The failure of Silicon Valley Bank on March 10 marks a bad moment for the market economy. It has opened the door for the possibility of unlimited deposit insurance and much stricter bank regulation.
In the US banking system, the federal deposit insurance of up to $250,000 covers only 57% of deposits. The rest are above the cap. Silicon Valley Bank had unusually large deposits. According to press reports, federal deposit insurance covered only 3% of deposits. In that respect Silicon Valley was more like a bank of a century ago, before deposit insurance was imposed.
Silicon Valley Bank was founded in 1983 to serve startup ventures in California’s tech industries. The bank made loans to tech companies that had just raised venture capital. Typically, the companies would deposit the money they raised. When venture capital flowed freely, the bank’s deposits grew at a phenomenal rate, but in the past couple of years, when the weather turned cool and the companies wanted their money out, the bank had trouble.
Silicon Valley Bank could have insured itself against a bond market collapse by hedging, but hedging costs money, and they didn’t do it.
The trouble at Silicon Valley Bank was not from the loans it made but from the way it invested its excess deposits. At the end of 2022 it had $91 billion in US government and agency bonds that it intended to hold to maturity. Held that way, government bonds are the safest investments there are. (Boring, but safe.) But the bank bought “long” bonds, whose maturities were ten or more years out. The risk on a long bond is that if you sell it before it’s due, and interest rates in the market have gone up, the value of your bond will have gone down.
In the short to medium term, long bonds are not so safe.
The risk in holding $91 billion in long bonds was that interest rates would go up by a lot. Which they did. Starting last year, the Federal Reserve pushed up rates again and again, which gave the bond market its worst year of this century. Silicon Valley Bank could have insured itself against this by hedging, but hedging costs money, and they didn’t do it. At year end, reported the Financial Times, the bank’s bond portfolio was $15 billion under water. The bank might have survived that, had the depositors not pulled their money out. But the depositors did — and the bank was done.
Federal regulators guaranteed all the deposits at Silicon Valley Bank, because its failure, they said, posed a risk to the whole banking system. At first, this seemed dubious. At just over $200 billion in assets, Silicon Valley Bank was only a medium-sized bank. But the failures and near-failures in the following two weeks showed that there was systemic risk.
But one bank’s failure need not be as drastic as it sounds. If the Federal Deposit Insurance Corp. had held to the $250,000 cap, it wouldn’t have meant a total loss of the uninsured deposits. The bank’s estate would still have the bank’s bonds and loans. These could be sold to other banks, with the money to go to the depositors. Silicon Valley’s depositors would have had to wait a while, but they would have received most of their money. Based on press reports, it seems (I stick my neck out, here) a receiver might have paid them 80 to 90 cents on the dollar.
The Fed’s special attention didn’t save Silicon Valley Bank. Regulators don’t know everything, and sometimes when they do know what to do, they don’t do it.
A libertarian could argue, then, that the depositors could have stood the loss. Probably most of them could have. Still, the freezing of their accounts in the short run would have chilled the public’s confidence in the banking system.
On to the $250,000 cap. Two progressive academics, Lev Minard, associate professor at Columbia Law and Morgan Ricks, professor of law at Vanderbilt, argued in the Washington Post that the $250,000 cap has been waived so many times in the past 40 years that it is now “window dressing.”
They write, “The time has therefore come, for Congress to scrap the $250,000 cap on deposit insurance coverage, strengthen regulatory oversight accordingly and charge banks much more for operating a government-backed deposit business . . . By making all deposits a governmental product, scrapping the cap would underscore the fact that banks exist to serve the public interest, not to privatize gains and socialize losses.” But that would also mean many more of the banks’ decisions would be made by, or at least limited by, government regulators.
A consistent libertarian would argue that the better answer is to scrap deposit insurance entirely and allow the full risk to fall on the depositors. At the moment, nobody is going to listen to that argument. We are too far removed from that world, and there is no urge to go back. The argument now is whether to keep the $250,000 cap or socialize all the risk. The defenders of the market have to argue to keep the cap or something like it.
Keeping interest rates at near zero for most of the past 15 years was, in effect, an attempt to eliminate risk from the financial system.
When deposit insurance began in 1934, its purpose was to stop runs on banks like the famous scene in the movie It’s a Wonderful Life. The argument for the cap, then $2,500, was that the American with less than $2,500 probably didn’t know how to read a bank balance sheet and judge the soundness of banks. That argument carried the day. The progressives now argue that corporate treasurers are equally unable to judge, and need the protection of the benevolent government.
And that’s a much weaker argument. A corporate officer with more than $250,000 to deposit should know how to read a bank balance sheet. Silicon Valley Bank’s 2022 annual report disclosed the $91 billion in bonds, and said they were valued at par and were being held to maturity. That’s a red flag. The banks’ huge increase in deposits over the past couple of years was another red flag. The decline of its stock during much of the past year was another. A corporate treasurer should have noticed the red flags. The regulators at the Fed did, and in mid-2022, they put the bank under special supervision.
The Fed’s special attention didn’t save Silicon Valley Bank. Regulators don’t know everything, and sometimes when they do know what to do, they don’t do it. Regulators don’t have the same “skin in the game” as the bank’s officers, whose jobs and bank shares are at stake. If the $250,000 cap is taken seriously, the big depositors also have skin in the game. And that is why having banks in the private sector will work much better than making them an adjunct of the Post Office. Private-sector banks will be more innovative, more robust, and more useful than public-sector banks.
There remains the issue of systemic risk — the risk to banks other than the one failing. As Nassim Nicholas Taleb writes, if you attempt to insulate an institution from all risk, you make it fragile. (The same with raising children.) To toughen up, you need to take some risk — to have “skin in the game.”
When the inflation came, the progressives said it was “transitory.” They said this word over and over like a prayer.
Now, on to the Fed’s policy. Keeping interest rates at near zero for most of the past 15 years was, in effect, an attempt to eliminate risk from the financial system. A whole generation grew up thinking that zero interest rates on bank and money-market accounts were normal — and they’re not normal. Originally, rock-bottom rates were the Fed’s emergency response to the recession of 2008 — a “stimulus” — but every time the Fed started to raise rates back to normal levels, the markets had epileptic fits and the Fed backed down. For the story of that, see PBS-TV’s new Frontline piece, “Age of Easy Money.”
An easy-money policy of the central bank is at the center of the Austrian theory of the business cycle. The theory says that when the Fed keeps the rates too low, it encourages entrepreneurs to borrow money, invest recklessly, and bring the economy to grief. Frontline didn’t interview any proponents of Austrianism — it’s not a theory favored on public television — but the story Frontline tells is the clearest example of the that theory in modern times.
A number of free-market economists predicted more than a decade ago that the Fed’s easy-money policy would raise inflation. The progressive economists, believing in a doctrine they called Modern Monetary Theory, jeered at the old-fashioned free marketers’ “gospel” (a laugh-word to them) and for predicting an inflation that never occurred. And for a whole decade, it seemed like the Modern Monetary folks were right — until they weren’t. When the inflation came, the progressives said it was “transitory.” They said this word over and over like a prayer: transitory, transitory, transitory. (Frontline mocks them for this.)
Inflation doesn’t seem transitory now.
Nine months ago, in a piece on the cryptocurrency collapse, I wrote here that a recession had already begun. I was jumping the gun. The economy did dip down for two quarters, then struggled up again: no recession, the economists said. America has suffered a labor shortage almost as if we were at war, and overall unemployment has remained low. Yet tech companies that have grown hugely in the recent boom, such as Meta, Twitter, and Amazon, announced layoffs for the first time in years — big ones, with some of them announcing additional cuts. In November, the crypto market had another disaster with the collapse of FTX. The stock market has held up, considering it all, but the bond market has had its worst year since 1982. Mortgage rates are up, and housing prices have turned down.
And now the bank failures.
I’ll repeat my prediction: a recession is at hand.
