What a month it has been for banking! I am sure that you have heard the name Silicon Valley Bank, or SVB for short, by now. SVB is a state-chartered commercial bank headquartered in Santa Clara, California. Prior to being closed by the California Department of Financial Protection and Innovation on March 10, 2023, it was the 16th-largest commercial bank in the United States, as well as the largest bank in the Silicon Valley by deposits. The reason why this failed bank closing was so significant is because it is the largest bank failure since 2008.
Not wanting a repeat of the Great Recession, the Biden administration decided to step in. The Federal Deposit Insurance Commission (FDIC) provides deposit insurance to bank depositors in the United States. Normally, the standard coverage with the FDIC is $250,000 per depositor per bank. On Sunday, March 12, the FDIC announced that it would provide coverage to all SVB depositors. What happened at SVB for this to get so bad?
You can read this article from financial market news outlet Seeking Alpha, but the short version is the following. The Federal Reserve has kept interest rates low, a concern I have expressed more than once (see here, here, and here). On top of that, the Federal Reserve injected billions of dollars into the economy during the pandemic in hopes of avoiding a deeper recession. What did the Federal Reserve end up causing with that quantitative easing and low interest rates? Its expansionary monetary policy was a major contributor to the inflation we have been seeing since 2021.
Where does SVB come in? Keeping interest rates low and flooding the markets with cash made low-interest, long-term federal bonds and mortgage-backed securities alluring enough for SVB to invest in. As long as the Federal Reserve kept interest rates low, long-term government bonds were a sound investment plan. Part of the problem was that the Federal Reserve's response to the inflation was to raise interest rates, which lowered the value of the bonds. While these bonds carry minimal credit risk, they carry considerable interest rate-risk.
This would have not been an issue if SVB followed one of the main principles of finance: diversification. The purpose of spreading out one's investments over multiple [types of] assets (i.e., diversification) is to mitigate risk. Not only did SVB have its clientele heavily be focused in the tech industry, but it invested heavily in longer-term mortgage securities and bonds that take more than 10 years to mature, which caused the problems previously described. SVB was negligent in its fiduciary duty to hedge against interest-rate risk.
SVB made the problem worse because its deposit base was larger accounts (i.e., greater than $250,000). As of December 2022, 89 percent of SVB's $175 billion in deposits were uninsured by the FDIC. This made SVB more vulnerable to the bank run it experienced this month. It is clear that SVB made a series of poor financial decisions that led to its closing. SVB was financially irresponsible when it took depositors' cash and converted it into devalued bonds.
The Left wants to curtail the decision-making of SVB and blame it on deregulation. Under Dodd-Frank, banks with over $50 billion in assets would be subject to greater oversight. The Economic Growth Act of 2018, which was passed by Republicans, made the threshold at $250 billion. As the libertarian Cato Institute counters in its analysis along with the Left-leaning Brookings Institution, the Economic Growth Act de facto gives the Federal Reserve the discretion to impose greater oversight for banks with assets over $100 billion. For context, SVB reached this threshold in 2020. The Cato Institute also pointed out how SVB's leverage ratio and tier 1 capital ratio were beyond what the regulations required.
This is not an issue of there being enough regulation. As pointed out in the previous paragraph, the Economic Growth Act gave the Federal Reserve the discretion to provide this extra oversight. It simply failed in this regard. As Brookings Institution scholar Aaron Klein illustrates, the Fed missed multiple red flags that it should have caught: quadrupled asset growth in four years, hyper-reliance on uninsured deposits (the ones greater than $250,000), huge interest rate risk, and contacting the Federal Home Loan Bank (FHLB) system. The FHLB is especially key because the FHLB is the lender of next to last resort.
As an additional point, economist Gregory Mankiw brings up that the Fed's stress test did not include a major bond drawdown. The fact that the Fed did not have the foresight to include it in its review of banks shows another flaw in government oversight. Another reason why the regulators would not have detected SVB's failure has to do with "hot money," as is explained by Wharton School business professor Kent Smetters. "Hot money" is currency that regularly and quickly flows between financial markets to maximize on the highest short-term interest rates. Smetters pointed out that most banks have more retail clients with "slow money" deposits, whereas SVB dealt with more "hot money" due to much of its clientele being in the technology sector. Since regulatory stress tests de-emphasize money elasticity, there is no plausible way that the Fed could have avoided the SVB bank failure.
Should the bank, or at least its depositors, be bailed out for SVB's ineptitude? That is another question I plan on answering in the near future. What is clear at this juncture is that the SVB bank failure was not due to there being insufficient regulation or oversight. This debacle was partially self-inflicted due to incompetent investment choices and partially due to myopic monetary policy. This point cannot be emphasized enough because until we can understand the causes, we cannot hope to provide a remedy.
What I will say for now is that the Federal Reserve is in an unenviable position. The Fed's unprecedented expansionary monetary policy during the pandemic injected too much "easy money" into the economy. The SVB failure is to be one of many symptoms of expansionary monetary policy. The Fed either has to make bank runs systemic or it has to let up on quantitative tightening, the latter of which will escalate inflation even more. Time will tell as to whether the Federal Reserve will learn the right lessons from its excessive intervention in the economy.
5-7-2023 Addendum: A couple of weeks ago, the Governmental Accountability Office (GAO) and the Federal Reserve released reports on what caused the bank failure. It was nice to see a vindication of what I initially wrote in March. To quote the GAO report (p, 26), "Although FDIC took some actions to escalate its supervisory actions in 2019 and 2020, its actions were inadequate given the bank's longstanding liquidity and management deficiencies. Furthermore, FDIC lacked urgency despite Signature Bank's repeated failures to remediate liquidity and management issues."
The second page of the executive summary of the Federal Reserve report said that "SVBFG was a highly vulnerable firm in ways that both SVBFG's board of directors and senior management and Federal Reserve supervisors did not fully appreciate." This would imply that either the best at the Fed cannot foresee or that the regulations in play are ineffective.
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