No, Sen. Warren, banks were not under-regulated

It should be no surprise that Sen. Elizabeth Warren blames deregulation for recent bank failures. The senator from Massachusetts is the Democratic Party’s most vocal advocate for regulating almost every dimension of the economy. But in her appearances on the Sunday morning shows and in a long letter written to Federal Reserve Chairman Jerome Powell, she offers no specific evidence tying any lack of regulation to the recent failures. Instead, the story since the Great Recession has been a massive increase in the size of government and regulation.

The Fed has grown in ways few could imagine in its powers and the sheer size of its assets. It has more control over the financial sector than it ever has before. In addition, an entire regulatory agency, the Consumer Financial Protection Bureau, was created with Sen. Warren’s patronage and imbued with vast new administrative powers. Its job was to prevent systemic risk events. So much for that theory. Even before the increased regulation, banks were already among the most regulated institutions in our economy. If under-regulation is the main economic problem, why do we repeatedly see so many crises emerging from its most regulated corners?

The fact is that Reagan was right—government is not the solution to the problem. Government is the problem. Silicon Valley Bank failed because it owned a large proportion of long-term treasuries. We’ve written before about how focusing on the long term was an unforced error by the bank’s hapless management team, but it’s fair to ask why this bank and others bought so many treasury bonds. They did it because the government told them to. As part of a wave of regulations, the Basel Accords, which were globally coordinated, the United States became more like Europe and pushed for banks to own more “Tier 1 Capital.” And what is Tier 1 Capital? Government bonds.

This had not worked well in Europe, which treated all government bonds as safe, including those issued by Greece and the other overextended, overaged, underworked nations, and the European Debt Crisis revealed that those were very bad bets.

No one should be surprised that the same approach is not working well in the United States, either. Treating banks as low risk because their balance sheets are gravid with treasuries was extremely short-sighted rule-making. Treasuries might be safe against the risk of default (a proposition becoming harder to defend), but they were very risky when it comes to the risk of losing value. The Fed’s easy money policy and its myriad of historically unprecedented acronym-multiplication programs, QE, QE2, TARP, TWIRP, Operation Twist, etc., were all different ways of buying treasury bonds.

This put treasury bond prices at nosebleed levels, with little room to rise and much room to fall. So when the Fed reversed course and started selling those bonds, the prices plummeted, and bank balance sheets took heavy losses right in the old Tier 1, the account the regulators told them a good, compliant bank needs to have. Moreover, SVB was under the regulatory authority and oversight of many agencies. Would one more acronymic overseer really have made a difference?

No, a swipe of Occam’s Razor shows us that the government told banks that to pass muster, they needed to own a lot of treasuries. They didn’t stop to realize that under certain circumstances, a bubble in the treasury market and a coming wave of monetary tightening would turn that margin of safety into a ground zero of risk.

It’s not as though this hasn’t happened before. Americans were placed under a vastly hypertrophied administrative state after the Great Recession. But that crisis itself was caused by government. The story is quite similar to the one playing out now—very easy money and aggressive tightening. The major difference is that in the run-up to the ’08-’09 crisis, the government was pushing banks into unsafe mortgages under the authority of the Community Reinvesting Act, warning them that saying no based on things like lack of credit history could open them up to charges of discrimination.

That bubble popped. The market got blamed for a crisis government created, and so government took on vast new powers, which eventually created the crisis we’re in now, which is leading to calls for even bigger government.

Friedrich Hayek called this the road to serfdom. An intervention causes a crisis, which is used to create another intervention, which creates another crisis and so on. It’s time to take the exit ramp off that particular road.