Is Our Financial System Starting To Melt Down?
It's beyond time to adopt Limited Purpose Banking and end bank runs for good.
VERY SORRY! I hit the send button too soon and included an earlier draft of this piece at the bottom. Here’s the right version of this newsletter.
It’s Monday, March 13, 203. Sunday morning at 1 AM, I fired off a newsletter entitled Why SVB’s Failure Is Really Scary. The newsletter suggested that, absent new government policy, we could experience a worst-case financial crash Monday morning when banks and markets opened. The scenario was a massive bank run by uninsured bank depositors on our nation’s commercial banks. This banking doomsday would trigger a colossal meltdown in stock and bond markets. And then the financial crisis would spread to other financial sectors and abroad. The poison icing on the cake? The Really Great Global Recession.
After hitting the 1 AM send button, I thought, Maybe I’ve gone nuts? But after I woke up and fixed the typos, I found emails from a range of global financial experts who had read my epistle. To a person, they agreed. The worst case scenario could, in fact, transpire. Worst yet, major global media were running headline stories suggesting the potential for a Monday-morning meltdown.
If you are just tuning in, on Friday Silicon Valley Bank (SVB), our nation’s 16th largest bank, failed. Early last week the bank had some $200 billion in assets. By Friday afternoon, when the bank was shuttered by the Federal Deposit Insurance Corporation (FDIC), its assets were roughly $160 billion. In the course of 36 hours, the 40 year-old bank had to sell off roughly one fifth of its investments to meet a $42 billion run by uninsured depositors. At this point, the FDIC pronounced Game Over!
SBV was unusual in several respects. Most important, north of 90 percent of its deposits were uninsured. Yet, across the entire commercial banking system, uninsured deposits constitute about $8 trillion compared with insured deposits of roughly $10 trillion. Thus two of every five dollars in bank deposits are uninsured.
Before President Roosevelt took office in 1933 and established the FDIC, bank deposits were entirely uninsured. This helps explain why one in three banks failed between the Crash of 29 and early 1933 — the early years of The Great Depression. Once the FDIC was established, bank failures came to an end. After all, why would anyone run on a bank if their deposits were guaranteed by the good faith and credit of Uncle Sam?
But the FDIC’s restriction, to which few paid attention in the ensuing years, is the per-depositor coverage limit. It’s now $250K. ($500K in the case of a married couple’s joint account.) This limit was raised — from $100K to $250K — during the Great Recession to reassure small bank depositors. The fact that small bank depositors wouldn’t run clearly reassured large uninsured bank depositors that their money was safe. So did the 1991 failure of the Bank of New England, in which the FDIC covered uninsured as well as insured deposits. (FYI, Fed Chair, Jerome Powell, was a party to this decision.)
Late Sunday, the FDIC announced that it would guarantee all deposits of SVB as well as those of Signature Bank, which the FDIC also closed, albeit yesterday. (FYI, the SVB and Signature Bank failures constitute our nation’s 2nd and 3rd largest all-time bank failures.) The Fed also set up a lending facility with $25 billion in a new piggy bank (the Bank Term Funding Program) to make one-year loans to banks against good collateral, where the collateral will be valued at par. I say piggy bank because $25 billion is peanuts compared to the $8 trillion in uninsured deposits.
Republic Bank, whose shares dropped dramatically — 70 percent! — this morning, before trading was stopped, appears to be an exceptionally solid bank. It looks nothing like SVB. It passed the vaunted Dodd-Frank stress test. Other regional banks are also suffering huge declines in stock values. Apparently, what everyone worried about over the weekend — a run by uninsured depositors — has started with the depositors of even “safe” regional banks moving their money to large, i.e., too big to fail, money central banks like JP Morgan or placing their checking account balances in money market funds that hold short-term Treasuries. The question is how long the run will last and how far it will extend.
But why are uninsured depositors running in light of the new piggy bank facility? Well, it’s a piggy bank. Then there’s the announcement that all SBV and Signature depositors would be fully protected. That’s an admission by omission — an admission that other uninsured depositors in other banks might not be insured.
All this is happening despite one very favorable reading of the new policy, namely that the piggy bank will be given as much money as needed by the Fed and that banks can use these loans to effectively eliminate their collective $620 losses that arise by marking their assets to market.
As described in my prior newsletter, regulators allow banks to carry Treasuries and similar securities on their books at hold-to-maturity valuations. But once they sell securities booked at par, they have to mark the sale to market, i.e, record the sale at the actual price received. The trigger for the run on SVB was the sale of a collection of Treasuries that forced SVB to acknowledge that what it sold was worth $1.8 billion less than it had been advertising. This government policy of explicitly letting financial entities pretend they have more assets than they actually do is the route cause of this crisis. SVB uninsured depositors guessed correctly that marking all of the bank’s “safe” assets to market would leave it insolvent. Indeed, the bank appears to have been insolvent at least back to September. Still, the new Fed policy gives the banks the liquidity they need to hold their longer-term bonds to maturity, i.e., to validate the fake valuation.
Here, though, is the deal for uninsured depositors. Seeing through all this complexity, worrying whether the piggy bank will be enlarged, wondering if your bank has the right assets to pledge as collateral for loans from the piggy bank, fretting over your bank’s share of uninsured deposits, losing sleep over what other uninsured and, indeed, insured depositors are thinking and doing, and dealing with your spouse who has spent the last 48 hours calling you an absolute idiot for having uninsured money in a bank, and, well, you jump on your laptop, run on, actually run away from your bank and get to sleep for the first time in three nights.
The bank run will surely continue until the FDIC announces all deposits, regardless of size, are fully insured. This announcement needs to be made immediately. Then we need to fix our financial system for good by adopting Limited Purpose Banking. It transforms banks and all other financial middlemen into mutual fund companies where each mutual fund is 100 percent equity financed, i.e., none have any debt. As a result, no mutual fund and, thus, no financial company can go broke. Imagine that, a world in which man-made financial crises are a thing of the past because no financial company can fail.
I am not sure about this one. Anyone who wants to put his savings in a money market mutual fund can already do so. OTOH, many people, myself included, want to keep funds in liquid form without worrying about valuation. I have a lot of money in several accounts at a small regional bank. The accounts are less than $250,000 each. I am happy with the situation and do not want to see it change.
I have investments in money market mutual funds, and I also own treasury securities directly. I just don't see how your proposal helps me.
Further, who will lend money to businesses and consumers in your system. How will they be funded?
What I think should be done is to adopt a less ad hoc and more structured insurance system How about this: for the first $250K, just like now., fully insured, the next 250, 99%, 500 to 1 million 98%, 1 to 2 mil 97%, 2 to 5 mil 96%, 5 to 10 mil 95% over 10 90%. FDIC should allow large depositors to buy back the deductible for a premium based on the yield on the deposit.
Prof Kotlikoff - Can you point to other experts, like yourself, that support your idea of transforming all financial institutions into mutual funds?
A return to Glass Steagall and putting limits on what interest banks can pay, which i know you hate, would insure more safety to the core banking system. Right?