Why SVB's Failure Is Really Scary
Our financial system is built to fail. Is it about to fail again?
The 40 year-old Silicon Valley Bank (SVB) — our nation’s 16th largest bank — just went poof. This is our nation’s second largest bank failure. But the experts are saying not to worry. Take Catherine Rampell of the Washington Post. She says SVB made “dumb decisions” and "this is no where on the scale of that (the 2008 financial crisis).” According to Catherine, the dumb decisions that SVB made was to invest in U.S. Treasury bonds. But U.S. Treasury bonds are the world’s safest securities. Not if interest rates rise. In this case, their market value can drop precipitously, leading to, in this case, SVB having too little assets to cover its liabilities, when the balance sheet is properly marked to market. Bloomberg says not to worry because SVB had a unique set of customers, namely tech venture capital firms. And former Treasury Secretary, Lawrence Summers, says this can’t spread because depositors will, without question, be repaid in full.
I’m not sure what these folks are smoking. The SVB failure is really scary for at least the following seven reasons.
The Fed and Treasury let the SVB fail even though it had excellent collateral, namely those “dumb investments” — the Treasury bonds — against which the Fed could have lent. The last bank the Fed and Treasury let fail was Lehman Brothers. It’s assets were not triple A rated. Presumably, the Fed and Treasury felt they didn’t have enough fire power to save SVB? How come? SVB had $175 billion in customer accounts. Eighty-five percent of these deposits weren’t FDIC insured. Recall, the FDIC insures checking accounts only up to $250K ($500K for joint accounts). Hence, had the Fed/Treasury stepped in, they would likely have had to insure all of SVB’s deposits to keep its large depositors from continuing to run for their money. But that would not likely have stopped them from doing so. A friend of a friend of mine had over $20 million in his company’s checking account in SVB yesterday. Now it’s gone. Do you think Fed/Treasury assurance would have kept him from transferring his holdings to, say, Vanguards money market fund? Hence, had the Fed/Treasury insured the deposits, they would likely have had to come up with $150 (.85 x $175) billion on the spot. That’s a big number even by historic standards. So, the Fed/Treasury blinked as they blinked with Lehman, leaving Lehman’s creditors to recover pennies, specifically 41 pennies, on the dollar. This is why Secretary Summers’ suggestion that everyone with money in SVB will be made whole is wholly absurd.
SVB is just one bank. But across the entire banking system, there are $18 trillion in commercial bank deposits. Of these, only $10 trillion are insured. If I’m one of the depositors with some of the $8 trillion in uninsured deposits, I’m heading for the hills, i.e., I’m pulling my money out on Monday and putting it in a money market fund that invests in Treasury bills. Hence, we could see a massive, immediate run on banks by uninsured borrowers — a run that the Fed/Treasury has just demonstrated they are unable/unwilling to stop.
SVB was not a “bad” bank/financial institution like Bears Stern, Commonwealth Financial, Lehman Brothers, and AIG — all of which were considered bad because they were run by somewhat unpleasant people, who looked and sounded nothing like Jimmy Stewart, aka George Bailey. In addition to having bad-seeming and, therefore, surely bad people at their helms, these financial companies had highly opaque balance sheets. But SVB is, well was, a good bank. It did what it was supposed to do —- invest in mortgages and Treasuries. Yes, it invested in longer maturity Treasuries. And mortgages have long maturities. But that’s what banks do — borrow short and lend long. Two Nobel Prizes in Economics were recently awarded to Douglas Diamond and Philip Dybvig for showing how efficient such an arrangement supposedly is. My view. The Diamond-Dybvig model is a classic not because it justifies the current banking system, but rather because it shows the current banking system is built to fail. What’s needed is Limited Purpose Banking — a financial system that can never fail because it comprises 100 percent equity-financed mutual funds and nothing else. (I lay out the scheme in my 2010 book, Jimmy Stewart Is Dead. Also take a read of The Economic Consequences of the Vickers Commission.)
The fact that SVB had a concentration of a particular type of depositor, namely venture firms, did not cause its demise. The nature of SVB’s depositors’ businesses wasn’t the issue. It was SVB’s assets, specifically their maturity. Any bank that has invested long term was and remains subject to a run by its uninsured investors, whether they are venture firms or cosmetic companies.
The Dodd/Frank stress tests are a bad joke. SVB surely passed its latest stress test. But large, uninsured depositors don’t care that its bank has a, say, 10 percent capital ratio (which is ridiculously low, but somehow viewed as roughly adequate). They will, realize, after today, that banks that pass the Dodd/Frank stress test can instantly collapse.
Good banks can start running on bad banks in the form of not honoring lines of credit or otherwise refusing to provide credit. The Great Recession was largely a run by banks on banks. But now we could see both a run by large depositors as well as banks on “bad” banks — the weakest member of the herd that’s just waiting to be picked off.
Financial crises are contagious. Over 80 major U.S. and foreign financial institutions failed during the Great Recession. The failures began overseas, came to the U.S., and then spread back overseas. Leveraged banking survives on confidence and successive failures means deeper and deeper losses of confidence. This is why bank failures happen serially not simultaneously. The weakest bank fails first, then the next weakest, and on we go. And failures in one country rattle lenders in another.
How should you react? Well, if you hold stock, like me, you’ve already been nailed. The market plunged again today, recording its worst weekly performance since June. But far worse is possible, so fasten your financial seat belt to the extent possible. In the Great Recession, the market fell 53 percent from peak to trough. And the SVB failure is hitting right as the Fed is poised to raise rates yet again. The irony here is particularly palpable as the Fed’s attempt to quell inflation may produce a financial crisis requiring it to reverse course and start printing money to bail out Wall Street yet again — thereby fueling more inflation. Had we switched to Limited Purpose Banking, SVB would still be in business and we wouldn’t all be worrying about the Really Great Recession.
YOU NEED TO GO TO THE DENTIST, YOU NEED TO TAKE YOUR MEDICINE, AND YOU NEED TO PLAN YOUR FINANCES. BUT MAXIFI TAKES AWAY THE FEAR FACTOR BECAUSE HOWEVER BADLY YOU’VE SCREWED UP SO FAR, MAXIFI PLANNER WILL LOWER THE PAIN BY FINDING YOU SAFE WAYS TO RAISE YOUR LIVING STANDARD.
I mentioned that the FDIC had nothing to back up its claim to be able to cover nationwide deposits in my Jimmy Stewart Is Dead Book. So, I'm with you fully. When this becomes public, we'll have more chance of a bank run, but by the "insured" as well as the uninsured.
Yeah, I think we should agree with Larry here, not the Rampells. I would add one more point, though. Another scary thing is that Summers MIGHT be right. Maybe the Fed WILL make 100 percent of depositors good, that is, reveal that the true deposit insurance coverage is 100%, not $250,000. Why would that be bad? No, not because it would add to the deficit, silly. It would be bad because it would produce the mother of all moral hazard scenarios. The thing that is supposed to restrain excessive risk taking by banks is not really regulation -- that is a back-up mechanism. What is supposed to restrain risk taking is depositor pressure -- rational people won't put money in banks that take excessive risks. In SVB's case, the risk was an unreasonably long duration gap. In 2008, it was investment in derivatives that the banks themselves (let alone their depositors) didn't fully understand. Who knows what it will be next. But 100 percent deposit insurance coverage will make the next time just that much more likely. (Personal opinion of Ed Dolan, not an official position of Niskanen Center as an institution.)