How Regulatory Missteps Fueled the First Republic Bank Failure

First Republic Bank is the latest bank to fail in the ongoing banking crisis that began in March. Critics of regulators are blaming a light-touch approach by the Federal Reserve and government agencies, but they are overlooking an alternative reason: the actions of the Fed and others leading up to the crisis.

Specifically, the Fed's management of interest rates during the last year, combined with regulators' overzealous response to recent banking uncertainty, proved to be more destructive than helpful. The story of the last year and a half is that inflation has returned with a vengeance. While most economic indicators, particularly job growth and wages, remain strong, the Fed must now prioritize inflation. To respond to inflation, the Fed raised interest rates seven times in 2022. One result of the Fed's actions is that economic growth has begun to slow considerably.

Raising interest rates ultimately slows growth by making certain consumption and less productive forms of investment less attractive. Rising interest rates also had an impact on SVB, which was largely profiting thanks to the so-called carry trade. In essence, SVB's balance sheet was prone to problems as the Fed increased interest rates, because they squeezed this arbitrage opportunity and made the banks' investments no longer profitable. As in the run-up to the Great Recession, the Fed's actions changed the investment calculus for the banking system, making the recent failures a predictable outcome in an overheated, inflationary environment.