A century ago, when a place not yet called Silicon Valley was mostly known for its abundant fruit orchards, the economist Alfred Marshall wrote as good a description as you’ll find of a bank run – the dynamic that last week consumed Silicon Valley Bank (SVB), and the aftershocks of which continue to shake financial institutions around the world.
“When rumours attach to a bank’s credit,” wrote Marshall in 1923, depositors “make a wild stampede to exchange any of its notes which they may hold; their trust has been ignorant, their distrust was ignorant and fierce. Such a rush often caused a bank to fail which might have paid them gradually. The failure of one caused distrust to rage around others and to bring down banks that were really solid; as a fire spreads from one wooden house to another until even fireproof buildings succumb to the blaze of a great conflagration.”
U.S. President Franklin Roosevelt said in his first inaugural address in 1933 that “we have nothing to fear but fear itself.” In some situations, that’s true. Control your fear and all will be well. But what if the threat is not your own fear, but the fear-driven actions of thousands or millions of other people? In the “wild stampede” of a bank run, the rational thing is to sprint in the same direction as the stampeders, trying to stay at least one step ahead.
Over the past week, trust has curdled into distrust at a series of banks, from California to Zurich. It sent depositors scurrying from mid-sized U.S. institutions such as First Republic Bank, which had to be shored up with an unprecedented injection of $US30-billion in deposits from other banks. It drove a surge in bank borrowing from the U.S. Federal Reserve, with loans at the Fed’s discount window on Wednesday hitting levels not seen since the 2008 financial crisis. It threatened to do in Credit Suisse, forcing Swiss authorities throw it a 50-billion-franc ($74-billion) lifeline.
And in the space of two days, it turned SVB from the lead purser of venture capitalists to the second-biggest bank failure in American history. Once the bank run started, customers quickly recognized that they were in a race against the clock, and their neighbours. They had to get their money out of the bank before the bank ran out of money.
A lot of those trying desperately to make withdrawals from SVB late last week may have been tech bros smacking refresh on smartphone apps, but the story that played out was ultimately a simple story that bankers and customers of earlier eras would have found all too familiar.
About halfway through everyone’s favourite Christmas movie, It’s a Wonderful Life, the Bailey Bros. Building & Loan Association finds itself short of cash. At a loss for what to do, Uncle Billy locks the doors. Poor, hapless Uncle Billy. His move to buy time ends up summoning a mob. The entire town shows up and demands their savings, now. It’s a bank run.
George Bailey, played by Jimmy Stewart, explains to the agitated townsfolk that he can’t possibly allow everyone to withdraw all their money, all at once. “You’re thinking of this place all wrong,” George tells them. “As if I had the money back in a safe. The money’s not here. Your money’s in Joe’s house, right next to yours. And in the Kennedy house, and Mrs. Macklin’s house, and a hundred others. … Now what are you going to do? Foreclose on them?”
That is exactly what SVB was forced to do – liquidate assets to pay depositors. It all started after SVB pulled an Uncle Billy, the last in its chain of Uncle Billys.
SVB had only a handful of branches, and a small number of depositors – mostly tech companies with big account balances far above the U.S. Federal Deposit Insurance Corp.’s insured limit of US$250,000. (The Canada Deposit Insurance Corp.’s ceiling is $100,000.) In barely two years, SVB’s deposits had nearly tripled, reaching US$198-billion by March of 2022. In bank accounting, a deposit is a liability. SVB accumulated a lot of liabilities, quickly.
What did SVB do with those deposits? It mostly didn’t invest in Joe’s house, or the Kennedy house or Mrs. Macklin’s house. It parked much of the money in U.S. government bonds. These are the safest assets on the planet. The chance of default is so low – zero-point-zero-zero – that financial models call the interest rate on short-term U.S. government bonds the “risk-free rate.”
There was no risk that SVB’s U.S. government securities would fail to pay regular interest, nor was there any risk of the principal being repaid at anything less than 100 cents on the dollar. But as for the bonds’ market value between now and maturity, well, that was a different story. That would fluctuate with current interest rates.
And in a bid to juice a bit more yield out of the ultralow interest rate environment of the pandemic, SVB invested heavily in long-term bonds – the kind of securities whose market value would fluctuate the most if interest rates changed, and the most negatively if rates rose.
That was SVB’s first Uncle Billy move.
Loading up on risk-free assets turned out to be very risky. Interest rates and bond prices move in opposite directions. As the Federal Reserve started jacking up its benchmark interest rate to cool inflation and slow the economy, the value of SVB’s bond portfolio fell.
At the same time, the tide of deposits that had flowed into SVB until early 2022 began to reverse. As Warren Buffett says, when the tide goes out, you discover who’s been swimming naked. On March 8, customers learned that SVB’s bathing attire was full commando.
That day, the bank announced that it had sold US$21-billion in securities at a US$1.8-billion loss and, to plug the hole in its finances, it planned to raise more than US$2-billion through a sale of shares. Customers reacted about as well as the townsfolk of Bedford Falls did when Uncle Billy locked the doors. It was all over before the start of the business day on March 10.
Deposit insurance was invented to prevent bank runs, by removing the reason for them. It is designed to drain away fear, and restore trust. The fear powering a bank run is logical, so deposit insurance aims to undo the logic underlying the fear. Why race to withdraw all your money if your deposits are guaranteed?
But at SVB, depositors were mostly over the US$250,000 limit. They all might as well have been an uninsured driver of a Rolls Royce Phantom, purchased with the owner’s life savings and now headed for a high-speed collision with a brick wall.
Over time, more will be learned about the mistakes made by SVB’s executives in the months leading up to the collapse. There are already questions about how auditors and regulators – not to mention the bank’s managers – failed to address the growing mismatch between liabilities and assets. There are questions about whether U.S. banking regulation has been too lax or – now that Washington has promised to make whole all SVB depositors, including those over the US$250,000 limit – whether at least one part of the regulatory regime is now too extensive.
And as Marshall wrote a century ago, the failure of one bank has “caused distrust to range around others.” Washington likely ended the immediate threat of more bank runs, at least in the United States, by hinting that all depositors at all institutions are all insured, to infinity dollars.
But the underlying issue that sparked a run at SVB – long-dated assets whose market value has been crushed by rising interest rates – is not unique to SVB. Markets are still wondering which other banks have been swimming naked.
A private corporation’s chosen bathing costume is normally it’s own choice, but banks are different. Banking is both a private business and a public utility. Banks are like the plumbing of the free-market economy.
And the people who put their savings into SVB are as blameless as the people of Walkerton, Ont., who got sick from contaminated drinking water. You can’t fault the utility company’s customers if sludge comes out of the tap, and they need to be protected against that possibility. The goal of deposit insurance is to do the same for depositors.
But in banking, that creates moral hazard – the possibility that a system of private profits and public risks will give well-paid bankers carte blanche to reap profits in good times, while socializing their losses in bad times. Heads they win, tails we pay. Or worse: Heads they win, tails we all get a financial crisis.
American regulators can argue that by offering unlimited deposit insurance to customers of SVB they prevented panic from spreading and causing more bank runs. That’s probably true. They can also try to claim that this was just an emergency one-off, never to be repeated.
But a precedent has been set, and bank executives and customers have reason to expect it to apply next time. Does that make things safer, or more dangerous?
One final irony: The sharp drop in bond yields and rise in bond prices after March 8, triggered by the collapse of SVB, would have benefited the bank if it stayed alive long enough to experience it. If SVB were still a going concern, its portfolio of long-dated bonds would be worth far more than it was last week.
And who purchased the US$21-billion of bonds SVB sold on March 8? Its investment bank, Goldman Sachs.
But SVB’s problem was that those securities could only pay off for it in some distant, unreachable future – a future that had become unreachable because, to quote Marshall, depositors were no longer interested in being “paid gradually.” They wanted their money now. That old saw about comedy is also true about investing: Timing is everything.