Passing The Buck On The SVB Bank-Run
Authored by Greg Orman via RealClearPolitics.com,
Over the last 72 hours, the demise of Silicon Valley Bank has been dissected in the media. What went wrong seems perfectly clear. SVB had a deluge of short-term deposits coming into the bank during the pandemic. Almost 90% of those deposits exceeded the FDIC’s insurance limits of $250,000. The bank invested those deposits in billions of dollars of low-rate, long-term debt issued by the federal government and government agencies. When rising interest rates eroded the value of those investments, their depositors, fearing SVB would fail, pulled their deposits out of the bank. Unable to meet the demand for cash, the bank closed its doors. It was a classic run on the bank.
Over the past four decades, bank failures have been largely driven by making bad credit decisions – generally loans to failing companies or investments in mis-rated mortgage securities. The SVB failure highlighted a risk in the banking the system that has largely been dormant over that period. Interest rate risk, the risk that fluctuating interest rates might cause financial stress on a bank as it did at SVB, hasn’t led to anything approximating a crisis since the 1980s.
As a result, some want to lay the blame for SVB at the feet of the Federal Reserve. They’re using this crisis to criticize the speed of rate increases. While the Fed has acted more quickly during this tightening cycle than in previous ones, banks have endured multiple tightening cycles during that four decades without a major interest rate-induced bank failure. Indeed, no other major bank seems to be overwhelmed by these recent rate increases. They all clearly took the Federal Reserve at its word when it said loudly and repeatedly that it was planning to raise interest rates.
In 1991, I wrote my senior thesis, “The Effects of Asset Size on the Level of Interest Rate Risk in Commercial Banks.” While that may seem like a particularly dull topic to fixate on for a semester, at the time it was timely. On Sept. 19, 1990, Charles Keating, the former CEO of Arizona-based Lincoln Savings and Loan Association, appeared on the front page of the New York Times in handcuffs. Keating was the poster child of financial mismanagement in the savings & loan crisis, having spent company money lavishly on personal luxuries. That crisis eventually cost U.S. taxpayers over $130 billion and almost ended the political career of a first-term United States senator, John McCain, who was one of five senators who intervened with regulators on behalf of Lincoln Savings. S&L executives went to jail. One-third of all thrifts failed. And, yes, shareholders, bondholders, and even some depositors lost billions of dollars.
Financial fraud committed by Keating and others was clearly partially to blame for the crisis that ensued. The primary villain, however, was something far more mundane and the same thing that took down Silicon Valley Bank: interest rate risk. S&Ls were legally required to invest almost exclusively in long-term, fixed-rate home mortgages. When interest rates skyrocketed in response to the inflation of the 1970s and 1980s, depositors fled S&Ls for newly formed money market accounts that paid four times as much interest. Unable to meet depositor demands without selling their low-rate mortgage portfolios at a significant discount, most S&Ls were technically insolvent. The government came up with an accounting gimmick that allowed them to write off their losses on mortgages over a long period. That fix ensured that S&Ls kept their doors open for the time being. The losses they were writing off were so large, however, if the S&Ls didn’t make high-risk, high-return investments, something they were ill-prepared to do, their failure was certain.
The question that I was looking to unpack in my thesis was simple: Are big banks better than small banks at managing interest rate risks? Having worked at a small, rural bank during the summers, I was exposed to the very detailed work they did every month to measure what would happen to the bank’s portfolio in varying interest rate environments. This was a topic of discussion at every monthly board meeting and impacted the types of loans and investments the bank was willing to make.
Larger banks had access to more sophisticated tools for managing interest rate risks. I wanted to know whether those tools were more effective than the simple measures available to a country bank. Based on the data available at the time, small banks were just as effective at managing interest rate risks as large banks.
When the Silicon Valley Bank debacle is unpacked, like the savings and loan crisis, there will be plenty of blame to spread around. Regulators, the Trump administration, and politicians who received SVB’s financial support, purportedly for supporting changes to banking regulations, are already being vilified in the press and on social media. Populist politicians from both sides of the aisle (except those from California and New York) are already pointing their fingers at venture capitalists who stoked the fear of a contagion in order to cajole the government into backstopping SVB, thereby saving themselves billions of dollars.
The failure of SVB, however, is driven almost exclusively by one thing – incompetence. Both regulators and bank management ignored something that almost every country banker in 1990 had figured out – you can’t finance long-term investments with short-term money.