SVB shows the dangers of regulators in the last war

How could regulators overlook the risks at Silicon Valley Bank? Many shocked investors asked themselves this question on Monday.

After all, the fact that SVB sat on a vast, unhedged portfolio of long-dated Treasuries was no secret; Last year, JPMorgan circulated shocking calculations to its clients (recirculated again this week) showing that these (then) unrealized losses could wipe out Tier 1 capital.

But while some former SVP clients tell me that this prompted them to withdraw money at the time, the bank’s regulators – namely the Federal Reserve and California regulators – appear to have done nothing.

Worse, SVB’s top executives were allowed to sell their shares two weeks ago, just before a botched attempt to raise capital. That’s shocking.

So what has made people so blind? One factor has been America’s fragmented regulatory structure, which often causes issues to slip through the cracks.

Another was politics. Republicans have pushed for loosening banking regulations in recent years, and banks like SVB have previously lobbied to be excluded from the category of “systemically important banks” – meaning they operate with lower capital and liquidity standards were faced. That’s crazy.

But the other problem is that investors and regulators – like generals – are trained to fight the last war. In particular, they have been concerned about credit and liquidity risk over the past decade, as these caused the 2008 financial crisis and the 2020 market crash, respectively.

However, interest rate risk has attracted less attention as it has not posed a significant threat in recent decades. The last time they caused big losses (in the derivatives markets) was in 1994 when companies like Orange County were hit hard.

However, no one under 50 would have seen this drama first hand; Instead, they built their careers in a world where interest rates seemed destined to remain permanently low.

Some of the US regulators that monitor small banks, like the Office for the Comptroller of the Currency, have tried to track interest rate risk in recent years. But the SVB was not regulated by the OCC.

Meanwhile, the Fed, for its part, had little incentive to alarm the public about potential interest rate risks in banks. After all, she arguably caused the chaos herself by unleashing extreme quantitative easing.

Therefore, it was easier for everyone in the system to talk about the last war – ie credit risk – while ignoring the elephant in the room. Especially since the Basel framework assigns a risk weight of zero to government bonds precisely because they are supposed to be super safe.

This is certainly not the first case of such a generational cognitive bias. In the run-up to the 2008 crisis, regulators and private sector risk committees overlooked the dangers posed by supposedly “safe” bundles of mortgage bonds because they were obsessed with the problems behind the two previous financial crises – namely hedge funds (which delivered shocks). in 1998) and risky corporate loans (ditto in the 2001 dot-com bubble).

But while cognitive bias is an inevitable trait of being human, the SVB saga shows that investors and regulators desperately need a better grasp of imagination — and history. After all, the SVB is not the only example of an institution taking a stupid one-way bet that interest rates would stay low indefinitely; The British pension crisis erupted last autumn on the basis of similar assumptions.

So if anyone is still making that bet now, they need to urgently – and seriously – think about a world where interest rates could stay higher longer than anyone thinks. Especially given that expectations regarding what the Fed’s next move changed so dramatically on Monday. We cannot assume that any pause in rate hikes will last; whatever the (teenage) herd thinks now.

gillian.tett@ft.com