March 26, 2023 | Latest Commentary
Bank Failures Warn of Deeper Economic Problems
The failure of Silicon Valley Bank and Signature Bank are markers of broader problems in the banking sector more generally. To be able to understand what is happening and how it may develop in the months ahead requires some institutional background on banks and some history on bank failures.
Banks specialize to distinguish themselves, just like other businesses selling a fairly homogenous product. Some serve a particular regional market or a type of depositor and lender. Banks like to mention this in their names, like ‘farmers’ or ‘merchants.’ Both SVB and Signature were large banks, serving a particular type of client. SVB both lent to and had deposits from businesses who received venture capital funds. Signature Bank had large investments in crypto currency.
The coming months will see several books written on management problems in both banks. At the very least, there will be civil lawsuits, maybe more serious legal risks in both institutions. But, serving one particular industry should not be sufficient to make a bank at risk of failure. That’s why they have risk management consultants and staff. What made these banks far more susceptible to a bank run was their extreme share of uninsured deposits.
The FDIC insures individual depositors up to $250,000. This deposit insurance is designed to reassure folks with cash in a bank that it is safe. That experience came out of the Great Depression, in which a substantial share of Americans lost their deposits in bank runs. The famous scene from “It’s a Wonderful Life” offers a superb depiction of a bank run, especially George Bailey’s explanation of fractional reserve banking.
Through deposit insurance, most money in banks is insured. Out of the nation’s 4,800 odd banks, fewer than 20 have more than one-third of their deposits that are uninsured. So, there’s little incentive depositors to remove their money, precipitating a bank run. But, SVB and Signature both had roughly 90 percent of their deposits uninsured. Their clients were heavily exposed to a bank failure. This type of exposure largely defeats the benefits of deposit insurance.
The failure of SVB was a classic bank run. Uninsured depositors got wind of a looming bank failure and quickly withdrew their money. But, just as George Bailey explained, the money wasn’t there, it was invested elsewhere. Therefore, the FDIC closed the bank. Signature Bank followed suit, and to stem further bank runs, the FDIC engaged in a bit of regulatory sleight of hand to insure all deposits.
Federal regulatory intervention stopped, for the meantime at least, a broader run on banks. However, that doesn’t explain why the bank was in trouble in the first place. The answer is simple and familiar—the bank bought a large number of U.S. Treasury bonds at low interest rates. The value of those bonds have since plummeted, as more-recently issued bonds pay much higher interest rates. So, the value of existing bonds, with lower rates, drops.
Banking has multiple regulatory authorities, so compared to other industries, bank failures are rare. During the second worst financial crisis in history, from 2008 to 2012, a whopping 0.014 percent of banks were closed by the FDIC. During the regulatory infancy of the Great Depression, roughly one in three banks failed. This is a big change in bank failures, but it is not foolproof, and more importantly it is not without cost.
At least one estimate has the bond valuation loss held by banks at roughly $2.2 trillion dollars. That’s a bit more than 10 percent of all deposits. This suggests that more bank failures are likely. I do not think this implies a broad banking crisis, yet. It does mean the U.S. should use alternatives to high interest rates to stem inflation. There’s only one way to do this; higher net taxes. Neither political party has an ounce of fiscal probity between them, so we will slump thoughtlessly towards higher risk of a broad financial crisis.
The problems here cannot be remedied through deposit insurance or other banking regulation. No nation will permit a bank run if they possess the tools to do so. It is silly to blame the Biden administration for extending deposit insurance. The broader problem is that insuring all deposits increases some of the long-term risk of bank failures.
Depositors should know something about the financial acumen of their banker. Deposit insurance reduces their enthusiasm in understanding the business practices of their bank. It also deprives bankers of information about the underlying risk tolerance of depositors. This clearly incentivizes bankers to take more risks to attract new deposits, thus destabilizing the entire bank system.
In truth, most depositors don’t have a big effect on bank risk. Few people are going to carefully scrutinize their bank’s prospectus. Moreover, few of these depositors will move money between banks every few weeks to take advantage of small changes in interest rates on deposits. Thus, there’s a reasonable argument that the current $250,000 insurance threshold on bank deposits does little to make banks more risky, while greatly reducing the risk of a bank run.
Still, any deposit insurance trades off risk of a bank run with longer-term risk of bank insolvency. To insure every depositor, no matter how large their holdings, may be extraordinarily risky. Very large depositors have the capacity to understand the risk of individual banks, and they have the ability to chase small interest rate changes by moving large deposits between banks. These deposits should not be federally insured.
Sustaining a universal deposit insurance isn’t a risk, it is foolhardy. It essentially nationalizes the risk to banks, while leaving the reward in the private sector. One challenge for the Biden administration is how to reverse the universal deposit insurance they engineered for SVB. The Treasury secretary is already making clear not all large deposits will be protected. That is a good first step, but I think private deposit insurance or partial deposit insurance would be an improvement.
It is also important that the owners of SVB and Signature Bank were not made whole. Bad businesses must be permitted to fail, and investors share in that failure just as they share in success. The bank officers and board members likewise should suffer financially and professionally. This practice helps to discipline risky behavior by banks. Just to be clear, the investments weren’t risky; the unsecured deposit levels are a major red flag.
The longer inflation persists, the more pressure banks will feel on their portfolios. This is an early warning of the economic problems that accompany decades of unfettered government spending and tax cuts. We’d be wise to cut spending and raise taxes now. But, we aren’t yet wise.
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