Bank Run! Bank Run! Bank Run!
America's banking system faces major test
Over the weekend, serious concerns over the stability and liquidity of America’s banking system. With the initial collapse of Silvergate bank and the subsequent government takeover of Silicon Valley Bank (SVB) , and today, Signature bank. People with deposits at regional banks are beginning to question their bank’s assets and ability to meet demands from clients to withdraw their cash.
The Collapse
Silvergate bank was the first to go bust, offering companies within the crypto ecosystem the ability to bank with a “crypto-friendly” bank. With FTX being one of their largest customers, the FTX collapse led to depositors worrying about contagion risk and withdrawing their funds from Silvergate. Although this did not cause the collapse of Silvergate, in the coming months, regulatory scrutiny and investigation by the SEC significantly altered public perceptions of the bank and forced more customers to withdraw funds which they were unable to cover.
Similarly, SVBs trouble came due to their over exposure to Silicon Valley tech start-ups, who have had a miserable year. Decrease in revenues funding meant that the companies banking with SVB had to call upon their cash to continue funding their ventures, leading to large outflows from the bank. The company's attempt to raise $2.5bn in emergency funding failed and spooked shareholders and depositors, who began to question the liquidity of the bank. A bank run resulted.
So, how can two publicly listed American banks not have enough assets to cover their liabilities? The Federal Reserve mandates this, and the SEC enforces it, so how did we end up in this situation?
Held to Maturity vs For Sale Securities
Both banks suffered very similar fates. Their assets were not sufficient to cover their liabilities in the short to medium term. On the surface, both banks seem to have strong balance sheets with ample assets to cover liabilities. Let’s observe SVBs latest annual report released at the end of February:
We can see that the bank has ample asset/liability ratio (>1:1). The problem arises when we consider the SEC’s friendly accounting standards.
First, we must understand what the difference between security classification on a balance sheet (e.g., a government bond, corporate bond or Mortgage-Backed Security [MBS]) and how they are accounted for:
Held to Maturity Securities: Securities held that are intended to be held until its maturity date.
Is allowed to be capitalized on a balance sheet basically at par value (the principal amount received at maturity)
Available for Sale Securities: Securities that are intended to be sold before they mature.
Must be capitalized on a balance sheet at its current market value (marked-to-market)
This is where these institutions ran into problems. As bond values are inversely correlated with rates, securities that were acquired when rates were at their lows (2020 & 2021) have now lost significant value when market-to-market, as we have witnessed one of the most rapid rises of rates in history.
Looking at the above table, we can see on the books that held to maturity securities account for $91,321bn of their total assets – although if you read to the left – their marked-to-market value (fair value) is $76,169bn. This leaves an approximately $15bn loss on their securities holdings.
While this hole would still theoretically allow them to cover all customer deposits, issues arise when selling illiquid assets like bonds and MBS, further pushing down the securities price and forcing selling at lower prices. When investors realised this and saw SVB’s attempt to raise $2.5bn in emergency funding, capital flight occurred at a rapid pace, which saw $42bn worth of withdrawals requests in just one day.
So, it turns out that the losses suffered by SVB were mainly due to poor risk management by its departments. You may remember learning about Macaulay duration in your finance classes, which tells us that long-term bonds are more sensitive to rate changes than short-term securities relative to price. SVB’s held to maturity securities consisted of mainly long-term MBS to aid in collateralising short-term liquidity needs, which was a pretty incompetent move in hindsight.
Bank Run?
Now, you might be wondering why depositors panicked and withdrew their funds when all deposits at a regulated bank are covered by FDIC insurance. Well here's the catch: the government's assurance only applies to deposits up to $250k. Given that most of SVB's customers were either wealthy Silicon Valley tech entrepreneurs or startups who received large funding, around 97% of depositors at SVB were uninsured (> $250k balance) and at risk of losing a lot of money if the bank went bust. It's no wonder depositors preferred to withdraw 100% of their money immediately, rather than settling for xx cents on the dollar later. This realization, in turn, caused others with uninsured deposits at other banks to panic and withdraw their money, making an already fragile banking system even more vulnerable. Someone had to come in and save the day, whether it was another financial institution acquiring SVB or government intervention.
The ’Backstop’
On Sunday night, the Federal reserve took swift action to prevent further damage from the failure of SVB come Monday morning when market open. The Fed introduced a program called the "Bank Term Funding Program" (BTFP) which allows SVB to borrow cash from the Fed secured by their assets/securities. As demonstrated, the securities that SVB hold have lost significant value and therefore would limit the amount of capital they normally would be able to receive. But this program allows SVB to secure their borrowing against the assets’ par value (full value). This action has effectively ensured that all deposits (insured and uninsured) will be returned back to depositors.
Janet Yellen, the Secretary of the Treasury, called it a ‘backstop’ rather than a bailout to avoid political dissent towards the decision, but it is essentially a bailout from the Federal Reserve.
Bailout vs No Bailout
The question now arises: should the Fed have stepped in or simply allowed natural market dynamics to play out?
Contagion effect
While some argue that allowing banks to fail would weed out banks who are illiquid and shouldn’t be in operation to start with, as they engage in risky banking practices that would not withstand the test of time, it’s important to consider the potential contagion effects that could arise.
A risk in simply letting this situation play out is that the fallout from this could significantly impact the reliability of other banks within America. A knock-on effect would most certainly lead to a much greater financial crisis that would be difficult to contain. As such, the Fed acting early to get a new loan program established and quelled any possibility of this occurring.
Moreover, the potential for panic amongst depositors is not to be taken lightly. The risk of bank runs, where depositors rush to withdraw their money en masse, could further exacerbate the situation. This was a very real possibility in the case of SVB, given the significant number of uninsured depositors who stood to lose a lot of money if the bank failed.
Unsuspecting Depositors
Another issue that has been bought up is that these businesses and individuals did not expect to lose deposits. Arguably, the safest place to put your money is in a bank, and if you can’t trust a bank, where else can you put your money? Thus, some argue that deposits should always be insured to ensure the safety of depositors’ money. This raises the question of why there is a cap on FDIC insurance in the first place. If depositors are going to be bailed out when a crisis ensues, why not insure all bank deposits under the FDIC?
Everyone is aware of the risk of a bank run. Although the risk is small, depositors must understand that if a bank run occurs, they will likely lose a large sum of money associated with that account if it exceeds the FDIC insurance limit. It's crucial for people to do their own due diligence and research on the banks in which they store their money. If they don't trust a bank, they should consider alternative options such as investing in gold, Bitcoin, or alternate currency reserves. This may be impractical, but this type of risk management can save a firm from incurring bank risk, especially when banks are in the business of fractional reserve lending.
Corporate Failure
It's clear that some people in the financial industry aren't performing their jobs competently, as evidenced by what happened in this case. Acquiring long-term MBS to cover short-term liquidity needs while rates were at all-time lows was a terrible decision, particularly if not properly hedged.
In 2021 it was obvious to anyone with an inkling of financial knowledge that rates were going to increase and in turn significantly devalue bond portfolios. The fact that the bank didn't take measures to counteract this is a complete failure on the part of their risk department
To not employ measures to counteract that is a total complete failure of the risk department. Once again this raises the question, should the Federal Reserve be made to step in when incompetent employees take on too much risk?
All of this begs the question, should the Federal Reserve intervene when incompetent employees take on too much risk?
Austerity and the Fed
The goal currently of the federal reserve is to squash inflation and slowdown the economy. They achieve this by raising interest rates and acknowledge that there may be some collateral damage that comes with it.
The Fed has specifically stated that it expects unemployment to rise due to job losses arising from the hiking cycle. At this point, the Fed will have the flexibility to consider cutting rates and re-stimulating the economy again without the inflation risk.
Considering this, the Fed stepping in and providing a credit line to bail out banks is in-line with their mandate of “promoting stability in the financial system”. If the Fed’s goal is to decrease inflation by affecting unemployment and in turn spending, wouldn’t allowing the collapse aided in moving closer to that goal? Allowing this sector to fail would directly align with the Federal Reserve’s tightening mission. It’s an interesting point to consider.
Moral Hazard Risk
Moral hazard risk refers to the possibility that individuals or organizations may take on more risk because they are protected from the consequences of that risk. If as an organisation you know that if you fuck up the government and Federal Reserve are there to pay off your debts, you will not act in a risk averse manner.
If people assume zero risk on bank deposits, they will continually deposit money into risker banks which provide higher returns on deposits. When that bank inevitably fails due to their high-risk operations, the depositor is guaranteed all of their funds back. So, what’s the point of settling for a lower yield at a safer bank? As a result of ‘backstops’, moral hazard risk can increase the likelihood of future crises and undermine financial stability.
By having the Federal Reserve come out and insure all deposits, it demonstrates that regardless of how the crisis occurred, the Federal Reserve will step in bailout the company. While bailouts may be necessary in some cases to prevent systemic risk and protect the broader economy, they should be used sparingly and with caution to avoid creating a culture of moral hazard.
Conclusion
It is clear that the decision to bail out SVB was not without its drawbacks. As the saying goes, there is no free lunch, and American taxpayers will inevitably bear the cost of these loans to struggling banks in some way, shape or form. This highlights the importance of considering the potential consequences of bailouts, particularly in terms of the moral hazard risk and the potential for future financial instability.
While it can be argued that the Fed's intervention in this case prevented a broader financial crisis, it is important to recognize that there may be unintended consequences of bailing out the first banks that wobble. By providing a safety net for banks, the Fed may inadvertently encourage risky behaviour and discourage responsible risk management.
It is still early days, and we will find out in the near future if the response by the Fed was the correct one.
