Banking regulators, along with the board of directors and management of Silicon Valley Bank (SVB), each failed to see or prevent the problems that destroyed in less than a week one of the largest banks in the country. The regulators, whose mandate is explicitly designed to prevent such a disaster, allowed SVB to grow too fast when effective controls were not in place. No chief risk officer was in place for eight months until January 2023, at which point it was too late. SVB’s total assets tripled in just two years, from $71 billion at the end of to 2019 to $211 billion at the end of 2021. While deposits also tripled, they were low quality demand deposits that could be withdrawn immediately at the first whiff of trouble. The bank grew deposits too fast to find creditworthy customers to lend to, so instead the bank invested over $100 billion of its liquidity in investment securities, which, when interest rates rose, resulted in billions of dollars of losses. Depositors got wind of the depth of the issues, and within hours SVB exploded, casting shrapnel far and wide, and the entire banking sector was set afire.
Rather than preventing the emerging catastrophe before it happened, the Federal Reserve, the FDIC, and the U.S. Treasury belatedly stepped in to clean up the mess, recognizing over a panicked weekend that the issue was now much larger than one bank headquartered in California. This was clearly a systemic crisis in the making, and emergency measures were required to address it. These regulators took actions that derived from the playbook established during the global financial crisis: provide ample liquidity (the Fed’s role), protect depositors but not shareholders or unsecured creditors (the FDIC’s role), and backstop the whole thing with credit enhancement from the U.S. Treasury. Yet none of those actions convinced the market that the blast radius could be contained, as seen by the deposit flight and market mayhem that continued throughout the following week.
So what are the costs and consequences of the government’s actions?
By guaranteeing uninsured depositors of SVB, the Fed has once again bailed out Wall Street, Silicon Valley, and the billionaires behind both. At least for now. The FDIC’s insurance limit of $250,000 per account, which was designed to protect the middle class and small businesses, is now meaningless. Guaranteeing all deposits leads to moral hazard. That is, it encourages banks and investors to take greater and greater risks as they assume that any losses will be covered by the government’s next bailout. Rather than increase “safe and sound” banking practices, this too will make the banking system more dangerous.
While all banking deposits are now implicitly backstopped, the government’s rescue package is nowhere near large enough (nor could it be) to prevent a systemic bank run. The $25 billion U.S. Treasury backstop and the FDIC’s $128 billion deposit insurance fund is a drop in the bucked against $18 trillion of U.S. deposits.
Too big to fail (TBTF) is still in play. The four largest banks in the U.S., JP Morgan, Citigroup, Bank of America, and Wells Fargo, which collectively hold a third (c. $210 billion) of total banking system unrealized losses on investment securities, are the biggest winners amidst the chaos. Deposit flight from the regional and small banks will continue, and much of it will find a home with the TBTF banks. As a result, the concentration of banking sector liabilities into the hands of the big banks will increase. This will make the banking sector more systemically risky, not less.
The American taxpayer will bear the cost. Following the announcement from the regulators, President Biden said “No losses will be borne by … taxpayers. Instead, the money will come from the fees that banks pay into the Deposit Insurance Fund.” This is not the whole truth, for whence does that fee money come from? From fees charged by the banks to their customers, including U.S. businesses, individuals, and others. And of course, any realized losses on the U.S. Treasury’s backstop guarantee of the Fed’s lending program will come out of taxpayer money.
Inflation will regain the upper hand. The Fed’s interest rate hiking cycle has come to an abrupt halt. Expect no interest rate raises at the next Federal Reserve Board meeting in March (or for foreseeable future). We are back to quantitative easing, a euphemism for printing money, which is the very issue that brought us here in the first place.
The cost of borrowing will increase. Risk premiums will go up even if the Fed Funds rate flattens or goes down. As banks incur more losses and watch their capital base deteriorate, lending will be restrained. This will result in a credit squeeze, and it will be the small and medium sized businesses that will be most severely impacted. This means that economic growth will be constrained for the foreseeable future, and that a recession in 2023 is now much more likely.
The regulators took the actions that they understood to be the only way to possibly prevent financial contagion and a widening of the crisis in the banking sector. A week later, as other banks are facing increasing strain, and as both investors and depositors continue to panic, the plan looks to be failing. Regardless of whether it succeeds or fails, these regulators should be held accountable for allowing the situation to reach this point at all.
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