SVB failure prompts Janet Yellen to worry that bank deregulation may have 'gone too far'

Janet Yellen, the Secretary of the Treasury, has previously warned that some post-2008 financial reforms were watered down during deregulation efforts, which she feels contributed to the current financial crisis.

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“This reminds us that we have an urgent need to complete unfinished business: finalizing reforms after the crisis, considering whether deregulation may have gone too far, and repairing the cracks in the regulatory perimeter that have been revealed by the recent shocks,” Yellen wrote in the text of the speech she is expected to deliver on Thursday.

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There has been a significant strengthening of the oversight of banks following the global financial crisis, but some of these regulations were rolled back during the presidency of former president Donald Trump, especially for mid-sized banks. Furthermore, Yellen pointed out in her speech that under the Trump administration, the staffing dedicated to dealing with financial risk had been gutted as well.

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In addition to Yellen's role as the top economic official and regulatory wrangler for the Biden administration, she will also contribute enormous weight to the effort to toughen financial rules in the wake of the recent bank failures in the United States. The Federal Reserve is one of the agencies that can improve the way it applies existing laws, although it will be difficult for Congress to enact any new laws due to the split partisanship of the House and Senate.

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A key concern raised by Yellen was the danger of "fire sales," where panic drives investors to dump assets at prices below their fair value, a dynamic that can end up crippling the broader financial system and damaging the economy in the long run. To minimize the risks associated with such fire sales, she identified a number of areas where more work needs to be done.

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"Among the targets that need to be addressed are non-bank financial intermediaries, including money-market funds, hedge funds, as well as providers of digital assets," she said.

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Additional Actions

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As a result, the Federal Reserve has launched an investigation into the events that led to the collapse of Silicon Valley Bank in California and Signature Bank in New York, and Congress is expected to open its own inquiry into the events that led to these collapses.

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The occurrence of these events prompted regulators to create an emergency lending facility to boost liquidity across the banking sector and to guarantee uninsured deposits in the bank, in an effort to prevent a contagion of customer runs. It was stated by Yellen that regulators would be prepared to take additional steps if warranted by the circumstances.

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Yellen has noted that she does not want to prejudge the results of the investigations underway, but at the same time, she stated that "we should reexamine whether or not our current supervisory and regulatory regimes are adequate for dealing with the risks that banks are facing now."

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Taking into consideration those who will oppose more stringent rules, the Treasury chief stressed the losses that ordinary Americans have suffered in the past as a result of the crisis.

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"The cost of regulation is borne by the firms," she said. “Even so, the costs associated with a proper regulatory system pale in comparison to the tragic costs associated with a financial crisis."

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It has been noted by Yellen that the global financial crisis of 2008-09 triggered the longest recession in the United States since World War II, resulting in the loss of 8 million jobs and a loss of $10 trillion from the net worth of US households.

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In terms of financial vulnerability, Yellen referred to the following areas:

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• The non-banks, are outside of deposit-taking institutions or are only tangentially linked to them. Since 1985, the amount of credit they extend has nearly doubled as a share of the economy, while the amount of credit provided by banks has remained relatively flat
• As a key component of that non-bank universe, money-market funds provide a close substitute for deposits, but they are not regulated like banks, as they do not fall under the umbrella of financial regulation.
• The open-ended funds have the advantage of daily redemptions but can hold illiquid assets as well.
• There are 25 biggest hedge funds in the world, where leverage is concentrated within them.
• There are stablecoins, which are digital assets that are typically pegged to the U.S. dollar.

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There has not been a place where the vulnerabilities of the system to runs and fire sales have been more clearly outlined than with money-market funds, according to the Treasury chief: "If there is any place where runs and fire sales have been clearly demonstrated, it is money-market funds."

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There has been a long-standing perception that money-market funds are one of the safest places to park cash for households and businesses. However, a run by institutional users in September 2008 played a crucial role in pushing global credit markets to the brink of collapse, which was the ultimate outcome. A massive temporary financial backstop was created by the federal government in that instance, as a result of which money funds were forced to rely on. There was another run on money funds in 2020, which prompted the Fed to create an emergency liquidity facility. Fears gripped the financial markets as a result of this run.

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Recently, however, money funds have experienced significant inflows, especially those that invest exclusively in US Treasury Bonds, as a result of withdrawals made by companies and households from their bank accounts.