In March 2023, three large US banks failed, and one was closed and liquidated. The most prominent failure was Silicon Valley Bank (SVB), a California chartered bank for which the Federal Reserve was the federal safety and soundness supervisor. Two of the banks were among the 30 largest US banking organizations and had been considered “well-capitalized” until the time of their failure.

The failures triggered runs on other banks around the United States, which the government was able to forestall only by promising to protect all deposits beyond the $250,000 level already protected by the FDIC. As bad as this was, it was only the latest in a continuum of bank failures and financial crises that have characterized the US financial system for the last 100 years. These continual disruptions are signals that the entire system of bank regulation and supervision must be must be replaced, not simply repaired.

In a 2013 speech to the Chicago Fed, Bill Isaac, a former chair of the Federal Deposit Insurance Corporation from 1978 to 1992, noted: 

The period from 1978 to 1992 was exceptionally tumultuous for the US economy and financial system. … Our largest banks were loaded with loans to lesser developed countries. The Federal Reserve, FDIC, and Treasury developed a contingency plan to nationalize the major US banks if the LDC countries renounced their debts. Some 3,000 insured banks and thrifts failed during this period. Our seventh largest bank, Continental Illinois, in downtown Chicago, failed and was in effect nationalized by the FDIC and many regional banks went under, including nine of the ten largest banks in Texas.

More recently, the FDIC reported that there were 516 bank failures between 2009 and 2023. Since the 1970s, over 90 banks with assets of $1 billion or more have failed.

The safety and soundness of US banks are the responsibility of three government agencies, the Federal Reserve (Fed), the Comptroller of the Currency (OCC), and the Federal Deposit Insurance Corporation (FDIC). The Fed is by far the largest of these—with the broadest responsibility—regulating and supervising over 4,900 bank holding companies, 839 state member banks, 470 savings and loan holding companies, 154 foreign banks operating in the US, 41 Edge Act and agreement corporations, 52 state member banks foreign branches, 40 financial holding companies, 442 domestic financial holding companies, and 8 designated financial market utilities.

The OCC regulates and supervises a little over 1,000 national banks, and the FDIC is the safety and soundness regulator for over 5,000 national and state-chartered banks and savings associations, as well as the deposit insurer for all US banks. 

There have been three major financial crises involving regulated and supervised banks and S&Ls just since the 1980s—one centered in 1989 involving bank and S&L failures with aggregate losses of $390 billion, one in 2008 with aggregate bank losses of $515 billion, and the one in 2023 with losses of $319 billion. 

This is an unenviable—maybe even scandalous—record. Not only has the FDIC been required to compensate the depositors in all these banks who had insured deposits, but it reduced the profitability of all surviving banks that had to pay higher rates for deposit insurance afterward. The losses to uninsured depositors, and to other individuals, businesses, and the economy generally have not apparently been calculated or reported, but they were surely substantial. 

A Better System

It’s time to admit that the government’s regulation and supervision of US banks has failed and is both ineffective and an increasing danger to the US economy. Its principal flaw, as with all governmental systems, is the absence of the incentives necessary to produce regulatory diligence. 

Accordingly, to create a more stable, safe, and sound US banking system, the regulation and supervision of the US banking industry should be transferred to a new and independent private regulatory structure—based on and utilizing the financial resources and knowledge of the banking industry itself—that can focus on the safety and soundness of the financial institutions it is supervising. 

Such a system, as described below, will not require any government involvement or resources and, through risk-based deposit insurance, will be able to produce a more stable banking industry than the US has experienced since the founding of the Federal Reserve in 1913. 

Many essential services work day-to-day without any government role, and without any significant failure or disruption that affects more than the particular customers of a failing institution. Why can’t this work for banking? 

In 2019–21, the total assets of Silicon Valley Bank and Signature Bank grew by 198 percent and 134 percent respectively—far exceeding growth for a group of 19 peer banks (33 percent growth in median total assets). To support their rapid growth, the two banks relied on uninsured deposits, which can be an unstable source of funding because uninsured depositors are more likely to withdraw their funds during times of stress. Moreover, it is now possible for depositors to withdraw funds electronically, without having to appear at the bank’s teller windows. This makes bank “runs” even more uncontrollable. 

In the five years before 2023, government regulators identified concerns with Silicon Valley Bank and Signature Bank, but both were slow to mitigate the problems the regulators identified, and regulators did not escalate supervisory actions in time to prevent failures.

A Private Sector Solution

A private system for monitoring and insuring banks requires only two elements: first, an effective privately run monitoring system with responsibility for assuring that each bank is well-managed and operating safely, and second, a private system for insuring all bank deposits backed by the capital of all US banks. In the first quarter of 2023, the aggregate capital of all US banks was $2.260 trillion. 

It would not be feasible, of course, for each bank to monitor all other banks. However, in the banking world today it should not be difficult to create a whole industry of private firms made up of or employing qualified bank or financial monitoring specialists, together with syndicates of banks willing—for a fee—to insure the depositors of banks and S&Ls against deposit loss. 

The Monitoring System

In this system, a monitoring group (“MG”), a private company somewhat like an accounting firm that employs qualified bank monitors and supervisors, would contract with the banks it will monitor. 

Indeed, accounting firms could find this activity to be a natural extension of their business. An MG could monitor dozens of banks. The Fed doesn’t charge for its regulatory and supervisory activity, but as we have seen it doesn’t do a particularly effective job either. The MG would be compensated by fees negotiated with the banks that it monitors. 

Given that this structure involves thousands of banks and S&Ls, and perhaps hundreds of MGs, it’s likely that monitoring rates would be established annually or semi-annually through a bidding process. 

Over time, if a bank’s condition remains healthy through both easy and troubled periods, the bids for monitoring it will decline. In this way, well-managed banks will be able to benefit financially from their quality management and reduced risk profile. On the other hand, of course, a bank that is deemed to take excessive risks will receive higher bids from prospective monitors, who will be reflecting the greater monitoring risks. 

After an initial investigation, the MGs interested in monitoring a particular bank will bid for that bank’s examination fee during the succeeding year, specifying the schedule for its examination and the information it will require. In most cases, the bank will accept the lowest bid or the one with the fewest restrictions or demands. Although the bank will be interested in reducing the cost of its monitoring, choosing the least expensive MG may not be the most effective strategy in the long run, because the bank will also have to pay the cost of its private deposit insurance, described below. 

A Private Deposit Insurance System

Following through on the idea that the banking industry’s capital—and not a government program—is what will back the deposit insurance system, groups of banks will form syndicates to bid for an individual bank’s deposit liability. In other words, the deposit insurance risk of any bank will be “acquired” by a syndicate of banks in much the same way risks are sold to (or bought by) insurance consortia on the floor of Lloyd’s of London. 

For assuming the deposit insurance risk of a bank, the bank syndicate will receive a payment from the insured bank. The payment will vary according to the risk of default as judged by the syndicate of insurers. One of the key elements of risk will be the quality, diligence, and experience of the MG that is the bank’s monitor. In general, banks that are well-managed, and pay low fees to the MG for monitoring, will pay a low premium to the deposit insurance syndicate. Banks with a weak or inexperienced monitor—or deemed to be taking more risk—will be required to pay a higher insurance fee to the syndicate. 

It should be possible for the premium on an insurance contract to be raised on an interim basis where the insured bank has missed certain risk parameters during a year. 

All US banks will also agree to “stop-loss” provisions so that the banks that are members of insurance syndicates that suffer significant losses would not be seriously weakened by a catastrophic loss. This means that the banks that initially assumed the risk would be protected by an agreement of all banks that no bank in a loss protection syndicate would lose more than a specified percentage of its capital in the event of a catastrophic collapse of one or several insured banks. 

If the losses from a catastrophic event reach that level, all banks will be required to assist the syndicate or syndicates that have suffered the losses. These cases would likely be very rare, but a stop-loss provision would ensure that a major collapse would not have unusual systemic effects. 

In this system, a bank like SVB would have faced additional monitoring fees from its MG and possibly a greater insurance fee as its condition declined or its risks increased. Its problems would have been promptly reported by its MG to the insurance syndicate, and would probably have increased its insurance fee. 

If a bank could not reach an agreement on a monitoring fee with a MG, or could not find another MG and insurer syndicate within a limited period of time, it would have to close. No bank or S&L would be permitted to operate without an MG and a contract with an insurance syndicate. 

The Power of Private Incentives

Bill Isaac’s summary is again applicable:

It’s clear from the three major banking crises in the past 40 years [(1974-1976, 1980-1992, and 2008- 2009)] that we have not achieved [the necessary] balancing act. None of these crises occurred because of lack of regulatory authority but rather the failure of regulators to use their authority effectively to rein in excessive speculation by financial institutions. … Ineffective regulation is worse than no regulation because it gives citizens a false sense of confidence that government is protecting them.

The relevant question about the current US system of supervising and regulating banks and S&Ls is whether there is a better way. Regulation as it’s done now—through various agencies of the federal government—has left the people and businesses of the United States, the richest and most advanced country on Earth, with regular financial crises, personal financial losses, and needless disruptions in their lives and activities. These have continued over the 110 years since the Federal Reserve and the government banking and deposit insurance system were established. Perhaps it’s because of the nature of banking—perhaps there just is no better way—but that seems highly unlikely. 

Let’s consider something as essential as the food delivery system for the 350 million people in the United States. The government has no significant role in this, except to assure safety through laws and periodic inspections, but Americans almost never find themselves without available nourishment, anywhere in the country, any day of the week, and any time of the year. The delivery of oil and gas for home heating continues without any government role, and the same is true of gasoline for automobiles and electricity for lighting streetlights and homes and powering manufacturing. Even Elon Musk’s Space-X has been putting more satellites into Earth’s orbit than NASA. 

All these essential services work day-to-day without any government role, and without any significant failure or disruption that affects more than the particular customers of a failing institution. Why can’t this work for banking? 

The answer is that it can. The difference between all these services and banking is that banking is heavily regulated and controlled by the government, while the rest run on private incentives. It may be that banks require supervision, but if so, incentives can be built into supervision so that banks can be compelled to act safely and soundly in the same way that other private sector suppliers of goods and services do. It only takes a bit of imagination and the will to try. 

This would be a radical change, to be sure, but no one can deny that the current system isn’t working.