Why another financial crisis?

Why every 15 years since the 1980s savings and loan collapse has there been a financial crisis? Martin Wolf of the Financial Times states, “We have created a banking sector that is in theory private, but in practice a ward of the state.” Let’s take a look at the failure of the Silicon Valley Bank, which ignited the recent debacle.

Over the years, the Silicon Valley Bank (SVB) became the friendly bank loaning to tech start-ups and receiving their deposits. This working relationship between techs and SVB was crucial because big banks ignored requests for loans from Silicon tech start-ups. Remarkably, one-half of the entire U.S. venture capital funds invested during 2022 in tech start-ups, $91 billion, were deposited in SVB.

Trapped by low interest rates, SVB shifted investments gradually from short maturity government notes to long-term bonds. Though this shift only raised their interest yield a miniscule .04 of 1%, it brought with it a one-way bet that the Fed would not raise interest rates. If the Fed did raise rates, SVB would incur large losses of up to $16 billion since the price of bonds moves inversely to the interest rate.

Adding to this risk, SVB was sitting on a potential large flight of deposits since 94% of their demand deposits, $151 billion, were larger than the FDIC-insured level of $250,000. This was a time bomb and fuse waiting to be lit if deposit flight occurred, forcing the selling of bonds to gain cash. Taking on this mammoth, unhedged risk was a gross violation of fiduciary responsibility, which the Fed warned them about.

On the evening of March 9, SVB clients at the bank’s annual conference learned of the risk load SVB was carrying. The following morning, one-fourth of SVB’s depositors created an avalanche of $43 billion of withdrawals. Before noon, it was clear the bank could not sell bonds fast enough to keep up with the run and avert insolvency. The FDIC stepped in, and SVB was history. Tech executives are notorious for telling government to keep out of their businesses. The irony is pungent. As investment commentator Barry Ritzholtz aptly noted, “Just as there are no atheists in foxholes, there are also no Libertarians during a financial crisis.”

Fear of contagion caused other banks in America, Signature and First Republic, to run off the rails. In Europe, even the historic Credit Suisse Bank came under attack and was purchased by the UBS Swiss bank in a shotgun marriage orchestrated by the Swiss National Bank. On March 24, the shares of Deutsche Bank tumbled. A rolling contagion continues. Distress is not over yet.

The causes of a financial crisis are complex, multiple, intertwined and fast-moving. Most observers place primary blame for this crisis on the egregious management by the board and management of SVB. Did the Fed help cause this crash by keeping interest rates too low too long? Also, did it supervise SVB as required? Yes, interest rates were kept low too long, causing market distortions as firms reached for higher returns by purchasing more risk. Yes, long before its collapse, strong deficiencies were charged against SVB. Unfortunately, pushback from Congress and President Donald Trump against alleged too-harsh regulation of banks succeeded.

President Trump appointed Randal Quarles as vice chair of the Fed for bank supervision. He was a well-known ‘reduce government supervision’ supporter and this presaged less Fed oversight of banks. Indeed, in 2018 Congress amended Dodd-Frank to reduce Fed scrutiny of regional banks such as SVB. Now banks under $250 billion no longer faced enhanced supervision or stress tests. The Fed notified SVB of its serious risk overload problem, but felt the board would never allow enforcement of its findings.

Perhaps the most difficult government decision related to the extraordinary losses in uninsured demand deposits. Tech firms cried out for relief. Treasury Secretary Janet Yellen faced a most difficult choice: restore fully all deposits, including those uninsured, or pay back depositors only up to the insured level of $250,000. She chose bailing out all depositors.

Europe was furious, saying we previously negotiated and agreed on this $250,000 level as prudent – what a dangerous precedent you have set in America. Either decision would have brought harm, but I believe the Europeans have it right. This decision says that no matter how banks invest and engorge on risk, the government will pay off all depositors. This is unacceptable and places an unlimited liability on the federal government. Capitalism functions as firms balance risk and return. As Wolf said, this decision makes banks wards of the state.

Once again, it is important to underline the fundamental reality that our complex and closely interconnected economic system cannot function without rules, referees and enforcers, and neither can the banking system.

Roy Wehrle is a professor of economics at University of Illinois Springfield.

This article appears in The future of farming.