have the financial wherewithal to withstand specific scenarios. But when something unexpected happens, as it has a habit of doing, everyone gets spooked and the whole herd stampedes in the same direction. In this way, regulation can actually increase systemic risk.

Far better, Goodhart argues, for regulators to encourage new entrants to the financial industry and a variety of different business models. That may be easier said than done. For one thing, the current high regulatory burden makes it next to impossible for new entrants to break into the industry. For another, if one business model proves to be particularly lucrative, what’s to stop a slew of copycats?

That being said, he’s definitely right that we need a rethink because the status quo clearly isn’t good enough. Time to head back to those airless rooms.