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Bank failures, like the one at Silicon Valley Bank on Friday, can’t be assumed to be idiosyncratic or isolated events, write Larry Hatheway and Alex Friedman.
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About the authors: Larry Hatheway and Alex Friedman are the co-founders of Jackson Hole Economics, and the former chief economist and chief investment officer, respectively, of UBS.
Sunday night, the U.S. government announced that all depositors in the failed Silicon Valley Bank will have access to their money. In essence, Federal Deposit Insurance Corporation protection—usually limited to $250,000 per account—became unlimited. Additionally, the Federal Reserve created a new program to help protect other banks from depositor flight.
These were the right steps to avoid contagion, but they also reveal a fundamental problem in the U.S. banking system.
Of itself, Silicon Valley Bank is a relatively minor player in the U.S. (and global) financial system. With assets and liabilities of roughly $200 billion each before its collapse,
SVB
was a medium-size bank, one that also mostly catered to the world of venture capital and start-ups. It wasn’t a behemoth like the banks and investment banks that caused the global financial crisis of 2007-2008.
Ironically, SVB’s smaller size is also why it matters so much.
How so? Because following the global financial crisis, U.S. regulators distinguished between smaller banks and “systemically important banks,” or SIBs, ones that alone could wreck the financial system and economy if they were to fail. For depositors at SIBs, all their money is effectively insured to prevent bank runs. That insured coverage, of course, comes with strings attached, namely that SIBs are more closely scrutinized by regulators than other banks.
Depositors at smaller banks, such as SVB, on the other hand, are only formally insured up to $250,000. Over that amount, as the FDIC announced on Friday when it shuttered SVB, depositors are treated like ordinary creditors. The implication is that when a bank like SVB fails, large depositors may only get pennies on the dollar back once other creditors are satisfied.
Unsurprisingly, therefore, large depositors across the U.S. got cold feet following SVB’s sudden failure. If it could happen at SVB, it could happen anywhere. To no one’s surprise, therefore, reports began circulating that runs were possible at other banks that had not been designated systemically important.
The irony is rich. Suddenly, non-SIBs are systemically important. And if the government had not acted as it did in covering the potential losses of uninsured depositors, numerous regional players would have experienced depositor flight and a series of bank failures would surely have followed. This weekend was full of stories of companies worrying about how to make payroll because money was suddenly frozen at SVB. Given the interlocking relationships of financial institutions and their important links to the real economy, it is difficult to overstate the risks to the U.S. financial system and economy that would have erupted.
Some have argued that SVB is a “one-off.” Postmortems, which have already begun, have tended to focus on a narrow and poorly diversified deposit base as well as an imprudent policy of investing in bonds without appropriate risk management.
But to conclude that SVB is an isolated incident is to miss the broader point. Banks are institutions that exist on confidence. No matter how well or poorly they are managed, when confidence evaporates, all banks—the good ones and the bad ones—head to the abyss.
So, yes, SVB appears to have been poorly managed. But banks aren’t like other private-sector businesses. Failures cannot be assumed to be purely idiosyncratic or isolated events. Failure cannot be ringfenced if it also sows doubt or increases risk. If a bank failure erodes depositor confidence more broadly, then the good, the bad, and the ugly face the same risk of depositor flight and failure, taking jobs, livelihoods, and—conceivably—the economy down with them.
So, what’s to be done?
In the short run, the Federal Reserve in its new Bank Term Funding program has made credit available to banks suffering large-scale deposit withdrawals. But the lender of last resort function isn’t meant to be a permanent replacement for private sector deposits. Moreover, for as long as the Fed is managing a banking crisis, it will be distracted from its other primary goal, fighting inflation.
The more durable solutions reside with other branches of government. Depositors could be reassured if SVB can be sold to a bank sound enough to restore the faith of all depositors. The Treasury, FDIC, and other regulators may be able help make that happen in the next day or so.
But in the long run, the risk of large deposit runs may require higher insured deposit amounts. Deposit insurance rates would accordingly have to rise to adequately fund those contingent liabilities. Raising deposit insurance levels would also mean that regulation of small and midsize banks would have to be intensified, along the lines of what now exists for SIBs. Many inside the world of finance would chafe at the expanded role of regulators in finance. Politically, it could be challenging to achieve.
If we have learned anything from the SVB debacle, it is that bankers, left to themselves, cannot only bring down their own banks—they can also take the entire financial system with them.
It has been said that war is too important to be left to the generals. That adage seems to also apply to finance. Banking may simply be too important to be left to the bankers.
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