An Explainer on Bank Failures and Bailouts
Professor Linda Allen comments on why Silicon Valley Bank and Signature Bank failed and whether the Feds were right to rescue the depositors.
In the past week, three midsize U.S. banks failed, and Credit Suisse, a major European bank, is teetering. Bank stocks have taken a beating, and other midsize U.S. banks, like New Republic, are facing losses of confidence from their investors and depositors. What is going on in the banking industry?
We invited Professor Linda Allen (GC/Baruch, Economics, Business), an expert in banking and finance, to help make sense of the latest headlines.
Allen, who holds the William F. Aldinger Chair in Banking and Finance at Baruch College, has written about the 2008 financial crisis and was quick to reassure that the current bank woes are not 2008 redux. Back then, banks were creating risky investments to boost their bottom lines. That’s not the case with Silicon Valley Bank and Signature Bank.
Silicon Valley Bank was brought down, Allen said, by old-fashioned interest rate risk.
“It's the oldest risk in the book,” she said. “This is the easy stuff, we've been dealing with this for decades, we know exactly what to do. It's not rocket science anymore.”
She explained, “Banks, by definition, borrow short to lend long. They borrow money on a day-to-day basis, and they put it into loans, which can have a five-year, or a 10-year, or a 30-year time to maturity. That's how they make money; they earn a higher interest rate on the longer-term loans, and they pay less for the short-term borrowings. That's the spread; that's the business of the bank.”
But when interest rates rise, as they have been recently, banks suffer in a few ways. First, the value of some of their investments, like bonds and fixed-income securities, can go down because people can get better rates on newer investments. Second, banks may have to pay higher interest to people who deposit money with them, which can also erode profits.
Silicon Valley Bank, Allen said, put much of its equity into longer-term securities, such as bonds and treasuries, with maturation rates of more than 10 years. They bet on interest rates coming down.
“If the Fed would have started to loosen up quickly, as they were betting on,” Allen said, “they would have been the heroes. Now they're not.”
The bank had successfully courted the tech industry and was flush with deposits from those firms. Most of the deposits exceeded the $250,000 threshold for backing from the Federal Deposit Insurance Corporation (FDIC). When the depositors got wind of Silicon Valley Bank’s weakness, they rushed to pull their money out. It was a bank run.
“Bank runs are fatal,” Allen said. “That's it. Game over. A bank run will cause the bank to go out of business.”
New York-based Signature Bank, by contrast, suffered from what Allen calls a meme bank run.
“It's the GameStop effect,” Allen said. “It's, ‘Everybody's talking about it, so I have to go and check my bank balance.’ If I'm the CFO of a medium- or small-sized company, I’m thinking, ‘Why do I need the headache? I'll just take the money out and move it somewhere else.’ And that, I believe, is the story of Signature. Signature did not have the same underlying problems that SVP did.”
The bank was profitable and had positioned its investments to earn money when interest rates rose. Also, after the cryptocurrency crash, the bank advised its clients who were in that business to leave. That meant, though, that the bank lost about 20% of its deposits, and its liquidity, or loan-to-deposit ratio, rose. The decline in liquidity and the connection with cryptocurrency fanned the chatter on social media, Allen said, explaining why she calls it a meme bank run. “I don't think Signature Bank deserved that,” she said.
The FDIC took over Silicon Valley Bank and Signature Bank and promised to make all depositors, including those with holdings over $250,000, whole. Allen takes issue with that decision.
“The Fed is backstopping the entire business world and certainly the financial world,” she said.
She understands that the Fed made the move so that the tech companies that had their holdings at the bank could continue to operate and pay their expenses, including payroll.
“This working capital is the lifeblood of the business,” she said. Had the tech companies lost their money, that would likely have triggered a recession, in Allen’s view.
Still, she would have preferred that the federal government hadn’t stepped in so quickly to take over Silicon Valley Bank.
“We have created a presumption in the business world, and certainly in the financial world, that heads I win, tails you lose,” she said, meaning that bankers never lose, only taxpayers. “That means there's no reason for any private bank or financial business to manage risk. Just roll the dice.”
Instead of what she and others (including Distinguished Professor Paul Krugman) call a bailout, she thinks the government should have acted faster to sell the bank.
“That would have been, to me, the simplest thing,” Allen said. “First of all, you get rid of the managers and the shareholders that made the bad decisions, so there are consequences to their actions. But all the counterparties, all the innocent bystanders, like those tech companies, are made whole because now they're doing business with the new bank.”
She added, “That's the FDIC’s bailiwick, and, for some reason, they've forgotten how to do it.”
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