Rethinking Banking Regulation

Foster Pine, May 2023

The US regulatory approach towards banks since the 1990’s has been proportionate to size. Larger depository institutions have been subject to ever-increasing levels of capital and a bewildering number of rules and regulations. Smaller institutions, on the other hand, have been left largely alone with “simplified” or “lite” capital and regulatory frameworks. Moreover, the approach focuses entirely on regulating and strengthening individual institutions with little or no use of networks of firms to mutualize risk activities. 

This approach has given us the 2-tier Banking industry we have today:

• Larger institutions who bore the brunt of increased focus over the past few decades have adjusted well to their higher capital and regulatory obligations by most measures (e.g., stress tests, investor returns, market share growth etc). Enhanced regulations arguably act as a  ‘regulatory moat’ and create institutions that are ‘too-big-to-fail’.  
• Mid-sized and smaller depositories were left mostly alone by regulators who believed that the risk to the US Financial sector largely accrued from larger firms. Recent events have shown that this belief was false. Mid-sized and smaller institutions remain brittle and because of increasing interconnectedness of the industry, have the potential to continue to create serious damage and contagion to the entire industry. 

Following recent events,  it would be convenient for US Bank Regulators to push down stringent capital and regulatory obligations of the largest institutions onto the entire industry. While some additional rules & oversight might be necessary, given the number (4,000+) and diversity of mid-sized and smaller US banks, compliance with new rules will be expensive, inconsistent and slow. Moreover, it’s not guaranteed these will prevent the next SVB-like run.  

It’s  time to explore new approaches to Banking regulation, drawing inspiration from other industries such as insurance, hospitality, and manufacturing where business models have been ‘free’ to evolve to enable greater functional collaboration,  ‘mutualization’ or ‘warehouring’ of certain risk activities, and greater public scrutiny over and transparency of risk metrics of individual players.  Also it’s time to address the moral hazard inherent in the implementation of our deposit insurance system and let markets and private capital play a larger role in selecting winners and losers.