The banking sector has become a hot topic in the news cycle recently. Last week, I dedicated two pieces to the topic. The first piece was on why Silicon Valley Bank (SVB) collapsed. It was not out of a lack of regulation or scaling back on regulations, but a combination of expansionary monetary policy and poor investment choices from SVB. The second piece was about whether or not we should worry about contagion. I illustrated why the worries for contagion are minimal at best. Today, I want to discuss the themes of whether the government can properly stabilize the banking industry, the concept of deposit insurance, and how worried we should be worried about moral hazard in light of the latest regulatory changes implemented.
Should we trust the government with bailing out the banking industry?
I do not make this assumption, but for argument's sake, let's assume for a New York minute that there is adequate concern over contagion. I have reservations as to whether the government can handle the task of stopping bank runs. This is more than how the FDIC or the Federal Reserve failed to stop bank runs from Bear Stearns, IndyMac Bank, Washington Mutual, or Wachovia in 2007-2008. As I pointed out last week, the regulatory system in place was incapable of identifying the red flags in SVB's operations and investments (e.g., investment portfolio, rapid asset growth, only 11 percent of depositors were insured). The Federal Reserve Chair Jerome Powell testified shortly before the SVB failure that there was no systemic risk in the banking sector. This was the same Jerome Powell that said that our inflationary woes would only be transitory.
The federal government lacks the incentive or the wherewithal to measure, identify, and punish risk before a bank failure happens because monetary policy in this context is reactive in nature. That is not merely my opinion, but part of how deposit insurance functions. While deposit insurance is supposed to create financial stability, that is very like not the case. Deposit insurance has been shown to make equity markets smaller than they otherwise would be (Bergbrant et al., 2016). This shrinkage of the equity markets can create financial instability. That could explain why one study shows that the greater extent of deposit insurance, the higher the likelihood for bank failures (Cebula and Belton, 1997).
Should we be concerned over moral hazard?
By using government funds to help SVB's depositors, such a bailout creates an unintended consequence of moral hazard. Moral hazard is when there is a lack of an incentive to guard oneself against risk of potential consequences. Moral hazard has emerged in other areas of life. With government-sponsored flood insurance, promising such broad coverage incentivizes people to live in hurricane-prone and flood-prone areas. In unemployment benefits, the moral hazard is higher unemployment levels for longer periods of time. Moral hazard also comes into play with housing and student loan "cancellation."
Bailing out SVB is not immune from the plausibility, and indeed likelihood, of moral hazard. To quote libertarian Reason Magazine:
"Moral hazard is one of the major worries when it comes to bailouts like these. Both banks and consumers have less incentive to be cautious with their money if they can plausibly assume that the government will step in and save them from any mistakes. So, a bailout like this uses public money to compensate for risk or bad financial decisions and incentivizes more risky or bad decisions in the future."
During his first term, former president Franklin D. Roosevelt said, "We do not wish to make the United States government liable for the mistakes and errors of individual banks, and put a premium on unsound banking in the future." Prior to last week, the FDIC insured up to $250,000 per depositor per bank. The government then changes the rules in the middle of one of the largest bank closures in U.S. history.
Instead of holding to its own rules, it states that it will cover all of SVB's depositors by liquidating SVB's assets and using that money to recover any deposits beyond insurance limits. It could have raised the limit to an amount of $1 or $2 million. However, the government tossed aside the limit on deposit insurance. Going from targeted protection to broad protection signals to informed depositors that they can "throw money at risky banks without diversifying or conducting diligence."
4-9-2023 Addendum: The Cato Institute brings up a good point on median bank account balances. The median account balance is $3,500, whereas the average is $42,000. They used Federal Reserve data to point out that less than one percent of account owners have amounts about the previous FDIC deposit insurance cap of $250,000. This would imply that a) most everyone would have had their deposits covered even if the federal government had not removed the $250,000 cap, and b) the federal government removing the cap really only serves the über-wealthy.
The theory of moral hazard created by deposit insurance plays out in practice. A study from the National Bureau of Economic Research (Calomiris and Jaremski, 2016) shows how "deposit insurance increased risk by removing market discipline that had been constraining erstwhile uninsured banks." If deposit insurance with lower thresholds caused moral hazard, imagine how much more moral hazard deposit insurance without limits will create!
We will not know whether or not financial contagion would have taken place because the FDIC stepped in and guaranteed that all the SVB depositors will be insured. A lesson we should have learned from the pandemic, which is more regulation does not guarantee safety. If anything, the lesson should have been that life is not risk-free. Financial investments are no exception. Alas, that lesson was not the one that sunk in for society.
People who have made bad investments should be allowed to fail, especially when there is no apparent sign of financial contagion being an issue. A business that ignores the basics of finance or make poor investments to the point of destroying wealth and productivity should not be rewarded. When a bank fails, it means depositors and investors think twice before trusting their money with a given financial institution. Furthermore, not all investments pan out. Since time immemorial, doing business has come with risks. That is why diversifying one's portfolio is so important: to hedge against risk. To quote the Foundation for Economic Education, "If they can have the profits, they should have the losses as well."
What the government has done is it has privatized profits while socializing risks, which distorts banks' incentives to no avail. Bankers will be incentivized to make riskier bets. It means that more prudent banks and their customers will have to pay for the recklessness of riskier banks. George Will is correct in saying that, "If everything is brittle, politicians have endless crises to justify aggrandizing their powers...This socialization of risk approaches a semi-nationalization of banks." This socialization of risk creates no upper limit on government intervention. By guaranteeing that deposits are covered in any circumstance, the message that the government is sending to the financial sector is that banks will make money in good times and the government will come to the rescue in bad times.
Postscript
The Federal Reserve kept interest rates artificially low for years and flooded the market with easy money vis-à-vis quantitative easing. This expansionary policy combined with various misguided financial regulations (especially Dodd-Frank) and you have the disarray in the banking sector we now have. The chicken has come home to roost, but the current administration somehow thinks that more of the same type of misguided regulation will get us out of this downward cycle.
By guaranteeing all of SVB's deposits, the moral hazard created by the government is weakening market discipline in the financial sector and actually creating more financial risk. Instead of helping contain failure in the finance industry, the federal government has created conditions in which bank failures are more likely to happen. As the Wall Street Journal astutely points out:
"A stable financial system requires clear and transparent capital standards, sound regulation, and above all market discipline to punish reckless behavior. The current panic shows that none of those exist in the U.S....The Administration is presenting this as a one-off. But once regulators do something, they create the market expectation that they will do it again. And if they don't, the ensuing market panic will invariably impel them."
I am not about to predict the future as to what will happen to the banking sector and to the extent to which it will happen. At the same time, there is something to be said for foresight. We have had years of monetary and financial policy that have created perverse incentives for the banking industry. Instead of becoming a lender of last resort, the Federal Reserve is becoming a lender of first resort. If the bailout of SVB and removing the limits on deposit insurance ends up lighting a powder keg that causes considerable economic downturn, let's say that I will be the least bit surprised.
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