Neither Silicon Valley Bank (SVB) nor Credit Suisse should have failed, thanks to all the measures put in place after the global crisis in 2008.

In the words of Mark Carney, then governor of the Bank of England and the head of the Financial Stability Board, "[o]ver the past decade, G20 financial reforms have fixed the fault lines that caused the global financial crisis" (Carney 2017).

Those post-2000 G20 financial reforms are founded on the philosophy of modern regulations. The notion is that all important risk is identified and measured, to be used by banks and the financial authorities to determine the appropriate level of risk. Then it is easy for the banks and regulators to fine-tune risk. If we need more growth, reduce capital requirements, as we did in March 2020, or demand more capital if risk is too high, as we should have done before 2008. Risk plays a key role in that because the amount of capital is a direct function of the riskiness of a bank.  (Perotti 2023, Dewatripont et al. 2023)

The case of Credit Suisse and Silicon Valley Bank challenges the modern philosophy of regulations. While there are many factors at work, here we want to focus on the trilemma of financial policy:

1. The economy should grow, or at least recessions must be avoided.
2. Inflation needs to be close to its 2% target.
3. Financial stability is to be high.

Financial regulations – both of the micro variety, including Basel III, and the macroprudential variety – play a key role in achieving these objectives. The problem is they cannot be achieved simultaneously. So the authorities need to pick the ones they prefer, hence the trilemma.

This conflict was not apparent in the decade after the 2008 global crisis because all three objectives were in sync. Financial policy helped growth via quantitative easing and low interest rates, inflation stayed close to its target, and financial stability appeared high. But that was an illusion.

Lax monetary policy, designed to help the economy grow, made the financial system dependent on low interest rates. Banks adapting their operations to the low interest rate environment was not seen as a problem because they would only face difficulty if rates were to rise. Consequently, a necessary condition for that monetary policy to be sensible is that inflation would never rise. It was a bet on low inflation and low interest rates lasting forever, akin to writing a deep out-of-the-money and decades-long maturity put option on inflation.

The longer monetary policy stayed lax, the more systemic risk increased, along with the growing dependence on money creation and the low rates. While not exactly hidden, these problems were hard for the private sector to find out because of the lack of granularity in accounting disclosures. However, the authorities had all the data and could identify the problems.

The ultimate consequence of the lax monetary policy was to undermine objective three, namely, financial stability. That should not have been a problem, since all the authorities had to do was rein in risk by raising capital. The problem is that increasing capital when the economy is doing poorly, as it is now, is recessionary. High financial stability conflicts with the first objective, namely, economic growth.