Two large regional banks failed within a period of only two days, Silicon Valley Bank (SVB) on March 10, and Signature Bank on March 12. Both banks had a combined aggregate asset size of $319 billion as of Dec. 31, 2022, with SVB and Signature ranked as the 16th- and 29th-largest banks in the United States, respectively, based on total assets of $209 billion for SVB and $110 billion for Signature.
The failure of SVB is the second-largest bank failure in U.S. history, behind only the failure Washington Mutual in September 2008. So, are the failures of SVB and Signature only isolated problems without systemic contagion, or do they represent the proverbial canary in the coal mine, warning of greater systemic troubles ahead? Here is a summary of the causes behind the failures of both banks, the response by the federal banking regulators, and the potential consequences.
Impact of Federal Reserve Policies
The Fed’s policy of artificially low interest rates and massive purchases of U.S. government debt since 2008, especially since 2020, has encouraged banks and businesses to engage in speculative activities that have not been driven by true market forces. This macro-financial environment can lull banks into a false sense of acceptable market and interest-rate risk.
With interest rates near zero from March 2020 to March 2022, along with an extraordinary 41 percent increase in the M2 money supply during that time period, the Consumer Price Index (CPI) reached a 41-year high in 2022. This prompted the Fed to abruptly change course in March 2022 with rapid increases in its Fed Funds Rate from 0.25 percent to 4.75 percent in February 2023. Such a swift increase in interest rates over the past year would require banks to adjust their asset-liability management to protect against interest-rate duration mismatches between assets and liabilities, known in banking terms as “duration risk.”
In the case of SVB, it was guilty of gross mismanagement of its duration risk over the past year, as it reported an abnormally high 41 percent of its total assets in Held-to-Maturity (HTM) securities, amounting to $91 billion at the end of 2022. These HTM securities, while mostly long-term U.S. government securities with little or no credit risk, had substantial duration risk in a rising-interest-rate environment, as fixed-rate securities fall in price when interest rates rise. This is how SVB got hammered, as it was forced to sell its HTM securities at big losses to cover the run-on-cash withdrawals by its deposit customers in the days leading up to its closure.
Flawed Regulatory Ratios for Assessing Bank Capital
Thomas Hoenig, a former head of the Federal Reserve Bank of Kansas City and former vice chair of the Federal Deposit Insurance Corporation (FDIC), made insightful comments in a March 17 article in the Wall Street Journal. He said that the use of the government-derived “risk-weighted capital” in evaluating a bank’s capital position is a major problem because it does not describe real, tangible capital. In the case of SVB, Hoenig notes in a March 10 article that SVB’s regulatory risk-rated “Tier 1 Capital Ratio” was around 16 percent, a presumably safe capital position, but the more market-realistic “Tangible Capital-to-Asset Ratio” was only around 5 percent. Hoenig is concerned that the use of risk-weighted capital ratios, adopted by bank regulators around the world in 2014, will lead to more problems in the banking sector. Hoenig makes this point in his Wall Street Journal article.
“The other thing about risk weight,” Hoenig said, “is that it’s a political process. It’s not a market process. The market no longer determines capital in the banking, industry. It’s now politicians, lobbyists and the regulators who have to battle it out among themselves. Therefore, you get these nonmarket solutions like risk-weighted capital. And banks are incentivized to increasingly leverage their balance sheets.”
Questionable Bank Regulator Oversight
The deposit runs that occurred with both SVB and Signature Bank raise serious questions about the competence and/or possibly even the corrupt complicity of the regulators with oversight responsibility for the two banks. While the management of the two banks appropriately deserve blame for their failures, the relevant bank regulators also need to be held accountable for missing obvious regulatory red flags from such large banks well in advance of their failures.
In addition to the asset-liability duration mismatch at both banks, other red flags included abnormally high growth rates and concentrations in risky business sectors (green energy technology startups at SVB and crypto exposures at Signature) and extraordinarily high amounts of uninsured deposits.
Looking at data for the end of 2022, SVB had only 12.5 percent of its total deposits within the FDIC-insured limit of $250,000 per deposit account, which indicates that a whopping $151.5 billion of its total deposits of $173.1 billion were uninsured. A similar situation existed at Signature Bank, with only 10.3 percent of its total deposits of $88.6 billion under FDIC deposit insurance, indicating $79.5 billion in uninsured deposits. Thus, the combined uninsured deposits of both failed banks amounted to $231 billion, which should have alerted the banking regulators of duration risk and potential liquidity risk.
It is unclear at this point how these regulatory red flags were missed by the relevant regulators. The primary financial regulators for SVB and Signature Bank were their respective district Federal Reserve banks, i.e. the Federal Reserve Bank of San Francisco (SF Fed) for SVB and the Federal Reserve Bank of New York (NY Fed) for Signature. The FDIC was also involved in its traditional role as regulatory supervisor over the banks’ deposit insurance. The state banking regulators in California and New York also conduct bank examinations.
Because of the unexpected large-scale deposit run on Silicon Valley Bank that resulted in its failure, Federal Reserve Chair Jerome Powell announced on March 13 that the Fed’s vice chair for supervision, Michael Barr, would lead a six-week review of the Fed’s regulatory supervision surrounding SVB. The Fed has committed to releasing Barr’s report by May 1.
Concerning Reactions by Federal Banking Regulators
The response to the failures of SVB and Signature Bank, and more recently to the troubled First Republic Bank, is extremely concerning for several reasons.
- Bailout of Uninsured Deposits: The decision of federal regulators (the U.S. Treasury, the Federal Reserve, and the FDIC) to guarantee funds for all depositors of both failed banks makes a mockery of the FDIC’s $250,000 deposit-insurance limit and signals a new acceptance by the federal regulators to bail out all depositors in any bank failure. This effectively means that the FDIC will now be expected to cover all of the deposits in the U.S. banking system.
At the end of 2022, the FDIC’s Deposit Insurance Fund (“DIF”) was $128 billion in comparison to the $17.7 trillion in total bank deposits in the entire U.S. banking system. The total deposits of SVB alone ($173 billion on Dec. 31, 2022) are enough to wipe out the entire balance of the DIF. So, how will deposits in excess of the Deposit Insurance Fund be funded? On March 12, a joint statement by U.S. Treasury Department, the Federal Reserve, and the FDIC announced that any losses to the DIF would be recovered by a “special assessment on banks.” Such a special assessment means that the entire U.S. banking system will need to raise fees and/or charge higher interest rates on its customers in order to cover the cost of the newly mandated special assessment to cover the mismanagement of failed banks.
- Creation of a New Emergency Lending Program for Banks: On March 12, the Federal Reserve announced the creation of a new emergency lending program for banks, the “Bank Term Funding Program” or “BTFP.” This new program will allow banks to obtain cash from the Fed’s discount window with one-year term loans backed by collateral comprising U.S. government securities. In addition to providing yet more government support to the banking system, the BTFP also allows banks to pledge their collateral at par. This is another misguided Fed policy action, as it allows banks to offload securities with below-par market values onto the Fed at par value. This will not only encourage less prudent risk management by banks, but will also likely result in further expansion of the Fed’s already massive $8.6 trillion balance sheet.
Within the first three days of its start, banks had already borrowed $11.9 billion from the new BTFP. For the week ending March 17, banks had borrowed another $148.2 billion from the Fed’s 90-day discount window, the largest weekly amount since September 2008.
- Inability to Sell the Failed Banks: Typically, the FDIC will have a buyer lined up ahead of the closing of a failed bank, typically another bank in good standing, but, as of Monday, the assets of neither bank have been sold. The market rumors indicate that the FDIC has, in fact, received several expressions of interest from legitimate institutional buyers, but they have been rejected by the FDIC Board. It is unclear why the FDIC has been rejecting interest from apparently legitimate buyers. Some market observers have speculated that it is due to the political ideology of the current FDIC Board, as it opposes mergers or acquisitions that lead to larger banks.
- Evidence of Political Corruption: When the FDIC initially announced the closure of SVB on March 10, it stated that uninsured depositors would not be covered in accordance with standard FDIC practice. However, just two days later on March 12, the FDIC did a complete reversal, stating that all uninsured depositors would be covered. The federal regulators justified taking this abrupt action by calling it a “systemic risk exception,” despite neither SVB nor Signature Bank having been designated as systemically important banks by the Federal Reserve.
This has led to scrutiny over the profile of the uninsured depositors at both banks and is revealing some noteworthy political connections. For example, the Intercept reported that Democratic California Gov. Gavin Newsom has been a client of SVB for many years and is associated with at least five bank accounts at SVB, including the accounts of three winery companies he owns. As for Signature Bank, it could not be more ironic that former Rep. Barney Frank (D-MA), coauthor of the largest banking reform bill in history, the Dodd-Frank Act of 2010, has been serving on the board of directors of Signature since 2015 and has earned compensation of over $2.4 million. Multiple media reports indicate that both SVB and Signature have been heavy donors to the Democrat Party and that uninsured depositors at both banks include other high-profile names that have been big donors to Democrats. Thus, evidence of possible political corruption behind the uninsured depositor bailouts of both banks needs to be thoroughly investigated (but don’t hold your breath).
Consequential Impact on Moral Hazard
The unprecedented bailout of $231 billion in uninsured deposits at two large regional banks, plus a new Federal Reserve emergency bank lending program with weak collateral requirements, will lead to yet more moral hazard in an American financial system already accustomed to being bailed out by the federal government. It also throws out the much-heralded objective of the 2010 Dodd-Frank Act to eliminate “Too Big To Fail” government bailouts in the U.S. financial system.
It remains to be seen whether the failures of SVB and Signature will result in any significant financial contagion into other banks and financial institutions. However, the two failures clearly affected New Republic Bank, which subsequently suffered $70 billion in deposit withdrawals. This triggered the collaboration of 11 of the largest U.S. commercial banks to transfer $30 billion in deposits to New Republic to save it from the same bank-run failure that SVB and Signature experienced. An important banking sector metric of concern is the explosive growth in unrealized losses in 2022. At the end of 2022, the U.S. banking sector held $620 billion in unrealized losses. This may indicate that more turmoil lies ahead for the U.S. banking sector. Stay tuned.