Here We Go Again?

The recent downfall of Silicon Valley Bank – and the bank failures, financial turmoil, and forceful policy response that followed – has summoned for many a sense of déjà vu. Why does the banking system remain so vulnerable 15 years after the global financial crisis, and how can another nightmare scenario be prevented?

According to Yanis Varoufakis, a former Greek finance minister, the banking system will always be crisis-prone. Banks were “designed not to be safe” and, together, “comprise a system constitutionally incapable of abiding by the rules of a well-functioning market.” Rather than try to fix an “unfixable” system, he concludes, we should take advantage of digital technologies to end our reliance on any “private, rent-seeking, socially destabilizing network of banks.”

Former Chilean Finance Minister Andres Velasco agrees that “banks are vulnerable by design, not by mistake,” and acknowledges that central bank digital currencies might one day “do away with bank deposits altogether.” But that day is “nowhere near,” which means that our “best hope” of preventing bank failures is “broad-based deposit insurance, swift liquidity provision by central banks (in their role as lender of last resort), and stringent regulation.”

Likewise, the “overhauled” financial-stability framework advocated by Lucrezia Reichlin of London Business School emphasizes “comprehensive deposit insurance.” More broadly, she writes, “if some sectors of the economy are going to be protected no matter what, we should establish a framework for doing that ahead of time, rather than bailing out uninsured depositors after the fact.”

But there is another piece to the financial-instability puzzle. “While many vulnerabilities in the banking system were created by bankers themselves,” write Raghuram G. Rajan and Viral V. Acharya, a former governor and deputy governor of the Reserve Bank of India, respectively, the US Federal Reserve “also contributed to the problem,” not least through quantitative easing. Given this, the problem “may be more systemic.”

Michael R. Strain, Director of Economic Policy Studies at the American Enterprise Institute, is far less worried about financial risks – “a series of bank runs across the country” is “unlikely to materialize” – than he is about an “overheated labor market and 1970s-like inflation.” In his view, the Fed’s top priority should be to continue to “move aggressively on the inflation front.”

Willem H. Buiter, a former member of the Monetary Policy Committee of the Bank of England, echoes this call for continued monetary-policy tightening to support price stability. Meanwhile, the Fed can manage the “conflict between the objectives of price stability and financial stability” by using “the size and composition of its balance sheet as a macroprudential policy tool,” thereby buying time for financial regulators to strengthen their regime.

But New York University’s Nouriel Roubini says that central banks face a trilemma. “Owing to recent negative aggregate supply shocks – such as the pandemic and the war in Ukraine – achieving price stability through interest-rate hikes” raises the risk of both “severe financial instability” and “a hard landing (a recession and higher unemployment).” Confident that central banks cannot “fight inflation and provide liquidity support simultaneously,” he sees only one solution: “a severe recession – and thus a broader debt crisis.”