Today, we present a guest post written by Charles Engel, Donald D. Hester Distinguished Chair in Economics at UW Madison.
I’d like to share some thoughts on the Silicon Valley Bank (SVB) failure. These may help clarify the extent to which the rest of the banking system is vulnerable and help understand why the Fed/Treasury/FDIC undertook the actions they did. I don’t have too much knowledge about the inner workings of SVB – just what I’ve been able to gather from the internet, mostly from the excellent coverage in the Wall Street Journal and New York Times – so I may be somewhat off base on some of the facts.
Funding of SVB:
There are a lot of moving parts to the SVB case. Start with the funding of the bank. Apparently, SVB had a disproportionate share of its liabilities in the form of deposits by Silicon Valley tech companies, and these were mainly in large amounts (for example, an average deposit size of $4 million, on up to deposits over $100 million.)
In the past couple of years, the amount of deposits at SVB grew rapidly as tech companies came into cash for several reasons. Part of it was from funds from the government to support businesses during the COVID crisis. Much of it came from financing of these firms by venture capitalists.
Funding of a bank by larger scale depositors already confronts the bank with liquidity risk. When the bank loses funding unexpectedly because a depositor withdraws its funds, it needs liquid assets on hand to pay back the depositor, unless it can find new creditors that allow the bank to roll over its funding.
In the case of SVB, there was considerable additional risk because so many of its large depositors were in related businesses in the tech sector. That increases the risk that many depositors will need to reduce their deposits at the same time.
Indeed, that seems to be what happened. When the tech sector was flush with cash, they increased deposits at SVB, but as the tech sector boom waned in the past year, they began to withdraw their deposits. None of that constitutes a bank run – this should have been normal banking activity.
What went wrong?
SVB was essentially running a “carry trade” – they were taking in demand deposits that paid a low rate of interest, and investing them primarily in longer-term Treasury bonds, government agency bonds, and bonds issued by government sponsored enterprises that had higher promised interest rates. When long-term interest rates went up, these bonds lost value.
SVB became, literally, bankrupt or insolvent, if by “bankrupt” we mean that the net worth of SVB fell below zero. This is different than saying the value of SVB’s equity fell to zero.
To be pedantic, here is a simple example:
- A bank is funded by $95 of deposits and $5 of its own money (its initial net worth.)
- The bank’s plan is to use the $100 to buy 1-year government bonds that pay 2% interest, and then to pay depositors a rate of 1%. (I’m using 1-year bonds in this example to keep the math simple, but SVB’s bonds were more like 10-year bonds.)
- At the end of the year, under this plan, the bonds pay off $2. The bank pays $0.95 to depositors (the 1% return on the $95 of deposits), and earns $1.05, which is a nice 21% return on its initial net worth.
- But suppose the market interest rate on 1-year bonds rises to 8%. Then these bonds, which pay off $102 at the end of the year are now worth $102/1.08 = $94.44. Now the bank does not have enough funds to pay back its depositors if they want their money right now, because they are owed $95. The bank is bankrupt in the sense that its net worth (the value of its assets minus its liabilities) has fallen below zero.
- However, if we can be sure the depositors won’t want their money back until a year from now, the bank will have $102, and it can pay back its depositors and make its 21% return. The bank’s stock will be valuable, even though its net worth is negative right now.
As you can see from this example, the value of the bank stock depends on how sure the owners of the bank are that the depositors won’t want their money back before the bonds held by the bank mature.
Liquidity and Hedging Risks
In real life, banks estimate how likely it is that depositors will make withdrawals that are not replaced by other depositors and keep liquid assets on hand to satisfy those depositors. In fact, they need to keep enough liquid assets on hand to be able to satisfy depositors even if there are fairly large, unexpected withdrawals. By “liquid”, I mean assets that are short-term, so their value does not fluctuate, and which can be turned into cash at low cost and with a high degree of certainty.
SVB was not doing this. If SVB were more prudent, it would have realized that its deposits were volatile, and would have kept more liquid assets on hand, such as short-term government bonds or reserves held at the Federal Reserve that would not have lost money when interest rates went up.
In addition, the SVB could have bought “insurance” against interest rate increases – that is, it could have reduced some of its vulnerability to interest rate increases by buying options. Although I have not seen any reliable reporting on this, I have seen unreliable reports that SVB did not hedge interest rate risk very much.
Also, perhaps SVB allowed itself to grow too quickly, making their balance-sheet risks harder to manage.
In short, SVB was gambling that interest rates would not go up much. They were not hedging interest-rate risk prudently, and they did not have enough short-term assets. If interest rates had not risen, SVB could easily have handled the decrease in their deposits from the tech sector, because they were holding bonds that are traded in very deep markets (so, at least their assets were liquid in that way.) If interest rates had not gone up, those bonds would not have lost value.
The bottom line was that SVB was running a risky business, betting that interest rates would not go up much. I say this with 20-20 hindsight, of course. Sometimes even very safe bets go wrong, but it does seem to me that the risks on SVB’s balance sheet were pretty apparent.
Is this a “classic bank run”?
I would say not, though I don’t want to get in the business of quibbling over definitions.
Here is the distinction I would make:
In a classic bank run, the bank may be forced to sell assets at a “fire-sale” price. By a fire-sale price, I mean the assets need to be sold at a price below what they would bring in a normally functioning financial market where potential investors have deep pockets and there is not a lot of hidden information about the value of the asset. For example, suppose a bank’s portfolio consists primarily of loans to local businesses and households. There are two circumstances where a fire sale could occur. One is if the bank is forced to sell off its assets (to pay off depositors) but potential buyers have difficulty valuing the assets. The bank maybe has made good loans, but potential buyers of those loans might not be able to assess the value of the bank’s portfolio on short notice. If the bank needs cash quickly, it might agree to sell off the assets for less than they are worth. A second case in which fire sales occur is if, even if the value of the assets is understood by potential buyers, there are not enough deep-pocketed investors to buy off the assets. This might happen in a time of widespread financial distress.
Note that neither of these conditions hold for SVB’s portfolio. It was holding Treasury bonds or other bonds that are traded in deep markets. The problem was not that SVB needed to sell off its assets at a fire-sale price. Its problem was that the value of those assets really had fallen.
In a classic bank run, the bank is solvent in the sense that its net worth is positive. The bank run is precipitated when depositors start believing – maybe based on rumors – that something is wrong with the bank and begin to withdraw their money. The bank is forced to sell their assets at fire sale prices. If enough depositors withdraw their money, the bank cannot repay all the depositors when they sell their assets at fire-sale prices (though they could repay if they were able to sell the assets at their true value.) Once depositors realize this, each depositor wants to run to the bank and get their money out when they can, and not be one of the depositors that doesn’t get their money back. When everyone does this, the bank fails. The depositors fear of bank failure leads to a self-fulfilling prophesy.
That was not what happened to SVB. It was not solvent – apparently, according to the press, its net worth, if assets were all marked to market, was negative. It could have held on had depositors kept their money in the bank, and that’s why SVB stock was still valued before last week. But the story of SVB is that they gambled and lost.
What is SVB worth now?
One indication that SVB was not the victim of a classic bank run is that no other bank wanted to buy SVB. The only real value from buying SVB might be if the bank had a good reputation which a buyer could still tap into.
The carry trade that SVB was running seemed profitable. However, if the carry trade really is valuable, there really is no need for another bank to buy SVB to profit from it. They could just do the carry trade themselves. The only value from buying SVB is if another bank thought it could keep SVB’s depositors because of the reputation SVB built up for being good to its customers. Apparently, at least for now, that good will was not valuable enough to induce another bank to buy SVB.
Did the Fed/Treasury/FDIC do the right thing?
There are two major policy changes undertaken by the regulators. The one with the most publicity is that depositors were repaid, even when their deposits were greater than the $250,000 limit that the FDIC had guaranteed. The second, which I describe below, is to turn long-term bonds held by banks into liquid assets.
Note that the owners of SVB were not bailed out. It appears the owners will lose their entire investment. Vanguard was a big owner of SVB. So, it isn’t just the rich guys that lose out. A lot of small investors have their wealth and pensions managed by Vanguard. On the other hand, the executives at SVB have made a lot of money the past few years, so they will lose their jobs, but they aren’t exactly hurting.
Will depositors ignore risks?
There is an argument that reimbursing all depositors creates “moral hazard”. That is, depositors should be monitoring the health of the bank in which they put their money. But if they can be sure that they will get their money back, even if the bank is careless, then depositors have little incentive to monitor.
Here, I think the small depositors should not shoulder blame. It is just too much to ask of a plumber or grade-school teacher to monitor the bank and assess the risk on the bank’s balance sheet.
Larger scale investors that had multi-million-dollar deposits bear more responsibility. I’m skeptical even then that there is enough sophistication in the finance departments of tech companies to recognize these risks, except in the largest ones.
In any case, the Fed/Treasury/FDIC at this point must trade off the problem of creating moral hazard by depositors with the risk of panic leading to “classic bank runs”, as I defined them.
Creating liquidity
The second major policy move was that the Fed agreed to supply short term loans to banks and take long-term bonds as collateral. The key provision is that the collateral value of these bonds is taken to be full face value. In other words, a bond that pays off $10,000 in 10 years is worth $10,000 of collateral, even if its current price on the market is much less. A bank can borrow $10,000 from the Fed, for up to one year, and post this bond as collateral.
That means that the long-term bond now provides $10,000 of cash to the bank with which it can pay off depositors.
Any bank that finds itself in the position of SVB or Signature bank will now be in a much stronger position.
I don’t think there are very many banks, though, that have balance sheets as risky as SVB’s and Signature’s. (Signature’s case is somewhat different than SVB’s but related.)
However, while most banks might stay solvent even if a lot of their funding disappears, the banks would still shrink in size. That would mean a reduction in the services these banks provide, especially to firms and households that need loans. While this would not constitute a financial panic, it would still be undesirable from a macroeconomic standpoint because productive investments would not get funded. It makes sense for the Fed to try to avoid such a situation.
It seems fair to let the banks that took on too much risk, like SVB and Signature, fail, but to provide liquidity to other banks. No policy can achieve a perfect outcome in the current situation, but I believe the policies that have been undertaken are good ones.
Parting thoughts
I realize this is not a definitive or detailed account of what happened. I’m just trying to fill in some of the blanks. You’ll see a lot of commentary of the form “we just need to reform the financial system by doing …”, or “regulators just need to …” There are many reasons why the market cannot, with complete efficiency, channel funds from investors to borrowers. There is probably an optimal way to organize and regulate the financial system, and I’m sure we haven’t hit on it yet. Even the optimal system, however, won’t be perfect. We will all learn from the current mess, and, I hope, make changes to the system that make it more nearly perfect.
This post written by Charles Engel.
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