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In this week’s Grumpy Economist Weekly Rant, John Cochrane examines a challenge facing the Federal Reserve that goes beyond interest rates and monetary policy: the recurring failure of financial regulation. Looking back at the 2008 financial crisis, Cochrane argues that the core problem was not simply risky assets, but the way banks and other financial institutions fund themselves in ways that can trigger sudden runs.
Cochrane argues that post-2008 reforms focused too heavily on regulating the risk of bank assets while leaving the deeper source of instability intact: short-term debt that can run. That flaw reappeared in the 2020 pandemic bailouts and again in the 2023 failure of Silicon Valley Bank, when uninsured depositors ran, and regulators responded with sweeping guarantees. Financial regulation needs to change. Without that structural shift, the financial system will remain fragile, heavily regulated, and dependent on future bailouts.
Transcript
Hi, I’m John Cochrane, senior fellow here at the Hoover Institution, and welcome to my Grumpy Economist Weekly Rant.
Today, one last thought about the Federal Reserve and its challenges going forward. We think about the Federal Reserve in terms of monetary policy, interest rates, balance sheet, and so forth. But in fact, much of what the Federal Reserve does is financial regulation. And in terms of reforming the Fed, there’s nothing more important than reforming the smoldering dumpster fire of our financial regulation.
Let’s remember where we came from. There was a huge financial crisis in 2008. The crisis was basically a run. Banks and other financial institutions lost a little bit of money on their assets. Depositors and other short-term creditors ran to get their money out before everybody else and caused a wave of failures. The Fed and the Treasury intervened with massive bailouts, and only those massive bailouts kept all of the big banks from failing completely and the financial system from cratering.
“Never again,” said our politicians. And to their credit, they said, “Something is wrong here. We need to reform it.” And they passed the Dodd-Frank Act, and the Fed passed a bunch of subsidiary regulations and decisions to implement the Dodd-Frank Act. I think it went fundamentally wrong, but let me at least salute the decency to say something went wrong and we need to do something about it—a habit that is not in evidence these days in Washington.
Where did they go wrong? They focused on regulating the risk of the assets rather than regulating the fact that banks and other financial institutions get their money from short-term borrowing that can always run and cause a crisis.
When you think about it, it’s really strange. A bank’s assets are a portfolio of loans and securities, relatively stable. Tesla’s assets are rocket ships to Mars, artificial intelligence data centers, and electric cars, which is risky. Well, duh, Tesla. Where are all the regulators looking at bank assets? Why? Because Tesla’s assets are funded by issuing stock, not by borrowing short-term. Tesla loses money, stockholders lose some money, they go home, they grumble, but it’s not a financial crisis.
Financial crises are always problems of short-term debt. So things got worse. The promise that there would never be bailouts was shown obviously false in 2020 in the pandemic, when the Fed bailed out the financial system once again. Not the big banks, but just about everything else.
Then, in 2023, the Silicon Valley Bank went under. Silicon Valley Bank had issued uninsured deposits to big companies, checking accounts with hundreds of millions in them, and invested in long-term Treasury bills. No fancy mortgage-backed securities and collateralized debt obligations, long-term Treasuries. Simplest balance sheet in the world. Interest rates went up. The value of the Treasuries fell.
The depositors, who were uninsured, ran to get their money out. The bank failed. The Fed and the FDIC turned around and guaranteed all deposits, $9 trillion, a huge bailout.
And that was the tip of the iceberg. Many other banks nearly failed as well. The idea that our central bankers can see asset risks, regulate them, and do something about it ahead of time, that idea is proven false by Silicon Valley Bank. They couldn’t see in real time, with all of our human frailties, an elephant in the room: interest-rate risk coupled with uninsured deposits.
The Fed had made matters worse by banning innovations that would’ve solved the Silicon Valley Bank problem. Other banks tried to innovate segregated accounts and narrow banks, ways for large institutional depositors to park their money that would be completely risk-free, not need deposit insurance.
Why? Well, I think they wanted to protect the profits of the big banks, but by doing so, they protected the fragility of the big banks.
There’s an answer out there. It’s been sitting on the shelf for a long time. Banks and other financial institutions must fund risky investments by issuing equity and long-term debt. If you want to offer something like deposits or short-term debt, that has to be backed 100 percent by reserves at the Fed or short-term Treasuries.
It’s easy to implement, but it faces huge political obstacles because many people make money off the current system. I hope that America will finally do the right thing after we’ve tried everything else, as is our habit.
The alternative is an increasingly regulated, sclerotic, crony-capitalist system, and one that will be prone to increasing failures and always dependent on bailouts.
Well, to my friend, colleague, Kevin Warsh, you have a lot on your plate. But great Federal Reserve chairs are forged in adversity. It would be a terrible job if it were just boring and minding the store.
Here is your chance to do some really great things in the future.
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John H. Cochrane is the Rose-Marie and Jack Anderson Senior Fellow of the Hoover Institution at Stanford University. An economist specializing in financial economics and macroeconomics, he is the author of The Fiscal Theory of the Price Level. He also authors a popular Substack called The Grumpy Economist.