The RECOUP Act would provide regulators with broad powers that could distort the allocation of capital and weaken financial stability.
The RECOUP Act would provide regulators with broad powers that could distort the allocation of capital and weaken financial stability.
T he collapse of Silicon Valley Bank (SVB) as a result of bank leadership’s stunning failure to manage elementary interest-rate risk has prompted well-deserved scrutiny in Washington. But a key provision of the bipartisan RECOUP Act making its way through Congress as a response to SVB’s failure could actually end up significantly weakening the stability of the financial system.
Bank management is the first line of defense in bank regulation, and aligning management’s incentives with public interests like mitigating the inherent instability of banking is an important public-policy objective. The RECOUP Act includes two big changes ostensibly designed to incentivize proper bank management.
First, it would impose compensation clawbacks on senior executives of failed banks. Clawbacks can be an important way for any business to ensure alignment between management and shareholders. But they are particularly important in banking, where the inherent instability of maturity transformation justifies such a government intervention. The financial system will be better off incentivizing bank management to prudently manage risks through the specter of clawbacks in the event of bank failure.
But the RECOUP Act’s second major change would dangerously weaken the financial system by providing significantly expanded authority to bank regulators to remove bank management.
Banking regulators have in fact long had the authority to remove the management of insured depository institutions in the event of willfully egregious conduct that threatens the stability of those institutions. The RECOUP Act would extend regulators’ existing removal authority to permit removal in the event that banking regulators determine that management has failed to appropriately implement or oversee risk controls.
How might regulators establish what constitutes “failure” or an appropriate system of risk controls? Supervisors engage in a constant back-and-forth with banks, often citing management deficiencies that are an inherent feature of our immensely complex system of bank regulation. Will regulators be able to dismiss management for mere technical deficiencies? Given supervisors’ recent failures, including at SVB, it would make more sense to ensure that they’re properly exercising their existing authority than to expand that authority.
Yet even if regulators are circumspect in wielding this vast new discretion, their possession of such a weapon could be used to further politicize bank supervision, distorting the allocation of capital across the economy and thereby weakening economic growth. The Biden administration has declared climate change to be a threat to financial stability. Could lending to fossil-fuel projects result in the removal of management for what regulators may deem to be a failure to properly monitor climate risk? Bank management’s mere knowledge that regulators have enhanced removal discretion will result in its decisions’ being more influenced by regulators’ dictates.
Beyond reducing economic growth, incentivizing bank management to conduct its business in a manner favored by regulators will actually increase risks to financial stability. Diversification of business models is essential to the resilience of the financial system. Encouraging further conformity in the financial system will only exacerbate contagion risks.
The lessons of SVB’s failure and the regional-banking crisis should be applied to increase resilience in the financial system. But Congress must fix the RECOUP Act’s removal provisions before it unintentionally empowers regulators to create another crisis.