The latest Bad Takes episode, also about Silicon Valley Bank.

In 2010, Congress responded to the global financial crisis by passing the Dodd-Frank overhaul of America’s financial regulatory system.

The primary goals of Dodd-Frank were to make bank failures less likely and to create a process for dealing with the failures of large financial institutions rather than having government officials make it up on the fly. Because bank regulation is a sprawling topic, things like the creation of the Consumer Financial Protection Bureau and various securities regulations also found their way into the legislation. But the bill passed because of a desire to avoid situations in which government officials were improvising their response to bank failures, ideally by avoiding failure in the first place.

And yet here we are in 2023, reading press releases about the FDIC invoking special authority to insure uninsured deposits and the Fed creating new special lending facilities for banks.

I don’t think there’s any big problem with these decisions, but they raise the question of how we came to this point after a major legislative debate about how to avoid exactly this scenario. And the answer turns out to be pretty straightforward: in 2018, the GOP-controlled House of Representatives wrote and passed a bill substantially curtailing the regulation of banks that are roughly the size of Silicon Valley Bank on the theory that banks of this size are not systemically important and could be resolved through the ordinary FDIC process. Moderate Senate Democrats who felt the need to burnish bipartisan cred chose this bill as their big bipartisan gesture, calculating that of all the possible issues they could defect on, this was the one that progressive groups were least invested in.

Trump administration appointees at the Federal Reserve, the FDIC, and elsewhere implemented this legislation very much in the spirit in which it was written, assuming that SVB-sized banks could be resolved through the ordinary process without causing broader economic harm and therefore didn’t need to be tightly regulated. Objections were raised by Democrats on these boards, including Lael Brainard, who now runs the National Economic Council, and Martin Gruenberg, who now runs the FDIC, but they were overruled. Michael Barr, who is now the Fed’s top bank regulator, also objected from outside of government.

Five years later, it turns out that Brainard, Gruenberg, and Barr were right all along — putting SVB through the normal regulatory process would risk the stability of a number of perfectly solvent banks, and therefore the government needs to step in and improvise.

These improvisational bailouts make a lot of people angry, and I share that anger. I’m particularly angry not because SVB or its depositors got “bailed out,” but because the executives and shareholders of other SVB-sized banks also got bailed out as a result of this, even though those executives were the ones who lobbied against Dodd-Frank on the theory that the regulation was unnecessary. And I’m secondarily angry that a lot of other angry people are going to take out their anger on government officials (like Barr, Gruenberg, and Brainard) who warned against this course of action, while the people who set it on us escape blame entirely.

Sadly, “being mad” is not a policy option. But as long as I’m mad, it seems like a good time to uncork a take I’ve been brewing for the last decade: banks operating on the scale of Silicon Valley Bank — the so-called large regional banks — are bad, and the policy of the United States government should be to encourage regional banks to merge and become megabanks comparable in scale to the Big Four. Megabanks are better-regulated and less risky than large regional banks, and creating more of them would lead to a more competitive megabank marketplace and eliminate some of the problems of concentration.

Bank failure without bailout

Something I see over and over again in the discourse is that Americans’ somewhat romantic notions about small businesses allow certain myths about small banks to persist.

A lot of people have it in their heads that small bank failures are inherently safer than large bank failures, and that’s why small banks are entitled to lighter regulatory supervision. Alternatively, people believe that small banks get rougher treatment from the government when they get into trouble — no bailouts! — while larger banks receive special privileges. This is because most people don’t really understand what happens when a small bank fails.

But here’s how it works. When Almena State Bank of Almena, Kansas failed in October 2020, the FDIC closed it and sold it to a bank named Equity Bank based in the Kansas City area. In this situation, the purchasing bank typically pays $0 for the failed bank and in exchange receives the failed bank’s branches, whatever investment assets are left on its book, and the failed bank’s clients and client relationships. The purchasing bank is also now obliged to give depositors their money if they ask for it. This means insured deposits are taken care of without the FDIC spending its money and uninsured deposits are also taken care of without the FDIC spending its money —a good deal for everyone involved. But it relies on the idea that when a small bank fails, another bank will want to take over its branch network.

This is basically a numbers game. There are a lot of banks in the United States, and since “buying” a failed bank is essentially free, the bet is just that some bank or other will have an executive team that’s ambitious enough to want to expand.

The main issue the FDIC deals with in practice is that it tries to avoid excessive geographic concentration. So if a bank with seven branches fails, the preference is to sell it to a bank that doesn’t currently have branches in those communities to preserve local competition. But sometimes that isn’t possible, and the bank that’s most interested in buying has an anti-competitive motive.

In practice, though, this process basically always works out. The FDIC shuts down a bank, it calls up some larger banks that operate nearby (but not in exactly the same locations), and the bank reopens. As I’ve mentioned before, when I first lived in D.C., my bank account was with a longtime local bank called Riggs Bank. Then Riggs was caught doing serious financial crimes, causing it to become insolvent. On Friday the bank was closed, and then on Monday its branches reopened as PNC Bank branches. No depositors lost any money, and the government didn’t need to spend a dime. In effect, rich people who had uninsured deposits got a “bailout” from PNC, as did the FDIC, which would otherwise have been on the hook for the insured deposits. But PNC got to expand into the D.C. metro area. Everyone wins.

In theory, a bank could fail with nobody willing to take it over. In that scenario, the FDIC has to cover the insured accounts, and there’s also a question of what happens with the uninsured accounts. Even if the bank were really small, wiping out uninsured deposits could be a problem because it might cause people to pull deposits from other small banks, wiping them out. But generally when a small bank fails, someone buys it and there’s no problem.

The problem of the middleweight bank

The problem is, what happens if PNC fails? PNC is the sixth largest bank in the country with over $500 billion in assets. That makes it dramatically smaller than the Big Four banks that are informally labeled “too big to fail” and formally classified as Global Systemically Important Banks (GSIBs).

But PNC is still big enough that almost none of the thousands of banks in America could buy it in the event of a failure. And even if Chase or Bank of America could swallow PNC, it’s not clear that they would want to. PNC has an expansive branch network, so expansive that it’s largely duplicative of the network of any possible purchaser.

When you map out the business logic of taking over PNC, splitting up the bank makes the most sense. PNC’s branch network in the South would be complementary to Citibank, its branches in the Midwest would be complementary to Wells Fargo, and U.S. Bank could take over its operations in the Northeast.

But dividing up a bank like that would be a complicated process requiring multi-faceted negotiations among a lot of stakeholders.

You certainly can’t count on getting something like this done over a weekend, which leaves the government with exactly the problem they faced with SVB: a looming Monday deadline at which point non-insured deposit accounts — belonging to a mix of rich people and businesses — are frozen. Not being able to access these accounts would result in some direct harm, like businesses having trouble meeting payroll, but resolving that

The Fed, the Treasury, and the FDIC would then look at the situation and decide that bailing out PNC’s depositors is not only better for the economy than liquidating a bunch of banks, but likely cheaper as well.

And that’s the call they made with Silicon Valley Bank.

SVB was a bit of a weird bank since it grew very large while having a small geographical footprint and because its clients included a lot of VC and startup types who are vocal on Twitter. But while I recommend these posts from Joey Politano and Noah Smith on SVB’s rise and fall, I want to emphasize that nothing about SVB’s interesting business model is particularly relevant to the endgame. For such an interesting bank, SVB went bust in an almost shockingly boring way — it made a big bet that interest rates on federal government debt wouldn’t rise,

Note this could have worked out. PNC is big enough to swallow SVB, and if you eyeball the map, their locations are complementary. And PNC’s CEO, William Demchak, who’s been a bank executive in Pittsburgh for 20 years running a successful but boring business, must have been at least tempted by the notion of becoming a major player on the Silicon Valley startup scene. But he decided to pass.

Sara Eisen @SaraEisen

Breaking: PNC is out. According to a source familiar, PNC sent an initial notice of interest to the FDIC to help with SVB. PNC held brief & preliminary discussions w/ FDIC. But after conducting initial due diligence, PNC informed FDIC yesterday that it decided not to move forward

9:47 PM ∙ Mar 12, 2023

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And that’s the general problem with large regional banks.

When they argue to Congress and regulators that their failure isn’t necessarily a systemic risk, they are correct. You absolutely could resolve these banks through the normal FDIC process. But the normal FDIC process relies on willing participants in the business community, and when you start dealing with a very short list of potential players, the odds of failure get unacceptably high. This is why Congress had this right the first time, and the large regional banks should have been treated as systemically significant — their creditors (including depositors) should have explicit guarantees, but they should face stricter regulation in exchange. We had a framework like that in place, but they wriggled out of it by arguing that they wouldn’t need bailouts in the event of failure. Then the first time a large regional bank failed, everyone panicked and decided we needed a bailout or the whole regional bank sector would get wiped out.

We should encourage regional bank mergers

The claim made by regional banks that wasn’t total bullshit is that being regulated to the same standard as the GSIBs put their much smaller operations at a competitive disadvantage.

That is completely true. Giving the regional banks a lighter regulatory touch lets them operate higher-margin businesses, which lets them invest in superior customer service, which is how a lot of business owners end up preferring to bank with them rather than with a GSIB. Take away the favored regulatory status and those banks will have a harder time.

I think the solution is to drop the regulatory skepticism of bank mergers.

The industry should admit that SVB-scale institutions’ relatively small size doesn’t change the fact that they are systemically significant, so they don’t deserve lighter-touch regulation. But the regulators should also admit this, which means there is no good reason to subject their growth through merger to heightened scrutiny. If PNC were to merge with another large regional bank, that wouldn’t create a new “too big to fail” entity because PNC is already too big to fail.

Looking at the FDIC’s largest banks list, the smallest of the Big Four banks has $1.7 trillion in assets.

To be a bit loose for the sake of argument, imagine banks five through seven merged, creating a fifth $1.7 trillion GSIB. Merge banks eight through 12 and you have a $2 trillion giant. Banks 13-21 would combine for $1.8 trillion. Banks 22-30 would be $1.3 trillion, and banks 31-50 would be another $1.4 trillion entity. Please don’t take that too literally as a business plan. The point is that right now we have a huge gap between the fourth-largest bank in the country and the fifth-largest bank. But banks five through 50 collectively have assets almost equal to those of the Big Four. And if they were allowed to merge, and indeed encouraged through a mix of regulatory carrots and sticks, we could have a Big Eight or Big Nine of giant banks, then a chasm where the remaining banks are dramatically smaller such that any of them could be easily swallowed by one of the Big Nine in a crisis.

That would let you draw a really clear regulatory line.

• On the one hand, you would have giant banks that cannot be liquidated, not because they are “too big to fail” but because they are too big to be purchased by another bank. These banks have a special regulatory status, designed to minimize the risk of failure, and are subject to various special fees, etc.

• On the other hand, you have small banks that are given more leeway (though of course not infinite leeway) in terms of how they conduct their business with the understanding that if one of them fails, it will be sold to another bank.

This would involve “more bank concentration” in the sense that eight or nine banks would control the bulk of the country’s banking assets rather than 50 banks. But in addition to clarifying the regulatory situation, I think it would provide more bank competition than the current situation because you would have eight or nine megabank-class banks instead of four.

Concentration versus competition

As a closing thought, I think this is just one example of a larger issue that’s wended its way into the policy discourse: the difference between encouraging fractured markets and encouraging competitive markets.

Or to put it another way, over the past decade, I’ve seen a revival of intellectual interest in competition policy and the problem of monopolistic and oligopolistic markets. But there’s also been a revival of intellectual interest in the idea that big companies are bad and we should prefer small ones instead.

These are genuinely different ideas. If you go to Blue Hill, Maine, there are branches of three banks in town: Camden National Bank, Bar Harbor Bank & Trust, and First National Bank of Maine. If instead there was a Wells Fargo, a Bank of America, a Chase, and a Citibank, that would be a more concentrated banking sector in national terms but a more competitive environment for people who live in the town. They would have more choices, not fewer. And that’s what competition policy should be aiming for — trying to create a situation where people have, in practice, access to as wide an array of competing businesses as possible. That’s different from pushing for a fragmented landscape in which you have lots of different small- and medium-sized companies scattered across America.

There are plenty of good reasons to think that competition is important, but people really struggle to explain why concentration per se is bad. We hear a lot of vague handwaving about political power, but in banking and elsewhere, the trend is for smaller businesses to be subject to a lighter regulatory burden.

What we see in the Silicon Valley Bank situation in particular is that the greatest danger by far comes from getting too sentimental about putatively small companies. The SVB executives themselves are out of a job, but every large regional bank in America is currently having its share price somewhat buttressed by the combination of depositor bailout and a light regulatory touch that was secured by promising that no bailout would be necessary.