Karen Petrou: The New Bank-Regulatory Paradigm We Need
On Friday, we posted a client alert to a new Federal Reserve study that, to put it succinctly, overturns received wisdom about what makes banks fail. It is a paradigm-busting analysis based on solid, validated, empirical evidence, not on the models notoriously replete with assumptions that suit a researcher’s fancy or whomever backs the work. This study’s main finding is that, even before the advent of federal deposit insurance, bank failure is due to and reliably predicted by growing bank insolvency – not illiquidity – at otherwise-solvent banks and generally not even by runs at very weak banks. Depositors and, worse, supervisors are demonstrably slow to catch on to emerging risk, with depositors understandably subject to information asymmetries and supervisors inexcusably distracted, confused, or even captive. Policy should not be based on one study, but this one study warrants immediate attention backed as it is by many others and replete with damning data analyzed with a straightforward methodology using records going back to 1986. Now would be a very good time to take heed – banking agencies in 2024 are building yet another regulatory edifice to compensate for yet another round of critical supervisory lapses. This may well prove as doomed as its predecessors unless regulators stop blaming banks after failure for bad behavior well within supervisory sight and reach long before indisposition turned terminal.
Importantly, I am not saying that this study proves there is no need for capital or liquidity regulation just as our new merger-policy study does …