To prevent bank runs, fix bank governance

Faced with a snowballing financial panic, regulators bailed out the largest customers of the failed Silicon Valley and Signature Banks on Monday. The FDIC now insures all the two banks’ depositors, even though coverage was ostensibly limited to deposits under $250,000. The regulators hope the bailout will reassure uninsured depositors at other fragile banks. 

While this debacle has many causes, skewed corporate governance incentives played an important role. As financial instability beckons, the executives and directors of banks owe fiduciary duties exclusively to their shareholders, even though their depositors and even the economy as a whole are very much at risk.

What caused the failures of Silicon Valley Bank (SVB) and Signature Bank that prompted depositors to fear for their uninsured deposits? The usual suspects of financial panics played an important role here. Banks borrow short to lend long. When interest rates go up as much as they have recently, this formula squeezes banks. They are locked in to low-yielding long-term loans while the cost of their funds increases. And because bank depositors can withdraw their funds at will, long-term loans cannot be converted to cash instantly, making all banks vulnerable to runs whenever their customers sense vulnerability.

Congress and bank regulators know this. They have developed an array of techniques to prevent runs and the financial turmoil they cause. Federal deposit insurance guarantees bank customers that their money is safe, reducing the likelihood of a bank run. Regulations require banks to have enough equity to remain solvent even if interest rates go up and to have enough cash to satisfy a sudden increase in depositors demanding their money. But these regulatory requirements were loosened for banks the size of Silicon Valley and Signature in 2018, making a run more likely and necessitating Monday’s bailout.

Commentators have overlooked the critical role played by corporate governance incentives in exacerbating the risk of runs like those at Silicon Valley and Signature. The people running these banks knew for months about the losses they were incurring on their long-term bonds as interest rates went up. To cover these losses, protect their solvency and reassure depositors, they should have raised equity. They didn’t — and here we are in bailout land.

Why didn’t the leaders of the banks raise equity before it was too late? As I observed in a 2020 co-authored academic paper, raising equity dilutes existing shareholders at the same time that it reduces the risk of runs. Under corporate law, bank executives and directors owe a fiduciary duty to their shareholders but no such duty to the depositors or to the taxpayers who ultimately guarantee bailouts, such as the expansion of deposit insurance.

Rather than raising costly equity that protects depositors and the financial system, the executives at SVB and Signature may have concluded that they needed to protect their shareholders’ returns. The relaxation of the regulatory standards in 2018 made this decision easier, but it did not create the law that mandates executives and directors to focus on their shareholders.

State legislatures should act now to fix this flaw. Bank officers and directors should owe fiduciary duties to depositors in addition to shareholders. This would mean uninsured depositors could sue bank officers and directors for breach of fiduciary duty if a bank unreasonably fails to mitigate the risk of a run by neglecting to raise equity or conserve capital. This corporate governance reform is not free — it will reduce shareholder returns and make bank executives more risk averse than the leaders of other companies. But the inherently unstable nature of banks, and the inevitability of bailouts in the wake of runs, makes altered corporate governance rules urgently necessary in the financial sector.

Yair Listokin is deputy dean and Shibley Family Professor of Law at Yale Law School and author of “Law and Macroeconomics: Legal Remedies to Recessions.”