The real failure with Silicon Valley Bank

Let us not shed tears for the investors of Silicon Valley Bank (SVB).

Oliver Thansan
Oliver Thansan
15 March 2023 Wednesday 23:24
16 Reads
The real failure with Silicon Valley Bank

Let us not shed tears for the investors of Silicon Valley Bank (SVB). On March 10, the bank, which had $212 billion worth of assets, failed with spectacular speed, becoming the largest bankruptcy lender since the 2007-2009 global financial crisis. Most of SVB's depositors were San Francisco Bay Area tech startups with accounts well in excess of $250,000 federally insured. They ran away and their panic was rational. By loading up on long-term bonds, SVB had made a huge bet not covered by keeping interest rates low. The bet went wrong, resulting in an insolvent bank (or almost). The fact that shareholders have been wiped out and bondholders will suffer heavy losses is not a failure of the financial system. A bad business has been allowed to go bankrupt.

What happened next reveals the flaws in the American banking architecture. SVB probably had enough assets for depositors to get all or most of their money back, albeit after a long wait. That caused many technology companies to be in a situation of financial paralysis. Roku, a streaming giant, had nearly $500 million invested in SBV. Spillovers and bankruptcies were looming throughout the tech sector. And regulators and the US government seemed to fear that depositors would lose faith in other banks as well. On March 12 they considered SVB too big to fail and guaranteed all the bank's deposits. If the sale of its assets does not cover the costs of bailing out depositors, a fund financed by all the banks will have to contribute, penalizing the entire sector for the imprudence of a single entity.

At the same time, regulators have had to deal with the threat of other banks facing panics from their customers. At the end of 2022, banks had $620 billion of unrealized losses on securities on their books.

On March 12, regulators also closed Signature Bank, another midsize lender, the third bank to fail in a week (as Silvergate, a heavily exposed cryptocurrency bank, collapsed on March 8). And the consequences in the markets continue. On March 13, bank shares continued to plummet. On that day, those of First Republic, a bank of comparable size to SVB, fell more than 60%.

To prop them up, the Federal Reserve offers aid to other banks on terms of surprising generosity. A new program is already in place to grant loans secured by long-term Treasury bonds and mortgage-backed securities, such as those accumulated by SVB. Typically, when a central bank makes loans, it imposes a haircut on the market value of the securities offered as collateral. Instead, the Federal Reserve will now offer loans up to the face value of the securities, which, in the case of long-term bonds, can exceed 50% of the market value. The inverted haircut ensures that another bank with a bond portfolio like SVB's will have ample access to cash to pay depositors.

The deposit guarantee was unavoidable given the size of SVB (and in any case may be fully covered by SVB's assets). The same cannot be said for the generosity of system-wide liquidity support, which is a dramatic expansion of the Federal Reserve's toolkit. The fall in bank share prices partly reflects that investors are realizing the risks that long-term bond holdings pose to returns. Still, while SVB's unrealized losses were enough to wipe out its capital more or less, other banks appear to have solvency and margin to spare.

It is right for the Federal Reserve to lend against good collateral to stop panics. However, doing so under such benevolent conditions is unnecessary and subsidizes bank shareholders. And while the Federal Reserve's support for the system is likely to prevent a banking collapse, by no means should policy makers have allowed it to reach a point where such extraordinary interventions were necessary.

The SVB's bankruptcy has been so chaotic in part because the bank was exempt from an excessive number of rules designed to prevent impromptu bank bailouts like the one just engineered by the Federal Reserve. Following the financial crisis, the Dodd-Frank Act required US banks with more than $50 billion in assets to follow a series of new rules, including creating a plan for their own orderly resolution in the event of bankruptcy. The idea was that a combination of large capital buffers in banks and careful planning would protect deposits and payment systems, while losses were passed on to investors in an orderly fashion. What the regulators planned was a quick recapitalization of the largest banks by converting some of their debt into equity, an internal bailout. Now, in 2018 and 2019, Congress and bank regulators eased resolution planning and liquidity rules; in particular, for banks with assets between $100 billion and $250 billion, many of which had pushed for lighter regulation. There have never been any internal bailout plans for banks the size of SVB. Instead, the bank briefly tried last week to recapitalize by issuing new shares.

The lack of robust bankruptcy planning has forced regulators to work on the fly. The problem has been compounded by the speed at which SVB lost deposits as executives in the San Francisco Bay Area withdrew money through their banking apps. Normally, regulators try to resolve bank crises over the weekend. However, the panic that seized SVB's clients has been so fierce that the entity had to close on March 10, a business day. Even if SVB had been solvent and able to receive emergency funding from the Federal Reserve (it had a lot of assets to put up as collateral), it is not clear that it would have had time to get it.

From depositors' ability to flee and regulators' willingness to support them, some will conclude that it would be better to remove deposit guarantee limits entirely and charge banks upfront for full protection. The truth is that, with adequate capital buffers and resolution planning, depositors would not have fared so badly out of the crisis. The bankruptcy of SVB would have posed less of a threat to the economy and the financial system. A full deposit guarantee for the banking system could lead to further recklessness. It would encourage banks to take higher risks to increase the rewards offered to depositors, who might be attracted by higher returns and would never have reason to leave a bank due to recklessness.

That moral hazard is not the only danger. The other is that the Federal Reserve, having seen the SVB collapse by raising interest rates, now chooses to ease the fight against inflation for fear that monetary tightening will lead to further bankruptcies. Having bet a week ago that rates would hit 5.5% this year, investors now expect little further tightening and rate cuts to begin in less than six months.

The Federal Reserve must keep an eye on inflation (although rising bond prices will ease pressure on balance sheets). Now that deposits are safe and the banking system is massively liquid, the crisis is unlikely to slow down the US economy much.

Furthermore, it is not the job of monetary policy to protect the profits of lenders. The correct conclusion to be drawn from the failure of SVB is that the regulation of large but not very large banks has been inadequate given the threat they pose to the economy. The job of policy makers now is to remedy that oversight.

© 2023 The Economist Newspaper Limited. All rights reserved. Translation: Juan Gabriel López Guix.