Banking crises rooted in a system that rewards excessive risk-taking -- as First Republic's precarious situation shows

First Republic Bank is on the brink of collapse^[1], a victim of the panic that has roiled small and midsize banks since the failure of Silicon Valley Bank in March 2023^[2].

Should First Republic fail, it would underscore how the impact of risky decisions at one bank can quickly spread into the broader financial system. It should also provide the impetus for policymakers and regulators to address a systemic problem that has plagued the banking industry from the savings and loan crisis of the 1980s^[3] to the financial crisis of 2008^[4] to the recent turmoil following SVB’s demise^[5]: incentive structures that encourage excessive risk-taking.

The Federal Reserve’s top regulator seems to agree. On April 28, 2023, the central bank’s vice chair for supervision delivered a stinging report^[6] on the collapse of Silicon Valley Bank, blaming its failures on its weak risk management, as well as supervisory missteps.

We are professors^[7] of economics^[8] who study and teach the history of financial crises. In each of the financial upheavals since the 1980s, the common denominator was risk. Banks provided incentives that encouraged executives to take big risks to boost profits, with few consequences if their bets turned bad. In other words, all carrot and no stick.

One question we are grappling with now is what can be done to keep history from repeating itself and threatening the banking system, economy and jobs of everyday people.

S&L crisis sets the stage

The precursor to the banking crises of the 21st century was the savings and loan crisis of the 1980s.

The so-called S&L crisis, like the collapse of SVB, began in a rapidly changing interest rate environment^[9]. Savings and loan banks, also known as thrifts, provided home loans at attractive interest rates. When the Federal Reserve under Chairman Paul Volcker aggressively raised rates in the late 1970s to fight raging inflation, S&Ls were suddenly earning less on fixed-rate mortgages while having to pay higher interest to attract depositors. At one point, their losses topped US$100 billion^[10].

To help the teetering banks, the federal government deregulated the thrift industry^[11], allowing S&Ls to expand beyond home loans to commercial real estate. S&L executives were often paid based on the size of their institutions’ assets^[12], and they aggressively lent to commercial real estate projects, taking on riskier loans to grow their loan portfolios quickly.

In the late 1980s, the commercial real estate boom turned bust. S&Ls, burdened by bad loans, failed in droves, requiring the federal government take over banks and delinquent commercial properties and sell the assets to recover money paid to insured depositors. Ultimately, the bailout cost taxpayers more than $100 billion^[13].

Short-term incentives

The 2008 crisis is another obvious example of incentive structures that encourage risky strategies.

At all levels of mortgage financing – from Main Street lenders to Wall Street investment firms – executives prospered by taking excessive risks and passing them to someone else. Lenders passed mortgages made to people who could not afford them^[14] onto Wall Street firms, which in turn bundled those into securities to sell to investors. It all came crashing down when the housing bubble burst, followed by a wave of foreclosures.

Incentives rewarded short-term performance, and executives responded by taking bigger risks for immediate gains^[15]. At the Wall Street investment banks Bear Stearns and Lehman Brothers, profits grew as the firms bundled increasingly risky loans into mortgage-backed securities to sell, buy and hold.

As foreclosures spread, the value of these securities plummeted, and Bear Stearns collapsed in early 2008, providing the spark of the financial crisis. Lehman failed in September of that year, paralyzing the global financial system and plunging the U.S. economy into the worst recession since the Great Depression^[16].

Executives at the banks, however, had already cashed in, and none were held accountable^[17]. Researchers at Harvard University estimated that top executive teams at Bear Stearns and Lehman pocketed a combined $2.4 billion in cash bonuses^[18] and stock sales from 2000 to 2008.

A familiar ring

That brings us back to Silicon Valley Bank.

Executives tied up the bank’s assets in long-term Treasury and mortgage-backed securities, failing to protect against rising interest rates that would undermine the value of these assets^[19]. The interest rate risk was particularly acute for SVB, since a large share of depositors were startups^[20], whose finances depend on investors’ access to cheap money.

When the Fed began raising interest rates last year^[21], SVB was doubly exposed. As startups’ fundraising slowed, they withdrew money, which required SVB to sell long-term holdings^[22] at a loss to cover the withdrawals. When the extent of SVB’s losses became known, depositors lost trust, spurring a run that ended with SVB’s collapse.

For executives, however, there was little downside in discounting or even ignoring^[23] the risk of rising rates. The cash bonus of SVB CEO Greg Becker more than doubled to $3 million^[24] in 2021 from $1.4 million in 2017, lifting his total earnings to $10 million, up 60% from four years earlier. Becker also sold nearly $30 million in stock^[25] over the past two years, including some $3.6 million in the days leading up to his bank’s failure.

The impact of the failure was not contained to SVB. Share prices of many midsize banks tumbled^[26]. Another American bank, Signature, collapsed days after SVB did^[27].

First Republic survived after it was rescued by a consortium^[28] of major banks led by JPMorgan Chase, but the damage was already done. First Republic recently reported that depositors withdrew more than $100 billion^[29] in the six weeks following SVB’s collapse, and now it appears that it could soon fail^[30] too.

The crisis isn’t over yet. Banks had over $620 billion^[31] in unrealized losses at the end of 2022, largely due to rapidly rising interest rates.

The big picture

So, what’s to be done?

We believe the bipartisan bill recently filed in Congress, the Failed Bank Executives Clawback, would be a good start. In the event of a bank failure, the legislation would empower regulators to claw back^[32] compensation received by bank executives in the five-year period preceding the failure.

Clawbacks, however, kick in only after the fact. To prevent risky behavior, regulators could require executive compensation to prioritize long-term performance^[33] over short-term gains. And new rules could restrict the ability of bank executives to take the money and run, including requiring executives to hold substantial portions of their stock and options until they retire.

The Fed’s new report on what led to SVB’s failure points in this direction. The 102-page report recommends new limits on executive compensation, saying leaders “were not compensated to manage the bank’s risk,” as well as stronger stress-testing and higher liquidity requirements.

We believe these are also good steps, but probably not enough.

It comes down to this: Financial crises are less likely to happen if banks and bank executives consider the interest of the entire banking system, not just themselves, their institutions and shareholders.

References

1. ^{^} brink of collapse (www.nytimes.com)
2. ^{^} failure of Silicon Valley Bank in March 2023 (theconversation.com)
3. ^{^} savings and loan crisis of the 1980s (www.federalreservehistory.org)
4. ^{^} financial crisis of 2008 (www.federalreservehistory.org)
5. ^{^} recent turmoil following SVB’s demise (theconversation.com)
6. ^{^} delivered a stinging report (www.federalreserve.gov)
7. ^{^} We are professors (www.sas.rochester.edu)
8. ^{^} of economics (www.minerva.edu)
9. ^{^} began in a rapidly changing interest rate environment (www.federalreservehistory.org)
10. ^{^} losses topped US$100 billion (www.heraldtribune.com)
11. ^{^} deregulated the thrift industry (www.federalreservehistory.org)
12. ^{^} based on the size of their institutions’ assets (papers.ssrn.com)
13. ^{^} bailout cost taxpayers more than $100 billion (www.fdic.gov)
14. ^{^} made to people who could not afford them (irle.berkeley.edu)
15. ^{^} taking bigger risks for immediate gains (www.sciencedirect.com)
16. ^{^} worst recession since the Great Depression (www.epi.org)
17. ^{^} none were held accountable (features.marketplace.org)
18. ^{^} pocketed a combined $2.4 billion in cash bonuses (www.law.harvard.edu)
19. ^{^} would undermine the value of these assets (theconversation.com)
20. ^{^} large share of depositors were startups (www.cnbc.com)
21. ^{^} began raising interest rates last year (theconversation.com)
22. ^{^} required SVB to sell long-term holdings (theconversation.com)
23. ^{^} little downside in discounting or even ignoring (www.ft.com)
24. ^{^} more than doubled to $3 million (news.bloomberglaw.com)
25. ^{^} nearly $30 million in stock (www.cnbc.com)
26. ^{^} midsize banks tumbled (www.forbes.com)
27. ^{^} collapsed days after SVB did (www.reuters.com)
28. ^{^} was rescued by a consortium (nypost.com)
29. ^{^} depositors withdrew more than $100 billion (apnews.com)
30. ^{^} it appears that it could soon fail (www.nytimes.com)
31. ^{^} had over $620 billion (www.fdic.gov)
32. ^{^} would empower regulators to claw back (www.warren.senate.gov)
33. ^{^} prioritize long-term performance (openyls.law.yale.edu)