Araha Uday, Stanford University
Supervision and regulation as we know emerged following the Great Recession when policymakers vowed to prevent what took place then–billions of dollars in bailouts for the biggest banks—from happening again. Although the majority of bailed-out banks eventually repaid their loans (from which the federal government in fact gained $109 billion), some still have outstanding balances. Still, a few missed payments are a small price to keep banks afloat—at least a chance of future repayment remains. A complete bank failure, on the other hand, would mean no repayments at all, which underscores the high stakes in maintaining a stable banking system.
To manage these risks and ensure financial stability, the Federal Reserve System and the Federal Deposit Insurance Corporation have employed tools such as stress testing and resolution planning. The former—required under Title I of the 2008 Dodd-Frank Act—simulates severe economic shocks to assess whether banks have enough capital and liquidity to withstand crises. These tests can expose vulnerabilities, and banks that fail to meet regulatory standards may receive warnings or fines from the Fed and FDIC. Meanwhile, resolution planning requires banks to periodically publish plans proving they can wind down operations in an orderly manner, minimizing losses and macroeconomic disruptions if they fail. This regulatory framework has strengthened the American economy, making it one of the safest and most resilient in the world. Investors can trust that their money is secure and research confirms that stress testing not only reduces banks’ credit risk but also enhances transparency for investors.
Yet despite these benefits, critics of contemporary banking regulation say it fosters a system in which a few firms indirectly benefit from the requirements intended to keep them in line. After all, regulation is not just a matter of following rules; it can also be a barrier to entry. According to the Bank Policy Institute (a lobbying group which recently sued the Fed over its stress testing framework), “The C-suite of the average bank spends 42 percent of its time on compliance tasks or examiner mandates”: One CEO reported spending 15% of operating expenses on compliance. Whole divisions must be hired to develop resolution plans, run simulations, communicate with regulators, and coordinate with legal departments (composing 5% of banks’ workforces on average). This is feasible for the eight designated Globally Systemically Important Banks: They have the infrastructure to hire the necessary human capital, can build sophisticated data collection systems, and have the budget to execute these tasks. Consequently, their ability to keep up with new regulations creates an industry moat which small banks cannot overcome. This is bad for regulation and the American taxpayer. When there are fewer banks, the failure of one bank is more damaging to the economy, which can cascade globally. If the economic cost of not bailing out a bank is high enough, preventative regulation and resolution planning can becomes pointless.
This very situation occurred when the large Swiss bank Credit Suisse failed in 2023. Instead of implementing the resolution plan, the Swiss government bailed out Credit Suisse, providing 259 billion francs with a promise to cover up to 9 billion in losses. Swiss bank UBS ultimately repaid the loans after acquiring Credit Suisse in an emergency rescue deal. However, it serves as a reminder that governments are still prepared to support bailouts in the face of potential failures of large banks. This creates the appearance that resolution planning is futile and reinforces banks’ reliance on bailouts.
But when regulators do employ planning and regulation, to what extent do these tools successfully prevent instability?
Although resolution plans have never been implemented, planning and testing have tangibly benefitted the banking system. Without certain processes and requirements, it’s uncertain whether banks would adequately devote resources to identify and address their risks internally. All it takes is executive mismanagement, inadequate training, or miscommunication of a few key checks to knock the tower down. Such was the case for the GSIB Citibank. In 2023, the Fed’s stress test on Citi’s resolution plan uncovered significant weaknesses in its data collection systems that led to a $136 million fine.
Yet, regulation and stress tests are far from a universal safeguard. Silicon Valley Bank’s (SVB) 2023 failure highlights the limitations of existing oversight. Unlike Citi, whose regulatory deficiencies were flagged through stress testing, SVB’s downfall stemmed from basic interest rate risk mismanagement—an issue that eluded significant regulatory intervention. Despite passing key capital requirements and stress tests, SVB received a deficiency rating in a 2022 memorandum from the San Francisco Fed for Governance and Control. The SF Fed later argued that the looser regulatory “tailoring” approach taken in response to the 2018 Economic Growth, Regulatory Relief, and Consumer Protection Act (EGRRCPA) impeded their intervention in the case of SVB. Then, is more or stronger regulation the answer?
Perhaps more stress tests and regulatory checkpoints could have prevented SVB’s collapse. However, existing regulations are already not being fully utilized. Additionally, countless factors can contribute to failure. While chasing every possible scenario with new regulation might help prevent the next bank failure, it also risks overburdening smaller banks. So given the diminishing returns of additional regulation, the challenge remains: how can governments effectively prevent future failures?
Proper testing is just one piece of the puzzle. Regulators must also back policies with real consequences by addressing the moral hazard of bailouts, which means allowing resolution plans to unfold as intended if a crisis hits again instead of resorting to a taxpayer backstop. Inevitably, this transition would shake investor and consumer confidence. To counter this, governments should enforce rigorous bank transparency and vocal regulatory bodies, ensuring that risks are identified and addressed early before they escalate.
Allowing some bank failures may have dramatic global consequences, but in the long run, it could realign incentives and foster a safer, more resilient banking system. It is only a matter of time before central banks and governments face the next major crossroads. As regulations loosen under the new administration, policymakers must remain vigilant—ensuring that resolution plans are robust and that accountability remains a priority. At the same time, they must strike a balance, preventing policies that inadvertently contribute to systemic risks.