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“ To stay in business, these banks did the only thing they could. ”
In the wake of the failures of Silicon Valley Bank, Signature Bank and Republic National Bank, a common misconception is that these banks failed because they grew too quickly. On Tuesday, former Silicon Valley Bank CEO Greg Becker testified in a U.S. Senate and was widely criticized for the bank’s collapse.
Both of these criticisms are misplaced. Silicon Valley Bank and the others failed because they could not compete with the systemically important banks, whose demand deposits the Federal Reserve Board effectively guarantees.
These regional banks took substantial uninsured demand deposits when short-term Treasury rates were near zero. They would have been immune to depositor runs if they had invested those funds in short-term Treasury securities. But, their interest rate margin on these monies — the difference between what they earn on the Treasurys (about 0.25%) and what they pay for the deposits (0%) — would have been only 0.25%, far less than is necessary to sustain their operations. No amount of bank capital would have changed this economic reality, which has nothing to do with deposit growth.
Faced with this reality, these banks had four choices. First, they could have refused to accept deposits over the FDIC maximum of $250,000. But that would have prevented them from providing transaction services to their bigger clients, making them uncompetitive.
Second, they could have loaned more to less-creditworthy clients. That would have increased their interest margin, but the banks would have failed if those loans went bad. The banks then would have needed to set aside reserves for bad loans that would have depleted their capital.
Third, they could (and did) invest long-term to take advantage of higher rates. Since current accounting rules do not require banks to write down their fixed-income investments when they intend to hold them to maturity, they did not have to reserve capital for the losses they incurred when long-term rates rose.
Finally, they could have imposed negative interest rates on deposits over $250,000 and invested these funds in short-term Treasurys. That could have increased their interest rate margin to cover the costs of their operations. But they could not lower demand deposit interest rates below zero when their large competitors — the systemically important banks — were not charging negative interest rates on deposits.
To stay in business, these banks did the only thing they could. They lent money at higher long rates and hoped that those rates would not rise too quickly and that their depositors would not lose confidence if they did.
Unfortunately, rates did rise quickly, and the depositors lost confidence. The banks initially borrowed money at high rates to pay their fleeing depositors. But they soon could not borrow further, because lenders recognized that the banks would not be able to repay the loans if continued demands on their deposits required them to sell their long-term assets at losses.
“ Local banks could not (and still cannot) compete effectively. ”
Had rates never risen, the strategy would have worked. But irresponsible government spending and COVID led to inflation, which increased rates.
The immediate cause of the failures was rising interest rates. But structural problems in banking ultimately caused these failures. Most importantly, the Fed’s backing of the deposits of the large, systemically important banks ensured that the regional and local banks could not (and still cannot) compete effectively against them.
The Fed imposes substantially higher capital, asset, and accounting restrictions on systemically important banks, but they still have a strong interest in maximizing their deposits to obtain low-cost money. To prevent these large banks from exploiting their unique position, the Fed must discourage them from raising their interest rates on deposits. But when the Fed funds rate was near zero, the Fed was unwilling to force the banks to charge their depositors’ negative interest rates as we saw in Europe, and the banks certainly did not want to do so.
The fundamental problem of banking is the duration mismatch between short-term deposits that may run and the longer-term investments that historically have backed them. This mismatch has led to banking runs throughout history.
Regulators can address the problem in two ways. First, they can guarantee demand deposits. Alternatively, they can require banks to hold short-term liquid assets to cover their deposits fully. Guaranteeing deposits is problematic because it leads to excessive risk-taking that regulators must control. This means the second alternative is the only sensible policy.
“ Regulators should require banks to hold short-term liquid assets to cover their deposits fully.”
Regulators should require banks to hold short-term liquid assets to cover their deposits fully, and in a bankruptcy, the depositors should have the first claim on these assets. In effect, this requirement would make demand deposits similar to claims on money-market funds. In practice, regulators can require banks to segregate their demand deposits and the backing assets, just as the SEC now requires brokers to segregate their clients’ assets.
The banking industry will surely argue that such arrangements will increase bank loan interest rates. Any such increase, however, would be due to eliminating the subsidy implicit in deposit insurance and governmental guarantees. This subsidy distorts capital allocation decisions and is unfair to all other financial institutions and individuals who loan money.
Instead of guaranteeing deposits, the government should ensure that banks can always pay out their deposits. Banks could still write loans — but they should fund them only from money that investors trust to the bank for this purpose.
Larry Harris is a professor of finance and business economics at the University of Southern California Marshall School of Business. He was chief economist of the Securities and Exchange Commission, 2002-04.
Also read: The Fed and other central banks face a reckoning for the damage they’ve caused
