The collapse of Silicon Valley Bank and prudential regulation

The collapse of Silicon Valley Bank, which had invested heavily in US government bonds, is a typical manifestation of a liquidity crisis.

Legislative reform in 2018 exempted US banks with assets not exceeding $250 billion from many capital adequacy and liquidity rules. Even the liquidity rules applying to larger banks, however, would not have been enough to prevent the problem, as government bonds are precisely the kind of securities that liquidity rules require banks to hold. The rules would have needed to limit the extent that a bank’s depositors and borrowers can be firms from the same sector of the economy.

In the UK, the Prudential Regulation Authority (PRA) would not normally be paying close attention to a firm like SVB because it did not have major UK operations so its failure would not cause any serious risk to the UK financial system. However, if it had not been for HSBC taking over the UK subsidiary of SVB, UK start-up tech companies would face substantial woes, as they had deposited significant funds with SVB or relied on continuing funding from it. Still, this kind of economic effect is not captured by the concept of systemic risk to the UK financial system that the PRA is required by the Financial Services and Markets Act to guard against.

Overall, the failure of SVB brings into focus the perennial problem of prudential regulation. Rules can only capture certain types of risky conduct, often reflecting past experience, but it is hard to predict how risks will arise in the future. While the fragility of SVB’s business model seems evident with hindsight, regulators are often constrained by their mandates, political pressures, and limited resources. Tough prudential rules come at a cost for economic growth in good times, so sustaining them in the long-term is hard even if it is clearly in everyone’s interests to do so.