OCTOBER 2023

FEDERALRESERVE:

CONFLICTS BETWEENMONETARY POLICY ANDBANK REGULATION IN
TACKLING
INFLATION
Aaron D. Klein, Miriam K. Carliner Chair and senior fellow, Economic Studies at the
Brookings Institution

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The Brookings Institution is financed through the support of a diverse array of foundations, corporations,
governments, individuals, as well as an endowment. A list of donors can be found in our annual reports
published online. The findings, interpretations, and conclusions in this report are solely those of its
author(s) and are not influenced by any donation.

Abstract: Covid was a worldwide economic shock, creating a global recession later followed bywidespread inflation. Central banks responded to the Covid recession by slashing interest rates.
Fiscal authorities across the world flooded their countries with direct stimulus. Combinations ofcentral banks in their lender of last resort authority, and fiscal authorities provided substantial
support to credit, equity, and debt markets, largely protecting (bailing out) investors from theunexpected and uncertain impact of Covid. As Covid’s economic shock wore off, inflation
surged.
America’s response to Covid was particularly aggressive across all three dimensions: monetary,
fiscal, and markets. America’s economy, as measured by traditional factors such as GDP and
employment, generally outperformed other nations similarly impacted by Covid. Inflation in
America was similar to those of other nations subject to Covid shocks and disruptions in theprice of energy and other goods caused by Russia’s invasion of Ukraine. However, America
experienced substantial instability in its banking sector. Multiple banks failed, resulting in theFederal Reserve and other government agencies invoking emergency authority designed toprotect financial stability.

This paper argues that the Federal Reserve has unique responsibility for this banking crisis fromits multiple roles of 1) monetary policy; 2) financial stability regulator; 3) lender of last resort; 4)bank supervisor; and 5) payment system regulator and operator. These roles should in theory
produce economies of scope allowing the Fed to more effectively perform each function.
America’s spring 2023 banking crisis instead shows that the Fed’s current implementation ofthese roles causes substantial contradictions and problems resulting in unnecessary financial
instability and bailouts of creditors. The promise of the financial reforms undertaken after the2008 global financial crisis, which resulted in increased regulatory power for the Federal Reserve
was greater financial stability and the end to financial bailouts. Yet 15 years later the Federal
Reserve invoked systemic risk authority citing a threat to financial stability emanating from thefailure of institutions it supervised. These mistakes will result in slower economic growth andgreater income inequality. Policymakers should question whether these roles should be separated
resulting in lower authority and a smaller mandate for the Federal Reserve.

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The 2020s Economy: Covid shock, Inflation Rebound
The Covid pandemic generated similar economic shocks around the world, with lockdowns,
supply-chain disruptions, and breakdowns in domestic economic activity and global trade.
Central banks globally responded with sharp decreases in interest rates (Vallence and Wallis2020). Fiscal stimulus was broadly enacted, with different mechanisms attempting to achieve
similar results: targeting assistance to those most directly impacted and vulnerable to therecession while stabilizing the macroeconomy until the pandemic could recede (Soyres,Santacreu, and Young 2022). Lenders of last resort authorities were activated, with support
provided to a broad array of participants including banks, broker-dealers, and in many cases
owners of debt and other investors (Vallence and Wallis 2020).
America’s size and distribution of US fiscal stimulus was among the largest (Council of
Economic Advisors [CEA] 2022). While the United States historically has a smaller social safety
net than most other developed economies (Gould and Wething 2012), the US fiscal response wassignificantly larger. Figure 1 shows the US fiscal response amounting to over 25% of GDP, noother country listed broke 20 percent and the Euro average was just over 10 percent (CEA 2022,
102)
Figure 1 Discretionary fiscal response, 2020: Q1-2021: Q3

Source: (CEA 2022, 102)
Original Data Source:(International Monetary Fund 2021)

The fiscal response consisted of large direct payments to individuals and businesses (CBPP Staff
2023). Direct individual and family support was provided to a large proportion of the public –228 million individuals (about 70%) of Americans were eligible for the first Covid payments of$1,200 for individuals, $2,400 for married couples, and an additional $500 for each child, withthese amounts being reduced for individuals making more than $75,000 (U.S. Department of theTreasury n.d.; Clark et al. 2023, 5).

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Enactment of these payments was swift; delivery lagged. Despite a divided government with a
Democratically controlled Congress clashing with President Trump, Congress enacted the
CARES Act in March 2020, before economic indicators such as unemployment and GDP had
been reported. However, actual payment was substantially slower. Payments were not sent out
until two weeks after the law was passed and then only to a minority of Americans for whom thegovernment had accurate bank data. By May 1st 34% of eligible families still did not have accessto their initial payments which continued to trickle out for months as shown in figure 2.
Figure 2 Percent of eligible recipients whose Economic Impact Payments were disbursed ineach period as of September 20, 2020.

Source: (Murphy 2021, 10).
Original Data Source: Financial Health Network analysis of GAO reports from 9/21/2020 and 11/30/2020.

Business payments labeled as attempts to provide support to workers, such as the “paycheckprotection program (PPP),” were often transfers to owners with relatively little requirement thatfunds go to workers (Klein 2020). America uniquely used the banking system as a conduit toreach business owners (Baker, Judge, and Klein 2022). As a result, aid was skewed toward
companies that had stronger relationships with banks (Li and Strahan 2021; Glancy 2023). Given
America’s history of racial discrimination and existing differences in banking relationships, theresult was disproportionate provision of aid toward white-owned businesses and away from those
owned by women and minorities, particularly in the first round of PPP funding (Chernenko et al.
2023; Chernenko and Scharfstein 2021; Fairlie 2022).

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Other countries, such as Germany, structured payments directly to workers through fiscal
authorities such as taxation agencies rather than through banks (Gotbaum, 2020). This resulted in
more equitable distribution of assistance and improved targeting to workers. It may account forthe order of magnitude less fraud experienced in Germany compared to the US. In the US $67
billion (about 8%) of funds from PPP loans and $136 billion of Economic Injury Disaster Loans(about 33%) were distributed to fraudulent actors, while a news report estimated German fraud
in only the hundreds of millions (Office of Inspector General 2023; Deutsche Welle 2021).
Analysis studying the efficacy of the responses (OECD 2020), including economist Jason
Furman, have argued that “the US will come out of this economically better than any country
that was similarly affected by the virus” (Matthews 2021). America’s GDP gap was the smallest
relative to other advanced economies as seen in figure 3 (Harris and Sinclair 2023).
Figure 3 Real GDP shortfall relative to pre-pandemic trends.

Note: Pre-pandemic trend is estimated over 2015-2019. Source: (Harris and Sinclair 2023)

America’s Mini Bank Panic of March 2023
America suffered a bout of financial instability when four banks failed in a short time spanstarting in early March 2023. Bank failures alone are not a mark of financial instability in
America. On the contrary, banks routinely fail, with almost every year having at least one bankfailure (Klein 2018b). In response to the bank failures in March 2023, the Federal Reserve and
FDIC with the support of the Biden Administration, invoked exceptional authority designed only
to address financial instability. This included the FDIC’s invocation of its systemic risk authority
and the Federal Reserve’s creation of the Bank Term Funding Program capitalized by funds fromthe U.S. Treasury (Board of Governors of the Federal Reserve System (US) [FRB] 2023d).

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Most of the rest of the advanced economies globally did not experience banking instability (withthe important exception of Switzerland who experienced financial instability resulting in themerger of Credit Suisse and UBS). To understand the root causes, it is important to begin with an
overview of some of the unique aspects of the United States banking system. We will thenincorporate the consequences of America’s pandemic response for the banking system. Finally,
we will turn to the Federal Reserve’s role as bank regulator in this crisis and connect the dots to
its conduct as monetary policy authority. This portion will include an analysis of the Fed’s
unique structure as a central bank comprised of both a government institution (Board) andprivate entities (Regional Banks).
America’s large and diverse banking system
America’s banking system is globally unique on many dimensions. One of which is the sheer
number of banks. America has over 4,000 banks, the largest number of any country (Smith
2023). America also has more than 4,600 credit unions, bringing the total number of insured
depository institutions to almost 9,000 as of the second half of 2023 (National Credit Union
Administration 2023).
America has so many banks today because it had even more in the past. America had over
14,000 banks in 1986 (Emmons 2021). America’s fractured banking system was the result oflegal structures that for much of its first century precluded national chartering and for more than
the next century functionally made multi-state branching extremely difficult. Consolidation
nonetheless took off during the late 1980s with a combination of technological changes
benefiting scale combined with significant structural problems through the savings and loansystem, which resulted in large public bailouts, depositor losses, and a massive wave of bankfailures (Emmons 2021). Subsequent legislation (FDICIA and FIRREA) reformed regulation anddeposit insurance while the Riegel-Neal Act functionally removed prohibitions on inter-state
branching.
As figure 4 shows, bank consolidation has been a hallmark of the American banking systemsince the mid-1980s. This long-term trend presents evidence counter to the argument that newlegislation and regulation following the 2008 global financial crisis caused bank consolidation,
as some, such as Lux and Greene (2016), have claimed.

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Figure 4 Commercial banks U.S

Fractured Regulatory System and Fractured
Federal Reserve System

America’s regulatory regime remains
fractured along historical lines. Most
American banks are state-chartered, free tochoose their federal regulator between theFederal Reserve (so-called member banks)
and the FDIC (non-member banks).
Nationally chartered banks are regulated by
the Office of the Comptroller of theCurrency (OCC). All banks are required tohave federal deposit insurance which gives
the FDIC secondary back-up regulatory
Adapted from: (Federal Financial Institutions Examination
authority and primary responsibility forCouncil (US) and Federal Reserve Bank of St. Louis 2023).
resolutions. Finally, America separatesbanking and commerce. That separation isenforced through a requirement that banks owned by an entity that owns multiple enterprises,must be a bank or financial holding company. All bank and financial holding companies are
regulated by the Federal Reserve.
The Fed’s regulatory authority is both deep and broad. As holding company regulator, the Fed
has substantial authority over the largest, most complex financial institutions even when they
operate nationally chartered banks. As a primary bank regulator and supervisor, the Fed has
direct responsibility for many of the nation’s state-chartered banks most of which are small.
Broadly speaking, regulation is the writing of rules and policies, while supervision is theirenforcement. As Conti-Brown and Vanatta (2021) eloquently put it: “If regulation sets the rulesof the road, supervision is the process that ensures obedience to these rules.”The Federal Reserve System is headed by a Board of Governors (Board). The Fed Board has
seven appointed Governors, with three secondary appointments as Chair, Vice Chair, and Vice
Chair for Supervision. The Chair serves as the agency’s head and as discussed later the leader of
the Federal Open Markets Committee that conducts monetary policy. The Vice Chair is thesecond in command of the Board. The Supervision Vice Chair is essentially the head of theBoard’s bank regulation and was created as part of the Dodd-Frank Act in response toCongress’s conclusion that the Fed had failed in its role as bank regulator in what caused thefinancial crisis (Conti-Brown 2021). The Board is based in Washington DC as part of the federal
government. Board Governors are appointed by the President and confirmed by the Senate.
The Federal Reserve has 12 Regional Banks. Fed Regional Banks are not part of the government.
Chartered by Congress in the Federal Reserve Act, the Regional Banks are owned by theirmember banks and run by a President selected by the Regional Bank Boards of Directors withapproval by the Fed Board. The hybrid public-private nature of the Fed was designed tomaximize political independence and allow for regional and banker input into the conduct ofmonetary policy (Conti-Brown 2021). While the system has been altered over time, the Regional
Bank/Board structure has remained largely intact.

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The Federal Reserve carries out its bank regulatory and supervisory responsibilities in a fractured
manner. The Board of Governors is responsible for all regulation. Supervision is primarily a
responsibility of the Reserve Banks. However, when banks or financial institutions become large
enough, portions of that supervisory authority are transferred back to the Board. Thus, the Fed’sinternal supervisory structure relies on both the Board and the Regional Banks to workcollectively with coordination and similar judgment.
The hybrid regulatory and supervisory system of bank regulation and supervision mirrors the
hybrid conduct of monetary policy. Monetary policy is established not by the Board but by theFederal Open Markets Committee (FOMC). The FOMC consists of all Board Governors andRegional Bank Presidents, however voting membership on the FOMC consists of just theGovernors, the President of the New York Federal Reserve, and four of the remaining eleven
Regional Bank Presidents on a rotating basis. Thus, when fully constituted, the Governors haveseven votes to the Regional Bank Presidents’ five. As a matter of custom, but not law, the Chairof the Board is voted by the FOMC members as chair and the President of the New York Fed as
vice-chair.
Sharp Rise in Deposits
America’s banking system experienced a sharp rise in deposits as a result of response measurestaken during the Covid pandemic. As figure 5 illustrates, the trend line of commercial bankdeposits was stable for years leading up to the pandemic but then jumped sharply and remained
elevated for several years. Deposits rose by $2.25 trillion between March 11 and September 16,
2020, as fiscal policy flooded consumers, businesses, and state and local governments withstimulus funds. Calculating from the data in figure 5, this was a 17 percent increase in theexisting deposit base. To put that in perspective, it took three years, from January 1, 2014, toJanuary 4, 2017, to achieve a 17 percent deposit increase over the 2014 level.
Figure 5 Deposits, all commercial banks.

Adapted from: (FRB 2023a).

The rapid growth in bank deposits in the US is plausibly explained in large part by America’s
larger fiscal response than other nations (Castro, Cavallo, and Zarutskie 2022). The federal
8government flooded households, businesses, states and local governments with cash. While somewas directly spent to replace lost income, much was saved. Savings were likely particularly highgiven uncertainty regarding the length of Covid shutdowns and the recession.
State and municipal governments received larger surpluses of federal assistance than they could
spend. State governments are required to run annual balanced operating budgets and use “rainyday” reserve funds to handle excess revenue and prepare for recessions. 1 41 states increased theirrainy-day funds in 2022, due in part to historical federal aid (Theal 2022). Figure 6 shows the
sharp increase of state rainy day funds, nearly $100 billion.
Figure 6 Total state rainy day fund balance

Source: (Boddupalli 2023).
Original Data Sources: National Association of State Budget Officers. State Rainy Day Fund Balances Historical
Data Set, 1988-2024. June 2023; Bureau of Labor Statistics. Consumer Price Index. “R-CPI-U-RS Homepage:
Updated R-CPI-URS, All items, 1977-2022.” 2023.

As seen in figure 5, covid policy responses resulted in the deposit base achieving 3 years ofgrowth in a six-month time span. This left banks with a simple but important question: what to
do with the excess deposits?
Banks’ traditional role is to take deposits and make loans (Gobat 2012). Thus, as deposits rise so
too should lending. However, the pandemic changed both demand and supply for lending in
multiple ways most of which pointed toward reduced lending. First, there was a sharp recession.
Economic contractions reduce the supply of bank credit as banks tighten lending standards andhave reductions to capital in the form of increased loan loss reserves (Chen, Hanson, and Stein
Technically only 49 states have balanced operating budget requirements (Vermont is the outlier which is a tinystate) for more see Boddupalli, “State Rainy Day Fund Balances Reached All-Time Highs Last Year.”https://www.taxpolicycenter.org/taxvox/state-rainy-day-fund-balances-reached-all-time-highs-last-year192017). This happened in the United States
as illustrated in figure 7 from the Federal
Reserve’s banking systems condition
report which shows the large increase inloan loss reserves in 2020 (FRB 2022, 5).
While this trend was reversed in 2021, theinitial experience in 2020 resulted in lower
availability of credit.
Additionally, high levels of uncertainty
impact lending. Increased uncertainty inthe future of individuals’ financial status
and businesses’ ability to execute their
Source: (FRB 2022).
plans, generally leads to less lending
Original Data Source: Call Report and FR-Y-9C.
(Raunig, Scharler, and Sindermann 2017; Buch, Buchholz, and Tonzer 2015). Banks should
therefore tighten lending criteria and reduce total lending.
Figure 7 Provisions for loan and lease losses as ashare of average loan and leases

Banks reduced lending standards in the United States. Figures 8,9, and 10 show changes in
lending standards in the US against changes in loan demand. All show lending standards rising
sharply in the US, even more so than in other countries. Figure 8 shows lending for households,
figure 9 for all firms, and figure 10 for a subsection of loans, commercial and industrial, that areclosely followed (Bodovski et al. 2021).
Figure 8 Changes in Lending Standard for Households

Note: The sample range is the interquartile range of lending standards for France, Germany, Italy, Japan,
Netherlands, Poland, South Korea, Spain, United States, and United Kingdom. The shaded area denotes the GFC.
Source: (Bodovski et al. 2021)
Original Data Sources: Bank of England, Bank of Japan, Bank of Korea, European Central Bank, Federal Reserve
Board, and National Bank of Poland.

10Figure 9 Changes in Lending Standards for Firms

Source: Ibid

Figure 10 Changes in Commercial and Industrial Loans, Credit Standards, and Loan Demand.

Notes: Tightening Credit Standards refers to the net percentage of banks reporting a tightening of credit standards.
Increase in Loan Demand refers to the net percentage of banks reporting an increase in the demand for loans over2020:Q2-Q3. C&I loans.
Source: Ibid.

America’s economy recovered faster and at a greater level than other countries (Milesi-Ferretti2021). All else equal, faster macroeconomic growth would be likely to correlate to faster11

lending. However, American banks tightened lending standards at a greater rate than observed inother countries. This created even greater excess deposits than observed internationally. The
investing of these excess deposits created an important seed that led to the financial instability in
America’s banking system in the spring of 2023.
Monetary Policy and Bank Regulation: Increasingly Conflicting
America’s banks were awash in deposits during Covid, substantially driven by Covid-related
fiscal policy. Lending opportunity declined during the pandemic, an expected outcome given therecession and rising uncertainty (Buch, Buchholz, and Tonzer 2015; Raunig, Scharler, andSindermann 2017). The result was that banks needed to put their deposits in something. The
Federal Reserve had cut rates to near zero, so parking excess reserves at the Fed would not be
profitable. Investing excess deposits into securities became the option.
At the time in 2020, interest rates were low. They remained low through the end of 2021 when
inflation began to accelerate in the United States and globally. The Federal Reserve began ahistorically fast cycle of interest rate tightening in 2022. As seen in figure 11, beginning March2022 the Fed raised interest rates by over 500 basis points as figure 11 shows. By September
2023 interest rates were the highest they had been in over 20 years.
Figure 11 Federal funds effective rate

Adapted from: (FRB 2023b).

Banks purchased a substantial amount of assets during the immediate Covid era. These assets
were purchased during periods of very low interest rates, given the sharp reduction in interest
rates by central banks globally during the crisis. Further, the flight to safety pushed down interest
rates on US Treasuries and agency debt that is perceived by the market to have varying levels ofgovernment support, aka agency debt issued by the US government-sponsored mortgage market.

12Bank regulation, largely re-written post-financial crisis, places differing capital weights on
different types of assets banks hold on their balance sheet. Risk-weighted capital requirements
influence which assets banks hold (BPI Staff 2023). In addition, banks may choose to maximize
safer assets for their own purposes to reduce risk. The main sources of risk in debt purchase arecredit and interest rate. Banks devote substantial resources to analyzing credit risk in theirlending business. That should provide an economy of scope in terms of risk analysis on holding
debt originated by others. It may also incentivize a bank to hold lower risk third party originatedassets so that it can concentrate credit risk on loans it originates, which again should be a bank’s
comparative advantage. As seen in figure 12, the result was massive purchases by banks of US
Treasuries and agency debt. This debt was purchased yielding historically low interest rates.
Thus, while the credit risk of this debt was minimal, the interest rate risk was substantial. As
soon as the Federal Reserve raised interest rates, the value of these assets would begin to fall.
The quicker interest rates rose, the sharper the decline in asset value.
Figure 12 Unrealized Gains (Losses) on Investment Securities.

Note: Insured Call Report filers only. Unrealized losses on securities reflects the difference between themarket value as of quarter end and the book value of non-equity securities. This calculation does not accountfor any unrealized gains or losses in "accumulated other comprehensive income" because they cannot bederived from Call Reports for the industry.
Source: (Federal Deposit Insurance Corporation 2023b).

The predictable result of the Fed’s interest rate tightening was massive losses by banks on assets
they had purchased with their excess deposits. Figure 12 shows losses of over $600 billion onthese assets. Note that these losses occurred at rates not seen since the great financial crisis,
precisely because of the magnitude and speed of the Federal Reserve’s movement of interest
rates.
The FDIC chart above is color-coded between the two accounting types of security assets a bankholds: held to maturity and available for sale. The sale of any asset that has been elected as held13

to-maturity triggers an immediate re-accounting for the value of all assets in that category. This
re-accounting would require the bank to mark to market the value of the entire held-to-maturity
portfolio, bringing forward any embedded losses and draining earnings and regulatory capital. As
consequence, banks are further incentivized to hold assets they initially elected as held-tomaturity, even as their value falls, lest the entire pool be re-accounted for.
Banks disclose the value of both of these aspects of their balance sheet. While the bank does notnecessarily directly disclose the change in mark to market valuation of the assets, it can be easy
to deduce the timing of the purchase of these assets and impute their value. For example, figures
13 and 14 below are Silicon Valley Bank’s regulatory filing on their agency debt (mortgagebacked securities by FNMA, FHLC, and GNMA) in its December 31 filing from 2019 (figure13) and 2022 (figure 14). At the end of 2019, the bank had just over $11 million in these assets(row 13a) split roughly $7 million to $4 million between held to maturity and available to sale.
After the pandemic, by December 2022 that amount had risen by more than 600% to over $64
million with over 95% of the increase having been designated as held-to-maturity. 2
Figure 11 Selected balance sheet items of Silicon Valley Bank as reported to regulators in 2019

Source: (Silicon Valley Bank 2019)

A careful reader of the charts will see a similar increase in over 6x in held to maturity securities issues by states
and local governments (row 12) and a rough doubling of holdings of US Treasuries. Treasuries are held as available
to sale column for SVB, an important distinction as that changed their accounting treatment. It also fights against thenarrative that it was purchase of US Treasuries that sank SVB put rather the facts are a much higher concentration in
mortgage-backed securities issued by the GSEs.

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Figure 12. Selected balance sheet items of Silicon Valley Bank as reported to regulators in 2022

Source: (Silicon Valley Bank 2022)

At this point, assets purchased over that time span had lost significant value on a mark to market
basis. The chart below from a Wall Street Journal in November 2022 article captures the losses
accumulating in real-time. Note that SVB was highlighted, along with two much larger globallysignificant banks, well before SVB bankFigure 13 Growth in net unrealized losses onentered the market crisis (Weil 2022).
held-to-maturity debt securities.
In a separate article that reads almost prophetic,
the WSJ highlighted the disconnect between
equity markets’ view of SVB’s health and theunderlying financial health of the bank: “Thestock market’s failure to anticipate SVB’s
results highlights the enduring confusion about
how banks and their clients will react to theFed’s supersize rate moves…. The turbulencein SVB’s stock may be a harbinger of what is tocome for banks when those increases cause
unexpected twists” (Benoit 2022). The article’s
subheader accurately focused on the two largest
banks that would fail less than six months later:“Lending profits are under pressure at nichefirms like Silicon Valley Bank and First
Republic.”
Bank regulation meant to reduce risk in thebanking sector, in combination with monetary
policy meant to fight inflation, led banks to purchase huge amounts of interest-rate-exposed
assets which plummeted in value once the Fed raised rates. This illustrates the potential
incompatibility of two of the Fed’s responsibilities: regulating banks and conducting monetary
Source: (Weil 2022)15

policy. A closer look at the Federal Reserve’s role as the primary regulator of SVB further
demonstrates this contradiction.
Federal Reserve’s Failure of Oversight and SVB’s Failure of Management
The Federal Reserve was SVB’s primary federal regulator due to SVB’s status as a statechartered member bank. The Federal Reserve Bank of San Francisco carried out that regulatoryrole for much of this period. The Federal Reserve had multiple points of regulatory failure
through this period. Problems include classic examples of regulatory neglect, misunderstandingof risk, and the failure of the regulator to take more forceful action quickly. Another set ofproblems relates to the structural relationship between SVB and the Federal Reserve.
Before examining the Federal Reserve’s role in SVB’s failure, it is important to start with theentity most responsible: SVB itself. The main reason for this bank’s failure, like most bankfailures is poor management. The purpose of regulation is not to prevent bank failure; America’s
economic system is designed to allow banks to fail. The opposite would be the creation of
thousands of perpetuities of banks guaranteed to survive regardless of the consequences of theireconomic actions. That is hardly capitalism.
The regulator’s goal then is not to prevent failure. The regulator’s goal is to make failure
unlikely through prudent rules, regulation, and timely supervision to highlight problems at thebank before they metastasize and threaten the viability of the bank. If the bank’s management
makes bad judgements, violates the rules, and/or ignores the supervisory actions to the point that
it fails, then the regulator must ensure that the failure of that institution does not jeopardize thestability of the broader financial system.
Thus, it is entirely consistent to acknowledge that the fault lies with SVB’s management while
also admitting that the Federal Reserve made significant errors. These errors failed to prevent
SVB’s collapse and the systemic consequences that caused the regulators to invoke financial
stability exceptions and bail out creditors. The Fed’s first paragraph of its SVB report does just
this: “Silicon Valley Bank (SVB) failed because of a textbook case of mismanagement by thebank. Its senior leadership failed to manage basic interest rate and liquidity risk. Its board of
directors failed to oversee senior leadership and hold them accountable. And Federal Reserve
supervisors failed to take forceful enough action, as detailed in the report” (Barr 2023, 1).
Regulatory neglect and misunderstanding of risk: Stress Tests Fail
Banks across the board and SVB acutely accumulated large interest rate risks as a result ofpurchasing low interest rate, low credit risk assets. Banks pursued this strategy in a manner that
was approved by the Federal Reserve and other regulators. The Fed has developed a series ofstress tests designed to ensure that banks were not individually or in a correlated fashion
developing vulnerability to a shock. The Fed states its stress tests “are intended to capture how
firms' net income and other components of regulatory capital would be affected by themacroeconomic and financial conditions” under different scenarios (FRB 2023e, 3). These
scenarios are designed by Federal Reserve staff, and while specifics are confidential, broader
trends can be understood.

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Two types of stresses can occur: those that can be reasonably foreseen and those that cannot. The
Covid pandemic is one that would be difficult to have foreseen. As former Fed Governor
Tarullo, who was deeply involved with the creation of stress testing, put it: “Precisely because aseverely adverse scenario arising from the COVID shock was so different from the 2008-2009
shock, neither the Fed nor the banks had systematically worked through the implications forbank balance sheets” (Tarullo 2023). Having been unable to reasonably predict themacroeconomic consequences of the Covid pandemic, stress tests were unlikely to model such a
scenario. Tarullo, in his June 2020 paper, drew the conclusion that stress tests were declining invalue, stating, “the annual stress test had already shown signs of ossification… the world ofstress testing has been turned upside down. Instead of a dynamic annual stress test, we haveincreasingly predictable compliance exercises. Instead of building on the 2009 SCAP and using
stress testing to estimate the losses that could ensue from an extended COVID crisis, a stale
scenario is used to allow banks to continue paying dividends. Instead of transparency aroundmeaningful stress test results, the public has only aggregate numbers from a sensitivity analysis
whose influence on bank capital policies remains unclear.”
Some drew the opposite conclusion, that the short-lived success of banks during the Covid
pandemic serves as an example of the success of stress testing. A March 2021 paper fromresearchers at the Federal Reserve entitled COVID-19 as a Stress Test: Assessing the Bank
Regulatory Framework concluded: “The overall robust capital and liquidity levels resulted in a
resilient banking system, which maintained lending through the early stages of the pandemic”(Wix et al. 2021, 2). Almost exactly two years later, this optimism proved deeply misplaced andTarullo’s concern proved correct.
The second type of scenario, that which can be foreseen should be simpler. Interest rate risk isforeseeable. The Federal Reserve devotes considerable resources to understanding the impact ofinterest rates on the broader economy and the banking system. To some extent, the Fed controls
market interest rates through its conduct of monetary policy. The Fed also controls, to someextent, the incentive for banks, particularly larger systemically important banks, to hold assetsthat have credit or interest rate risk. Changes to bank capital models alter economic incentives tohold assets of different risk nature. The Fed’s Stress Test is one of the most important suchmodels (Baer 2018).
The Federal Reserve’s stress tests left banks vulnerable to a rising interest rate environment
according to a 2018 article written by former Federal Reserve then Bank Policy Instituteeconomists Nelson and Covas (2018). They found that: “For the past four years, with the
exception of CCAR 2018, the Fed’s annual stress tests have been based on the assumption that
long-term interest rates will fall, not rise. While banks are currently extraordinarily safe, withcapital and liquidity levels at record highs, it is hard to see how banks could not have responded
to the incentives created by the Fed’s stress tests by protecting themselves from rising rates byless than they would have otherwise.” Figure 16 shows the interest rate assumptions in the
CCAR tests which stop examining the possibility of a sharp rise in rates in 2015 (note even
before then they did not contemplate the magnitude of rate hikes the Fed itself undertook in
2022-2023).

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Figure 14 Change in 10-Yr treasury yield over
CCAR scenarios.

The Fed’s stress tests thus drove banks to acertain type of asset. As Nelson and Covas
state, “the more the Fed cranks up the severityof the scenario to make it produce acceptablelevels of stress even as banks adjust to pass
the previous year’s test, the stronger are the
incentives driving the banks to choose
portfolios correlated to do well in that specific
set of conditions, portfolios without loans tosmall businesses or loans to middle classhouseholds, but with an abundance of longerterm fixed-rate securities.”

Long-term fixed-rate securities were exactly
what banks invested in. These securities then
Source: (Nelson and Covas 2018)
lost value as interest rates rose. This decline
hollowed out bank capital, creating the conditions by which banks were vulnerable to runs. As
former FDIC Chair Bair pointed out in 2023, “Unfortunately, the Federal Reserve’s recently
completed “stress tests” gave high grades to banks for passing exams that fail to prepare them forthe biggest risk that likely awaits them: a prolonged period of high and rising interest rates… The
assumptions within the Fed’s stress tests do not assess banks’ ability to withstand these very real
challenges. Instead, the tests make those challenges magically go away by assuming that interest
rates will return to zero fairly quickly if there is an economic downturn” (Bair 2023).
The inefficacy of these stress tests and capital allocation can cause bank failures regardless of theliquid nature of these assets. Much has been written on liquidity as a cause of bank runs (e.g.,
Diamond and Rajan 2005; Williamson 1998). However, when highly liquid assets lose value,
this can lead to rapid loss of capital and also cause a bank to fail. The Federal Reserve correctly
determined that “While the proximate cause of SVB’s failure was a liquidity run, the underlying
issue was concern about its solvency” (Barr 2023, 2).
One recent paper analyzing the 2023 banking crisis created a model that “illustrates that interest
rate increases can lead to self-fulfilling solvency bank runs even when banks’ assets are fullyliquid. The model identifies banks with asset losses, low capital, and critically, high uninsured
leverage as being most fragile” (Jiang et al. 2023, 1). This model presented troubling broader
results: “Even if only half of uninsured depositors had decided to withdraw, almost 190 bankswith assets of $300 billion are at a potential risk of insolvency, meaning that the mark to market
value of their remaining assets after these withdrawals would be insufficient to repay all insured
deposits” (4). More recent concerns have risen after Bank of America acknowledged over $100
billion of losses on its asset portfolio in October 2023 (Gandel 2023). This begs the question:
Were the March 2023 problems a precursor to a bigger quake to follow?

18

Regulatory neglect and delay
A second issue has to do with the Fed’s failure to act in a quick or forceful manner whenproblems were recognized. This criticism falls under bank supervision more than regulation. The
Fed acknowledges it failed as a supervisor of SVB stating, “supervisors did not fully appreciate
the extent of the bank’s vulnerabilities, or take sufficient steps to ensure that the bank fixed its
problems quickly enough” (Barr 2023, 2). The Fed argues that part of its failure as supervisor
was due to a different approach put in place as a result of a combination of legal and personnel
changes enacted during the Trump Administration. This includes both legal changes enacted in2018 and regulatory rollbacks instituted by Vice Chairman Randall Quarles, who was appointed
by President Trump. It is worth noting this critique came from a report authored by Fed Vice
Chairman for Bank Supervision Michael Barr, who helped lead the drafting of the Dodd-FrankAct under President Obama and was then appointed to the Fed under President Biden.
One aspect this critique of supervision highlights is that supervisory standards change over time
and those changes are correlated and caused by differences in politically appointed personnel.
Elections have consequences, and while the Fed as an institution has independence from theexecutive branch, the Fed is not immune from politics or political change. Presidents andCongresses that pursue increased levels of regulation will lead to greater regulation and tighter
supervision. Presidents and Congresses that pursue deregulation will result in the opposite effect.
Some have described this as a pendulum, although that somewhat assumes both a fixed and“correct” center that policy wobbles around (Peretie 2011).
The Fed’s supervisory weakness had another element: its structure. Supervision of banks at the
Fed is split between Washington and the Regional Banks as described earlier. The Fed uses a
size threshold of $100 billion after which a bank changes categorization from Regional Bank
(RBO) to Large or Foreign Bank (LFBO). Although both are supervised by the Regional Federal
Reserve: “LFBO supervision is also delegated to the Reserve Banks but with greater Board staff
involvement on substantive topics than in RBO supervision” (FRB 2023c, 30). According to theFed, SVB crossed that threshold in February 2021, and that transition between groups createdproblems: “Staff describe a sharp shift and “cliff effect” as SVB Financial Group rapidly wentfrom RBO supervision to LFBO supervision, requiring building of a new supervisory team,
implementation of horizontal examination processes, establishment of more intense continuous
monitoring routines, and phasing in of EPS [(Earnings per Share)]” (35).
The Fed acknowledges its internal processes were too slow to recognize problems from SVB, toobifurcated between San Francisco and Washington, and dominated by a supervisory culture thatwas too timid. The Fed’s own report does not discuss the conflict of interest between SVB’s
CEO and the SF Federal Reserve, but its inspector general does which is the subject of the next
section of this paper.
Structural
Federal Reserve regional banks have nine member boards of directors, which include threebankers who are members of that regional bank. Those bankers serve multi-year terms. Having
bankers on the board of their regulators is a legal requirement and a clear conflict (Government

19

Accountability Office [GAO] 2011). Congress has failed to remedy this problem, taking only aminor step in the Dodd-Frank Act of removing the banker board members from a voting role inselecting the President of the bank (GAO 2011, 10). This conflict of interest was apparent in
SVB’s regulatory treatment.
SVB’s CEO was a member of the SF Fed’s Board of Directors. The Federal Reserve’s inspector
general in its material review of SVB’s failure noted this “created an appearance of a conflict ofinterest for the [Federal Reserve] System” (Office of Inspector General 2023b, 46). At one point
during SVB’s problems, the SF Fed considered removing the CEO from this position but wasconcerned that doing so would “reveal confidential supervisory information and potentiallysignaling to the market the bank’s declining condition” (46).
The SF Fed concluded internally that it could not remove a bank’s CEO from its board during aperiod of stress at that bank because doing so would signal to the market the bank’s problematic
health. This logic means that once a banker is appointed to a Fed bank board, the Fed is unable toremove the banker when the bank has problems. This exacerbates the appearance of a conflict, asa bank CEO’s board role signals sound management of the bank to markets.
The Federal Reserve has supported the status quo with Federal Reserve officials arguing to keepbankers on their boards. Former Kansas City Federal Reserve President George argues that thesebankers provide value in setting monetary policy: “Bankers provide valuable banking expertise
regarding credit conditions, the payments system and the local economy, and I strongly defend
the role of bankers as Reserve Bank directors” (George 2023).
Federal Reserve Bank Presidents who vote on monetary policy rely on anecdotal insights fromtheir board members, particularly their bank board members. This belief is also held by the bankCEOs who serve on these boards as St. Louis Federal Reserve Board Member and Planters BankCEO McCoy states, “we are in a position to influence how the Federal Reserve feels about local
economies and especially about rural America, and I think it’s invaluable to the Fed as they try todevelop monetary policy” (Smith 2021).
Bank CEOs serving on Fed Regional Bank Boards also create conflicts of interest in regulation.
This is in both appearance to the market and in terms of the inability to remove such a director
even when the bank is troubled. The Fed’s preference for bankers to stay relates to the banker’s
input through the Regional Bank Presidents for their conduct of monetary policy. This is an
example of the conflict between the monetary policy function and the bank regulatory functionof the Federal Reserve.
A policy recommendation from this conflict is simple: remove bank CEOs from Federal Reserve
Regional Bank Boards. This requires an act of Congress, which has been proposed by Sen.
Sanders (I-VT) (Sanders 2023). However, according to the Fed’s defense of the status quo, thiswould result in lower quality conduct of monetary policy. If this is correct, then the banker CEOs
selected must be adding value to the FOMC which results in a different course of action than it
would have taken without their position as Regional Bank board members. That means thatmonetary policy is influenced by the bankers selected as Class A directors, giving those bankers

20an outsized voice in the conduct of monetary policy. If the bankers do not meaningfully impact
monetary policy, then the Fed’s prior argument is logically false.
Additional Factors that Contributed (or not) to Bank Instability
This paper’s hypothesis is centered around the role the Federal Reserve played in its capacity asa central bank that contributed to the banking failures America experienced in the spring of 2023.
However, activities beyond the Fed’s role played a meaningful role and deserve exploration.
This paper considers three possible additional factors: crypto, changes in payment technology,
and social media. It finds that crypto played a meaningful role in several of the bank failures,
while payment technology and social media did not.
Crypto: Unique But Important Role
Many of the banks that failed in the United States in spring 2022 were exposed to cryptocurrency and that exposure played a meaningful role in their failure. Four banks failed during
this time period, the first of which was Silvergate Bank. Silvergate’s failure did not result in the
invocation of special systemic risk exemptions nor were significant portions of the bank sold toother banks as was the case with the other three. Silvergate self-liquidated, a relatively rare
method of failure resolution (Silvergate Capital Corporation 2023a). Silvergate was heavily
exposed to crypto-currency, particularly FTX: as FDIC Chairman Gruenberg stated, Silvergate’s“business model focused almost exclusively on providing services to digital asset firms”(Gruenberg 2023a, 5). Focusing on crypto clients is a theme common between both Silvergate
and Signature Bank (Gruenberg 2023a, 9). While both banks shared significant crypto businessmodels, Signature Bank was much larger and crypto was a significantly smaller proportion of
Signature’s customer base (Tierno 2023, 1).
Silvergate experienced a sharp outflow in deposits as crypto crashed in the wake of FTX’s
collapse toward the end of 2022. This caused the bank to have to sell securities that had lost
value as a result of rising interest rates (Silvergate Capital Corporation 2023b). The securities
were 70 percent residential and commercial mortgage-backed securities that were either directly
issued by the US government or were issued by government-sponsored enterprises (GSEs)
Silvergate Capital Corporation 2023b, 6). As of the end of 2022, these assets were earning a
combined 2.6% as shown in Figure 17 from Silvergate’s 4th quarter 2022 earnings. By that point,
the Federal Reserve’s Fed funds effective rate was already 4.33% with expectations in themarket (supported by Federal Reserve statements) that it would continue to rise (FRB 2023b).

21

Figure 15 Silvergate's assets end of 2022.
Silvergate’s announcement on March 8, playeda meaningful role in sparking the contagion
that resulted in Silicon Valley Bank’s failure
two days later (Gruenberg 2023a). Signature
Bank in New York had substantial exposure to
crypto. Signature Bank’s failure, the same
weekend as SVB’s, played a substantial role infinancial regulators invoking systemic risk
authority to conduct broad based bailouts ofuninsured depositors at both institutions(Gruenberg 2023b).
In examining the cause of the failure of
Signature Bank, the FDIC concluded that it“failed to understand the risk of its association with and reliance on crypto industry deposits or
its vulnerability to contagion from crypto industry turmoil that occurred in late 2022 and into
2023” (Federal Deposit Insurance Corporation 2023a, 2). Signature developed a digital payment
platform, Signet, which it “touted as the first to market for an FDIC-insured bank [to enable its]
clients to settle US dollar payments globally 24 hours a day/7 days a week/365 days a year
within the bank” (13). The FDIC’s report found Signature had significant exposure to FTX,
Alameda, and Silvergate Bank whose own crypto problems caused its demise. These connections
were broadly known in the market with media, as one CNBC article described Signature andSilvergate as “the two main banks for crypto companies” (Sigalos 2023). As Allen finds “whilemost banks have eschewed crypto business, Signature Bank and Silvergate… had aggressively
pursued business models based on providing banking services to crypto businesses” (Allen2023). As banking turmoil mounted with SVB’s and Silvergate’s earlier failure and Signature’s
known exposure, depositors fled, and Signature quickly failed.
Source: (Silvergate Bank 2023b)

Exposure to crypto played a direct and meaningful role in the failures of Signature and Silvergate
banks. Signature being the first failure and Silvergate’s failure creating something of a tipping
point for extraordinary government intervention, including bailing out uninsured depositors, lay
a strong predicate for crypto playing a meaningful role in creating the turmoil in the Americanbanking sector experienced this spring. Further, the only bank to fail since the spring, a smallbank in Kansas, appears to have failed due to ownership falling for a cryptocurrency scam(Bloomberg 2023; American Banker 2023).
Cryptocurrency regulation is not part of the Federal Reserve’s mandate and is contradictoryevidence to the core thesis of this paper. One could view cryptocurrency as a more traditionalsource of financial instability, that of a new asset whose value is not well understood. Despite
substantial appreciation since its launch in 2008, crypto valuations have fluctuated widely, withlong periods of bear markets, and some well-known failures of specific cryptocurrencies (FTT,
Terra Luna, etc.). Financial crises require both asset valuation uncertainty and leverage (Klein2022). That the banking system would have some level of exposure to crypto is predictable
despite attempts by regulators to safeguard the system. As the Financial Stability OversightCouncil concluded: “The Council finds that crypto-asset activities could pose risks to the22stability of the U.S. financial system if their interconnections with the traditional financial
system or their overall scale were to grow without being paired with appropriate regulation,
including enforcement of the existing regulatory structure.” (FSOC 2022, 11).
However, an alternative analysis attempts to link crypto speculation not to the emergence of a
new asset such as internet presence or social media followers, but rather as an attempt by capitalto chase yield in a structurally low interest rate environment. Allen, a well-known crypto
skeptic, goes further than simply blaming exposure to crypto as the cause for these bank failures(Allen 2022). She argues crypto exposure was a symptom of a larger phenomenon driven by low
interest rates. Her central argument is that “when policy makers respond to financial crises withprolonged periods of low interest rates, that can sow the seeds for the next round of financial
instability – and those seeds may sprout in unexpected ways” (Allen, 33). In this context, crypto
is an example of the unexpected sprout of venture capital firms and other investors searching forhigher yields as a result of prolonged periods of low interest rates stemming from the 2007/2008
global financial crisis. Thus, the magnitude of the crypto frenzy (she would argue bubble thatwill burst) is not completely an endogenous event, but rather related to the conduct of monetary
policy by the central bank.
The False Narratives: Payment Speed and Social MediaThe speed at which the spring banking failures occurred has been ascribed by some to changes inpayment speed and by others to social media (Lopatto 2023; FRB 2023c, 4, 15, 24). Attributing
these changes to these external factors obviates the central bank from fault of poor judgement ofpoor supervision or the consequences of monetary or other regulatory policy. Incorrectly
identifying the cause leads to policy solutions that are likely to fail to correct the problem.
Both of these arguments, faster movement of money and faster spread of information on social
media, start with the argument that banks failed faster in 2023 than in the past. Figure 18 shows
the share of outflow from the recent bank failures was similar to those in the past, while the shareof deposits that were covered by insurance was also similar to Continental Illinois 3. However,what was different was the speed of outflows, with depositors withdrawing their money more
quickly. This speed of outflow change is made to argue that bank failures are faster because oftechnology (Cookson et al. 2023; Sweet and Chloe 2023; Neuman 2023; Welburn 2023).

Continental Illinois failure in 1984 gave rise to the term ‘too big to fail’ and is considered a benchmark in
American bank failures for multiple reasons (Nurisso and Prescott 2017). One reason is that Continental was an
early adopter of electronic banking and in fact did network its depositors and funds using the newly available
computing power (see Rose 2023 for more). Given that it is nearly 40 years since Continental’s failure and thewidespread adoption of computing did change the way money moved, the analysis uses that as a benchmark.

3

23

Figure 16 Selected Deposit Runs from 1984 to 2023

Note: *Figures with asterisks are the expected amount of outflows that were scheduled to go out the next businessday, but did not actually occur because the banks were closed.
Source: (Rose 2023)

However, careful analysis shows that the speed at which money actually moves out of banks is
not faster today than it was in 2007/8 or even for Continental Illinois. Bank outflows are
typically handled by bank payment networks (e.g. ACH, FedWire, etc…) which have remained
batch systems operating only on working days. While technology has allowed retail depositors
the ability to initiate deposit movements from their homes or phones, retail depositors were notthe ones moving funds. Furthermore, the United States, unlike much of the rest of the world has
not adopted faster or real-time payments for consumers (Klein 2023a). The Federal Reserve’s
faster FedNow payment system was not operational in March 2023 (it came online later in July).
Nor had the Fed used its regulatory authority to force banks to move customer funds quickly,
despite the legal authority to do so (Klein 2018a). Simply put money did not move out fasterbecause the speed at which money moves between banks in the United States has remainedlargely constant.
The real question is whose money is moving: the answer is predominantly large depositors. As
the chart shows, 94 percent of SVB’s depositors had accounts greater than $250,000. The top 10
depositors at SVB had over $13 billion in depositors (Gruenber 2023a, 13). Silvergate andSignature similarly were focused on institutional, corporate, and in many cases crypto-relatedclients. These banks did not have retail footprints the way that true regional banks that failed in
the 2008 crisis such as Washington Mutual or Wachovia had. Only First Republic had asomewhat larger retail deposit core, although their business model was more skewed toward
wealthier individuals. However, First Republic limped along in terms of its depositors sticking.
The chart shows a similar time horizon for First Republic to prior bank failures.
As the Federal Reserve Bank of Chicago’s Jonathan Rose concluded: “There is little indicationthat depositors waited several days in 1984 or 2008 to make withdrawals because oftechnological limitations… technological changes since the 1970s appear capable of speeding
up withdrawals for smaller uninsured depositors by a matter of hours or a day or two. But it isdifficult to view depositors in 1984 or 2008 as delayed by several days by the technology of thetime” (Rose 2023, 3).
The bank failures were the first systemic tremor to the banking system during the age of social
media. Social media did light up around bank failures. One paper quickly produced after the24bank failures in April 2023 went so far as to try to ascribe a more causal relationship arguing
that: “negative sentiment tweets in the run period translate into immediate stock market losses”
for these banks, speculating that social media played a meaningful role in these bank failures(Cookson et al. 2023). This analysis is flawed for several reasons.
The logic behind social media playing a role is “that greater exposure to social media increases
communication during the run, which amplifies bank run risk by increasing” depositor’s
willingness to pull their money, aka depositor run (Cookson 2023). This stated model logic isthat depositors’ expectations of bank health influence their behavior, which is a logical starting
part. However, in the case of SVB, we are not dealing with a random sample of depositors.
SVB’s depositors were 94 percent uninsured and heavily corporate. The 10 largest controlled$13 billion in deposits, with the largest identified as Circle, a stablecoin currency. Figure 19 is alook at how SVB identified its depositors in 2022 Q3 (SVB 2022). Figure 17 Silicon Valley Bank
client funds breakdown.
Analysis of SVB’s depositor bases show it to be heavily corporate,with a skew toward technology and start-up companies, whichmakes sense given its location and business model. Around 50
percent of US venture-backed tech and life science companies
were depositors at SVB (Baker 2023). Specific companies BILL
Holdings (financial services technology) at $670 million, Roku at$487 million, ZoomInfo at $284million, Roblox at $149 million,
Vit Biotechnology at $220 million, Oak Street Health at $106
million, and many more corporations (Gilbert 2023).
Source: (SVB 2022)
The logic behind the model states that corporate treasurers make decisions on the basis ofchanging their company’s bank account on the basis of tweets. This social media argument is notbased on specific Tweets by leading authorities, but rather on total Twitter traffic. They claimthat “The severity of bank runs increases markedly when banks are in a Twitter conversation”
without regard to who is engaged in the conversation. Estimates are that five to 15 percent of
Twitter accounts are not people but rather bots (Dang, Paul, and Chmielewski 2022). Further,since Musk’s takeover of Twitter, the verification process for factual information has fallen. The
logic behind this paper is not that retail investors get nervous because of what they see on social
media and pull their money. The logic is that sophisticated corporate treasurers of large, often
multi-billion businesses, change their bank on the basis of the quantity of tweets and theconversation occurring between people on Twitter, regardless of their validation or reputation.
Who were corporate treasurers listening to? Venture capitalists who often had equity stakes intheir companies. Gary Tan, president of Y combinator, the large Silicon Valley VC firm posted
this message to companies they invested in: “We have no specific knowledge of what’s
happening at SVB. But anytime you hear problems of solvency in any bank, and it can bedeemed credible, you should take it seriously and prioritize the interests of your startup by not
exposing yourself to more than $250K of exposure there. As always, your startup dies when you
run out of money for whatever reason” (Weil and Eisen 2023).
Tan was hardly alone and SVB management took the threat of VC calls for companies to pull
deposits so seriously that SVB CEO Becker held a video call on March 9 with VCs and SVB

25

depositors urging them to keep their money (Baker 2023). That call did not work as depositors
pulled over $40 billion and the bank failed the next day.
The question then is what is more likely: that corporate treasurers listened to their VC investors
and were not assured by personal interaction with the banks’ CEO; or that they were monitoring
unverified Twitter accounts and moved by Twitter sentiment from strangers?
This flaw ought to be enough to question the paper’s claims of causality. However, the paper
goes further to try to relate bank equity price as an indication of bank health and then equity
price to Twitter traffic. As Figure 20 shows, SVB’s equity price was trading stably for weeks
before its failure. The week of its failure it started in that
Figure 18 SVB Financial Group stock price:same range, only falling sharply two days before its
February-March, 2023.
failure.
The equity price was not a meaningful signal of SVB’s
solvency. SVB’s assets did not change materially overthis week. Using SVB’s equity price as an indication of
the underlying health of the bank would lead anobserver to argue the bank was healthy. Instead of
falling equity prices causing depositor runs, it is theother way around. Depositor runs caused equity prices
to react. Contemporaneous reports argued that “thepanic surrounding SVB kicked off Wednesday [March8], when the company said it would book a $1.8 billion
after-tax loss on the sales of investments and see to raise Source: Google Finance$2.245 billion by selling a mix of common and preferredstock” (McCabe 2023). Equity reacting to plans of dilution is a more logical explanation that
Twitter traffic.
The equity pattern of SVB is not unique in bank failures. Signature Bank’s equity price hoveredaround $110 per share from March 1 through 6, falling below 100 only on March 9, two days
before its failure (Yahoo! Finance. 2023). Lehman and Bear Sterns equity prices were
substantially higher the weeks of their failure. Bank equity price is not a reliable indicator of abank’s potential for sudden failure.
Conclusion
The Federal Reserve was at the epicenter of America’s episode of financial instability in March
2023. Banks were awash in deposits as a result of a combination of fiscal and monetary policy
during the pandemic. Given troubled lending environments and regulatory rules focused on
credit risk, banks invested in low credit risk, long duration, assets, and heavily mortgage-backed
agency securities. The Fed’s shift to raising interest rates to combat inflation had the predictable
impact of devaluing these securities. Losses grew on bank balance sheets, hidden in plain sight toregulators and investors.

26

The Federal Reserve was in the pole position as bank regulator. Silicon Valley Bank was so
closely linked to Fed supervision that its CEO was on the Board of the Regional Federal Reserve
which regulated it. SVB’s business model screamed a series of risks that should have beencaught by basic supervision and regulation: rapid asset growth, overreliance on Federal Home
Loan Bank borrowing, declining asset valuation, heavy reliance on uninsured deposits that werehighly correlated to venture capital, and poor management. Yet the Fed missed these obvious
warning signs and allowed SVB to continue until it was far too late. SVB’s demise was rapid,
also catching the Fed off guard.
The most immediate, proximate cause of SVB’s failure was the failure of Silvergate, anotherbank under the Federal Reserve’s regulatory purview. Silvergate was much smaller than SVB but
shared similar bad business practices of over-reliance on uninsured deposits and concentration in
depositors in the tech sector. Federal Reserve supervision and regulation was problematic andinsufficient in both cases (Jarsulic and Thornton 2023).
In America’s fractured regulatory system, it is ironic that the banks whose failure started a crisis
so severe regulators judged it a systemic threat to the financial system, the central bank’s
monetary policy choices would be the mechanism by which the bank’s asset quality would
degrade. That the Federal Reserve would be unable to detect this vulnerability brings into
question the Fed’s competence as a bank regulator.
Other countries have split the role of monetary policy and bank regulation. This model is often
referred to as “twin peaks” and has been tried in many countries often with successful results(Schmulow 2017). Regardless of the structural model pursued, regulators and supervisors mustact with independence and quality judgment. Both were lacking in the oversight of the banks thatfailed.
The Federal Reserve, like many central banks globally, gained greater authority after the global
financial crisis (Calvo et al. 2018). This authority included macro-prudential and microprudential tools. As it relates to the March 2023 crisis, the Fed’s failure as a micro-prudential
regulator and supervisor resulted in its use of macroprudential systemic risk tools designed tobail out and stabilize the broader American financial system.
The modest reforms to the Federal Reserve Regional Bank structure under Dodd-Frank appear tohave been insufficient. As the BIS found in its review of regulators across the G-20: “enhanced
supervisory effectiveness may require some institutional changes” (Calvo et al. 2018, 3). The
conflict of interest in having the SVB CEO on the Board of the SF Fed limited the Fed’s
response to problems at the institution and gave the appearance (at the least) of greatersupervisory and regulatory approval.
Removing all bankers from the Boards of the Regional Federal Reserve Banks is one
recommendation that addresses some of the structural problems inherent at the Federal Reserve.
It is perhaps the least aggressive change. A more aggressive change would be to move bankregulation out of the Fed to one of the two other main bank regulators (OCC or FDIC). This
move is justified based on the Fed’s track record as supervisor. Further, such a move could
enhance the freedom and flexibility of the Fed to conduct monetary policy.

27

Monetary policy is the Federal Reserve’s top priority, as it should be (Klein 2023b). Everyorganization can only have one number-one priority. Ancient Greek philosophy called this toppriority telos, the one north star guiding goal. Adding additional responsibilities and goals to theFederal Reserve requires them to be secondary objectives to the organization’s telos. This may
be OK. Organizations can achieve multiple objectives. Objectives can be complementary, benefit
from economies of scope, and even improve each other’s understanding.
Bank regulation and monetary policy have the potential to create many benefits through coexisting in a single institution. They also have the potential to be in conflict. The financial
instability episode of March 2023 is a clear example of their conflict. To prevent similar failuresin the future, reforms of the Federal Reserve System are needed.

28

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