The turmoil touched off by the collapse of Silicon Valley Bank has demolished much of what the Federal Reserve, political leaders and investors thought they had learned from the global financial crisis of 2007-09.
They assumed complex securities, too-big-to-fail banks and shadowy, lightly regulated lenders were the weak links in the system. Instead, the weak links were its mundane, ostensibly safe parts—government bonds, smaller banks and deposits.
Perhaps this will blow over with few consequences for the broader economy. But if it doesn’t, two unappetizing paths loom: Smaller and regional banks, newly exposed as fragile, may struggle to survive on their own; or the federal safety net will expand, creating new risks down the road.
The global financial crisis originated with “shadow banks”—lightly regulated finance companies, securities dealers and off-balance-sheet vehicles (some of them subsidiaries of bank holding companies.) They invested in subprime mortgages and related derivatives, financed with skittish wholesale funding—asset-backed commercial paper, prime brokerage customer accounts and repos.
By contrast, SVB was pursuing the epitome of safe, boring banking: taking in deposits, which are usually stickier than wholesale funding, and investing them in Treasurys and federally backed mortgage securities. Such securities have no risk of default, unlike the emerging market, commercial real estate and subprime loans that drove previous crises.
The problem is that financiers tend to double down on a safe strategy until it becomes unsafe. Between 2007 and 2022 banks boosted their holdings of Treasurys and federally backed mortgage securities to 20% from 12% of total assets, while the uninsured share of domestic deposits rose to 45% from 38%. SVB and Signature Bank went to extremes, with uninsured deposits at 94% and 90%, respectively, according to S&P Global Market Intelligence.
Government bonds may not have default risk, but they have interest-rate risk: their market value goes down when rates rise, more so when they rise from rock-bottom levels. That, of course, is what they have done since last year.
For banks, that was only an issue if the bonds had to be sold to redeem deposits, which is exactly what happened to SVB. Signature was more reliant on loans, but it too experienced a run on its uninsured deposits.
Banks are supposed to be safer than shadow banks because they are tightly regulated. So how could the Fed, which shared oversight of SVB with California regulators, let this happen? The situation was hardly unprecedented: A mismatch between long-term loans and short-term deposits brought down many savings-and-loan institutions when interest rates soared in the late 1970s and early 1980s. Reliance on uninsured deposits precipitated the collapse of Continental Illinois in 1984 and Bank of New England in 1991.
Conceivably, Fed regulators, like their monetary-policy colleagues, were caught off-guard by how much interest rates would rise because of inflation. Such a scenario wasn’t in the stress tests administered to the much larger global systemically important banks (GSIBs). Even so, banks should have tested for such a scenario on their own.
Fed supervisors also thought, wrongly, that uninsured deposits were a safe form of funding. “Long experience has taught supervisors and regulators that uninsured deposits from your customers, as opposed to brokered deposits or wholesale short term funding, are rather stable,” said Randal Quarles, who oversaw regulation at the Fed as a governor until 2021. That assumption needs to be rethought, he said.
Regulators and legislators thought the global financial crisis showed small and regional banks were inherently safer than GSIBs. Smaller, simpler and less interconnected, they wouldn’t take down other institutions if they failed. That rationale led Congress to raise the asset-size threshold at which tougher capital and liquidity requirements kicked in to $250 billion from $50 billion in 2018.
Whether that change would have made a difference is unclear; regulations only matter if examiners are enforcing them, and supervisors still had a lot of powers to discipline smaller institutions. While Fed examiners did alert SVB’s management as far back as 2019 with their concerns, they didn’t, it appears, take more severe steps such as forcing them to turn away deposits or raise capital. That is despite multiple red flags such as rapid growth, high dependence on uninsured deposits from concentrated sectors, large deposits tied to venture-capital deals and no chief risk officer.
SVB and Signature may have been outliers, in which case their failure should have had no ripple effects. But enough banks shared a passing resemblance that skittish depositors began yanking out their money. That is the essence of a bank run: Psychology can transform a bank that is healthy, liquid and solvent one week into one that is unhealthy, illiquid and insolvent the next.
Fearing such an outcome, the Fed offered to lend to banks against bond collateral valued at par instead of much lower market values, and the FDIC, invoking an exception for systemic crises, guaranteed all of SVB’s and Signature’s deposits. Whether this was an overreaction is impossible to know right now; that bank stocks have since fallen further suggests it wasn’t.
So how can this new source of fragility be eliminated? Uninsured depositors don’t seem to discipline their banks’ behavior, said Eric Rosengren, former president of the Federal Reserve Bank of Boston and now a scholar at the MIT Golub Center for Finance and Policy. Smaller banks could be required instead to issue junior debt, he said. Such debt could be converted to equity or wiped out to resolve a failing bank, as Swiss regulators did in forcing Credit Suisse Group AG to merge with UBS Group AG, he noted.
But the Swiss authorities still had to backstop UBS’s losses and provide it with extra liquidity.
Without government backing, U.S. community and regional banks stand to lose large deposits and customers to big banks already deemed too big to fail. In response, midsize banks are urging the government to insure all bank deposits for two years. On Tuesday, Treasury Secretary Janet Yellen said more bank deposits could be protected.
A blanket deposit guarantee would certainly stabilize banks, but at a cost. It could draw funds from similar investments such as money funds that lack the guarantee. It could effectively turn every bank into a government-sponsored enterprise, as Fannie Mae and Freddie Mac once were. In the process, a key goal of the postcrisis regulatory push would go up in smoke: that the public should never again have to backstop the losses of private risk taking.