More turbulence likely ahead after bank collapses

U.S. Federal Reserve

Graeme Sloan/Sipa via AP

Work & Economy
More turbulence likely ahead after bank collapses

Christina Pazzanese

Harvard Staff Writer

March 15, 2023 6 min read

But Larry Summers says regulators have significant tools at their disposal, need to be vigilant of specific vulnerabilities

Steps taken by the federal government to boost confidence in the U.S. financial system appear to have contained a potential banking crisis after the collapse late last week of Silicon Valley Bank and Signature Bank. But uneasiness remains over possible spillover effects on global finance from increased scrutiny by U.S. regulators and questions about the fitness of banks around the world, concerns that have rattled financial markets this week.

The Gazette spoke with former U.S. Treasury Secretary Lawrence H. Summers, president emeritus and Charles W. Eliot University Professor at Harvard, about the prospect of imposing greater restraints on banks and whether the recent collapses could foreshadow more serious global financial trouble. A noted macroeconomist, Summers is also Weil Director of the Mossavar-Rahmani Center for Business and Government at Harvard Kennedy School. Interview has been edited for clarity and length.

Q&A

Lawrence Summers

GAZETTE: Numerous investigations are now underway. Was this largely a regulatory failure, a supervisory failure, something else?

SUMMERS: Accidents always have many causes. This one would not have had happened if the bank had practiced serious risk management. It would not have happened if supervisors had been on the job. It would not have happened if bank regulations were better directed at reflecting market values rather than purchase prices of assets held by banks. It would not have happened if we had not had sharp increases in interest rates in the country. It would not have happened if the bank had responded more rapidly to emerging problems. So, there are many different elements of causation. But certainly, this is an important supervisory and regulatory failure.

GAZETTE: Is this a problem specific to mid-sized banks in the U.S. and likely to stay confined to this cohort, or could these collapses be a harbinger of trouble for the venture capital world and global finance more generally, as some hedge fund executives have begun warning?

SUMMERS: Whenever there are earthquake tremors, there’s ground for concern about more tremors to come. We’re seeing right now, a few days after the events at Silicon Valley Bank, substantial strain around institutions in Europe. There may be financial aftershocks. There quite likely will be some implication of all of this for levels of lending and therefore, for the American and global economies. Some of that will come from banks being alarmed, some of it may come from regulatory tightening.

GAZETTE: Do you share the concern of some hedge fund executives about tightening of lending, specifically venture capital?

SUMMERS: There’s no question that this will have impacts on the supply of credit. I think it’s not yet possible to judge what their magnitude will be. Many regional banks are not caught up in these difficulties, and regional banks are only a portion of the total banking system. Far more credit in the United States is intermediated through capital markets than is intermediated through the banking system. So, I think it’s too early to judge just how much of a contractionary impact these events will have.

GAZETTE: What potential aftershocks or knock-on effects could come from this event?

SUMMERS: The issues go to more institutions facing confidence issues and deposit withdrawals. The issues go to reductions in the supply of credit that, in turn, affects the level of investment and economic activity, that, in turn, affects the economic health of borrowers. We don’t yet know what the magnitude of these effects are going to be. But I think there are risks. Probably in the United States, the fact that regional banks are particularly focused on lending to commercial real estate at a time when certain parts of commercial real estate, like office buildings, are facing strains is something that needs to be watched carefully.

GAZETTE: Congress does not appear poised to revise or pass new regulations right now. Are there non-legislative actions or regulatory features, like stress tests, that could be tightened that would make a demonstrable difference?

SUMMERS: I think the regulatory community has substantial authority to act within its own discretion without the need for new legislation. They have the prerogative to design stress tests as they see fit. They have the ability to define what constitutes capital and how capital is measured. They have the ability to certify or not certify that banks are in a healthy position and able to continue operating. So, I think regulators have very substantial scope for action here without legislative action.

They are going to have to strike difficult balances, though. On the one hand, we want to regulate for safety; on the other hand, we don’t want to magnify credit crunches. On the one hand, we want to maximize accountability for those entities or individuals who have made financial misjudgments; on the other hand, we want to maintain confidence in the flow of credit. So, there’s a great deal of challenge for regulators, and there’s a great deal of challenge for academics like those at Harvard to distill lessons of this experience for future policy.

GAZETTE: The U.S. Federal Reserve is reportedly reviewing tightening capital and liquidity requirements for midsized banks. Is the Fed likely to follow through? And how effective could that be at preventing future collapses?

SUMMERS: I think we are in far better circumstances right now but for the sweeping changes in bank regulation that took place in the wake of the 2008 financial crisis. Particular credit should go to Harvard Law Professor Dan Tarullo, who spearheaded those efforts during his service as governor of the Federal Reserve of the Federal Reserve System.

Unfortunately, in 2018, Tarullo’s successor at the Federal Reserve Board, with the support of many other Federal Reserve governors, undid a number of the important changes that had been put in place, having the effect of loosening stress tests and relaxing requirements for midsized banks. I think we will look back and see those policies as having been grave errors, even though some part of them were codified into legislation by the Congress with a reasonable amount of bipartisan support.

GAZETTE: Will this situation influence the Fed’s decision on interest rates next week? Should it?

SUMMERS: Anything that affects economic prospects should and will affect Federal Reserve decision-making. Before any of these problems, I thought it was fairly likely that there would be a 50 basis-point increase this coming week. That now seems extremely unlikely. Whether the Fed will carry through on a smaller, 25 basis-point increase is not knowable at this time.

I don’t think that these financial strains can or should be an excuse for the Fed losing its focus on inflation. But it needs to maintain that focus with an awareness of economic conditions, and there certainly has been a contractionary change from what has taken place.