Banks are critical to the economy. They also have the potential to destroy it. When threatened by a “bad economy” originating in the financial sector, politicians of all stripes have tried to shield banks from their bad decisions through bailouts.
Bailouts have a well-deserved bad reputation. The entire establishment defended them in 2008 as necessary to stop systemic risk. At that time, insolvent banks began to fail, having taken huge and improvident risks on mortgage-backed securities, as well as more exotic instruments concocted by the dubious talents of financial engineers.
A closer examination of then Fed-chief “Helicopter Ben” Bernanke and the Troubled Assets Relief Program (TARP) reveals a lot of mischief. Partly by design, the bailout money permitted the banks and their shareholders to make money, pay salaries and bonuses, and recoup losses from speculative investments, even as their depositors failed en masse. Even if something were required to fix the upside-down housing markets, no one adequately explained why the money had to go directly to big New York banks and not to underwater homeowners.
Critics rightly called it a case of “socialized losses, and privatized profits.” The rank hypocrisy of these programs gave birth to the Tea Party movement; it also made a lot of small-government conservatives (including me) more cynical about the big businesses they defended during and after the Reagan years.
The sense that big institutions—big business, big government, big labor, big healthcare—were all in cahoots was one of the factors that supported the rise of outsider Donald Trump in 2016.
New Problems, Same Solutions
Our comparatively placid economy since then, along with more conservative banking practices, put much of this experience and anxiety in the rearview. Tighter lending standards and capital requirements seemed to prevent the loose money giveaways that prevailed in the banking sector during the run-up to the 2008 recession.
We now face a different set of problems. Excess spending to deflect the self-inflicted harm of COVID, augmented by the giveaway to Biden’s friends, led to massive inflation, which required an increase in interest rates. This environment makes once-safe choices no longer safe.
Long-term government debt has become upside down, much like mortgage-backed securities did after the collapse of the housing market in 2008. Ironically, the normally prudent decision to hold low-risk, low-return U.S. government paper and long-dated mortgage backed securities proved to be one of the main causes of problems at Silicon Valley Bank.
Banks are not like other businesses. They function and are regulated more like utilities than ice cream stands. The “little guy” cannot easily choose between banks based on their relative quality. Thus, some protection for depositors, such as the FDIC insurance system, is a good idea to ensure both stability and justice.
But it is also rightly limited to $250,000 in deposits.
Big Boy Rules
There are little guys and there are not-so-little guys. Silicon Valley Bank’s customers reflected the economy and culture of Silicon Valley. Large venture capital firms, startups, and their wealthy management tended to leave a lot of cash there. Since so much of the money being raised for the startups took the form of equity ownership, there was not the same commercial loan practice as one might expect from, say, the biggest bank in Knoxville.
Companies with nine-figure holdings are not Joe the Plumber. They are sophisticated people who know what they are doing. When they keep that much cash at a single bank, they act as investors making an investment decision for reasons of perceived advantage, whether it is more favorable loan terms, concierge service, returns, or something else. Treasurers, accountants, comptrollers, and CFOS are supposed to think about the risks involved in such choices, and 2008 is not exactly ancient history.
People I know with a lot less than these guys spread their money around among multiple institutions. If their accounts exceed FDIC limits at any one institution, they do so knowingly and for specific reasons.
Having bet on the wrong horse, the bank run on SVB became a stampede. A similar meltdown occurred at New York-based Signature bank. Regulators, the president, as well as other banks, took notice and supported drastic interventions. By guaranteeing all the large depositors at SVB and other banks, a new backstop shielded the entire uninsured, large depositor class from risk regarding which bank they choose.
By implication, this guarantee would apply to any regional bank about to fail.
Systemic or Personal Risk?
It is easy to misclassify personal risk as systemic.
Someone I normally respect a lot, David Sacks, has argued that the guarantee of SVB’s and similar banks’ large depositors is very different from the old TARP-style bailouts. He is certainly right that by allowing the bank’s equity holders to be wiped out, this bailout is less offensive than what happened in 2008. But now the group being bailed out are simply the wealthy, over-limit depositors.
He argues that this intervention was necessary to prevent systemic risk. In his words, “[D]ecisive action by the Fed was imperative. This meant protecting deposits (uninsured are 50 percent) and backstopping regional banks. No matter how distasteful you may find those things to be, preventing a greater economic calamity was necessary. This, in turn, would scare away investors, as well as employees.”
Perhaps that is all true and perhaps not. But it’s a lot like all those vaccinated people who got COVID and said, “without the vaccine it would have been much worse, I’m sure.” In both cases, there is no way to test the counterfactual.
To point out the obvious, aren’t a lot of these startups going to fail anyway? It does not inspire confidence for the long haul if they manage their cash so poorly that they leave all their money in a single bank, when they easily could have hedged by spreading it among two or three, particularly for payroll and other mission-critical needs. It is funny how you don’t hear much about “creative destruction” from the same titans who repeat this mantra when they’re riding the wave of success.
Moreover, if these startups are so valuable and likely to succeed in the long term, why couldn’t the venture guys put up money to give bridge loans to these companies as the FDIC figures out how to liquidate the bank? I suspect one reason is that this became the fashionable bank among the insiders and a lot of these guys who might otherwise lend were getting wrecked because they also had exposure at the same bank.
The risks of a “bank run” when the bank has a lot of assets, some of which are just difficult to liquidate right this second, is not complete evaporation. In receivership, banks often come up with enough to pay the vast majority of depositors back. It may take time and be a bit inconvenient, but it’s not like these venture capitalists and startups are babes in the woods. By wiping out equity, selling assets, and disposing of things in an orderly way through the FDIC receivership process, the chief losers would be the bank’s shareholders, as it should be.
Finally, I question the premise that the public interest is implicated here. Is Silicon Valley really that important to the country and the economy? These companies produce few jobs, make almost nothing that would be useful in a major war of attrition with China, and generally siphon away talent and investment capital from the manufacturing and other tangible sectors of the economy. They make money for investors and cool amusements, but most of these are luxuries that we could all live without if they disappeared.
Of course, it’s a free country. If people want to make the next TikTok instead of flying cars, that’s their right. But they shouldn’t be in a privileged position when taking financial risks compared to the guy who opens up a barber shop and goes out of business.
What Happened to “Fail Faster?”
As long as banks are competitive businesses, there should be some risk of failure. Since the smaller investors are largely indifferent between banks, as they are fully insured, the only sources of discipline are variability in interest rates and the stability of the overall asset mix, which combine to attract (or scare off) wealthy individuals and commercial depositors.
I confess I am a bit surprised that the risk management people at SVB did not change the asset picture, as it became clear their long-term debt holdings were creating a risk of major insolvency. Rising interest rates were something everyone was aware of. But there is incompetence everywhere you look.
Some conservatives have also latched on to the “woke” policies of the bank, but this seems to flow from the desire to talk about something they understand, rather than the admittedly-complicated cascading failures arising from a rapid rise in interest rates, the phenomenon of interest rate convexity, and failures in portfolio management.
Unlike other businesses, banks have many stakeholders, they are crucial to the economy as a whole, and thus they need to be more regulated than average businesses. But so long as they are for-profit businesses, they should not be shielded from all failure. In fact, what brought down SVB—large depositors moving their money around to the best-run banks—is precisely what should be happening in a properly functioning economy.
In the end, banks should be unglamorous, carefully run, and risk-averse businesses. Their mantra should be safety and resilience, rather than maximum efficiency and profits. When some of them take foolish chances, are mismanaged, and face punitive bank runs and failures, it benefits the public interest and the competitive economy pour encourager les autres.