The Banking Crisis: How Did We Get Here? What’s Next?
It’s been the rockiest couple of weeks since 2008 in the world of finance and banking. It all started with the collapse of Silvergate Capital Corp., Silicon Valley Bank (the sixteenth largest bank in the US), and Signature Bank, with things looking dire for several other US regional banks. Meanwhile, the embattled Credit Suisse AG, one of just 30 global financial institutions designated as being “systemically important” by the international Financial Stability Board, was facing potential collapse before its purchase on March 19 by rival USB.
In short, things are changing rapidly, and confidence in the global banking system is flagging. According to American University Associate Professor of Economics Gabriel Mathy, this situation was not easy to predict in advance, but the causes are not that mysterious.
Mathy unpacks the situation for us:
Q. In short, what happened to Silicon Valley Bank?
Under the Trump administration, there was a big push to loosen regulatory scrutiny of regional banks like Silicon Valley Bank. The thinking was that the largest banks posed a systemic risk, while these smaller, regional banks (despite not being all that small), did not pose a systemic risk to the overall financial system. In 2018, regulations were weakened on these regional banks. As we have seen, this deregulation was a mistake. The reduced scrutiny corresponded to SVB not taking precautions to reduce their risks, and in the end, this regional bank was large enough to causes systemic issues for the banking system.
Q. How did interest rates play a role?
When the pandemic hit three years ago, the Federal Reserve sprang into action. Short-term interest rates were quickly cut back to zero, and longer-term interest rates fell sharply as well. Stock prices collapsed when the pandemic hit, but with low interest rates and stimulus checks filling Americans’ bank accounts, the stock market roared back. Low interest rates fueled a stock bubble in the tech sector, along with boosting other asset prices like housing.
As COVID receded, other factors, like supply chain disruptions and the Russian invasion of Ukraine, combined with the red-hot economy to generate accelerating inflation. The Fed saw these inflationary pressures as being “transitory’’ and kept interest rates low through 2021. As it became apparent that inflation was here to stay and that they were behind the curve, the Fed started hiking interest rates rapidly. Many underestimated how fast the Fed would hike, and that the Fed would still be hiking quickly through 2023. With the end of easy money and with a return to in-person work ending the hype around many tech companies, the stock bubble in tech burst.
As interest rates have risen, other asset prices have corrected downward, with the stock market today lower than when the Fed started hiking interest rates. Treasury bonds have been even more significantly affected, with 10-year bond prices falling significantly. If an investor can get a higher return on a short-term Treasury bill paying the higher interest rates of 2023, then a bond purchased in 2021 with rock-bottom interest rates will have to fall in price to provide the same return. However, the 10-year bond will still pay out the promised value at the end of the 10-year period, so as long as a bank could hold on to the bond until its maturity date, then the losses would remain paper losses and not real losses.
Q. Back to Silicon Valley Bank: what happened next?
Silicon Valley Bank was the bank of Silicon Valley, as the name indicates. As they got new deposits during the tech boom, they put that money into long-term Treasury bonds. Tech’s collapse combined with losses on their bonds created serious questions about the continuing viability of the bank. While SVB probably could have survived eventually, once some deposit holders pulled their money out, the panic accelerated. SVB sold off their bonds to raise cash, which meant locking in their losses. Contagion then spread to other banks which were either located in California or exposed to the tech sector. This contagion has now claimed Signature Bank, which had large exposure to cryptocurrencies. First Republic Bank, also in California, is teetering on the edge of closure but remains intact at the time of writing.
Q. Can you explain how the FDIC protects banks from failing? And is it a good idea?
The Great Depression saw huge waves of bank runs and bank failures, with about 1/3 of all banks failing from 1929-1933. In the wake of this crisis, the Federal Deposit Insurance Corporation (FDIC) was created. Banks would pay insurance fees, and in exchange, their deposits would be covered up to a certain limit. In 1934, this limit was set to $2,500 but was quickly raised to $5,000.
The reason for the limits was to provide protection for small deposit holder, the vast majority of Americans. Those with large balances or responsible for managing deposits for large organizations would not be covered. For those that could afford it, they should be exposed to the risks of the bank failing, so that these deposits would be withdrawn if the bank was mismanaged, providing some market discipline. As the FDIC tried to shut down banks before they were too deep in the red, even uninsured deposits took small to zero losses, though their funds were often tied up for months or years at a time.
However, deposits would often “run” whether the bank was actually mismanaged or was simply perceived to be risky. Once large deposits fled, as they did at Silicon Valley Bank, good banks would be taken down along with bad banks through this contagion process. In the end, the Fed extended coverage to all depositors to try to stem the current panic. This will contain the crisis, and while some more banks may fail, this will not spread to be a broader banking crisis, as the government has guaranteed all deposits. Some banks are likely insolvent given that asset prices are sharply down, but that’s a problem for bank shareholders and perhaps bank bondholders, but not for depositors. Banks that are insolvent should be sold off or dissolved just like any other business that is insolvent -- this is a normal feature of the workings of a capitalist economy.
Q. Should ordinary Americans with be worried about losing their money in bank accounts?
If you have your money in bank accounts with a balance under $250k (in each account), you have absolutely nothing to be concerned about and your bank account is safe. Even if you have an account with a balance above $250k, you will probably be in the same boat, as policymakers have been extending insurance to all deposits, large and small. While this policy has guaranteed that this banking crisis will not harm the broader economy, there are clear costs.
Q. What are the drawbacks to bailing out banks?
There is no longer a good reason for depositors to try to bank with banks that are well managed, as they will not bear any costs to banking with poorly managed banks. Banks that take excessive risks will be able to attract depositors with better terms than more responsible banks when times are good, making it more difficult for the better managed banks to compete. When things go bad, the higher fees paid by the better managed banks will cover the losses from the banks taking excessive risks. Perhaps it’s not reasonable to expect large account holders to monitor banks, but we had a system that managed fine without unlimited deposit insurance for at least three quarters of a century. It seems that the status quo is now for unlimited deposit insurance. Perhaps this was inevitable, but if this is the case, then the de jure limits of deposit insurance should be adjusted to reflect the de facto reality.
The Fed also changed how it lends to banks. Before, the Fed lent based on the market value of their collateral, but this presents some issues in the current environment, as interest rate hikes have reduced the value of the bank’s collateral (especially Treasury bonds). In response, the Fed now lends based on the par value of the bonds, which is the value at maturity, which is not affected by interest rates. As a result, this will insulate the banks from the negative effects of interest rate cuts.
There is a lot of market sentiment that the Fed will halt interest rate increases or will even cut rates. But on March 22, the Fed raised interest rates by a 25-basis point (quarter percentage point). Inflation is still high, and the guarantees to deposit holders will limit the fallout from problems in the banking sector.
The Fed has also extended dollar swap lines to foreign central banks. This provides dollar liquidity to foreign central banks, which can only provide liquidity in their local currency. This is likely to contain similar issues in European banking systems. If we look at Switzerland, where UBS has just acquired Credit Suisse, they went from a situation where interest rates were negative for most bonds, such that bonds would trade above their par price, to having positive interest rates, creating large drops in asset prices on bank balance sheets.
Q. What are the risks?
In acting so boldly in response to the banking crisis, the Fed has shown a serious double standard in how it responds to the pain that interest rate increases can deliver. The Fed has explicitly linked increases in unemployment as central to their policies to control inflation. When concerns about the human costs to workers have been brought up, the Fed has brushed them off, arguing that the costs of inflation are more important. But when a single bank runs into trouble, large deposit holders were immediately bailed out. Why should the rich and business ownership get free deposit insurance while workers in the millions will face financial devastation if the Fed is successful at raising unemployment significantly? Why shouldn’t pain in the banking sector be used to cool down the economy and reduce inflation instead?
The optics are terrible, and the Fed is willing to provide unlimited support to large deposit holders who should have known better than to keep such large uninsured deposit balances. On the other hand, the Fed has shown little concern for the working class who will bear the brunt of their policies to raise unemployment.
Perhaps the actions the Fed has taken were worth it to prevent an incipient banking crisis from becoming a full-blown financial crisis, but the Fed has damaged their credibility significantly. The Fed looks to be on the side of Wall Street, willing to sacrifice Main Street on the altar of inflation control while pulling out all the stops to insulate the banking system from the costs of interest rate increases. This episode should cause the Fed to rethink how their mandates to ensure financial stability and inflation stabilization interact, and which parts of the economy should bear the costs of inflation stabilization.
About Professor Mathy
Associate Professor of Economics Gabriel Mathy currently focuses his research and teaching interest on the macroeconomics of the Great Depression, and on macroeconomics and economic history more generally. At AU, he teaches courses on economic history, macroeconomics, monetary economics, and international finance. Mathy has published in journals like the Journal of Monetary Economics, the Journal of Economic History, Explorations in Economic History, the Journal of Macroeconomics, and the Financial History Review.