Over the weekend, the Treasury/Federal Reserve/FDIC stepped in to guarantee the deposits at the failed Silicon Valley Bank (SVB) and did the same for Signature Bank in New York, a more crypto-focused bank which was also put into FDIC receivership. Declaring a systemic risk to the banking system, the Treasury/Fed/FDIC also guaranteed deposits over the normal $250,000 insured limit. SVB had been closed on Friday after a classic “run on the bank” driven largely by venture capitalists (VC), who were badly exposed because they had deposits well over the $250,000 limit covered by FDIC insurance, withdrawing their money all at once. Apparently, over 95% of the deposits held at SVB and over 90% at Signature were uninsured. In addition, SVB itself was badly exposed to interest rate risk, having locked in investments in what were higher-yielding government bonds pre-pandemic but have now become huge money losers as interest rates have skyrocketed in the last year. The reason those bonds are such losers is primarily because those bonds are now worth far less than what SVB originally paid for them but also because SVB now has to pay a higher rate of interest to their depositors than those bonds currently produce. While that interest rate mismatch has no direct effect on depositors’ money, it does eat into the bank’s profitability and eventually its capital.
It was SVB’s downgrade by Moody’s and its failed attempt to raise new capital on Wednesday that really precipitated the bank run. A number of the primary VC depositors, including the inexecrable Peter Thiel, advised their friends to pull their money out of SVB, saying there would really be no downside to doing so. In the insular world of venture capitalism, that word spread faster than wildfire, resulting in over $40 billion in withdrawals on Thursday alone. For the venture capitalists, it did turn out that there was a downside, and it was the collapse of the bank that held their uninsured deposits. The ultimate irony is that it was the herd mentality of these supposed free thinkers that created the crisis that threatened their money.
To say that SVB was poorly run is probably an understatement. The bank had had no chief risk officer for about eight months. The bank apparently made no effort to either hedge or mitigate its interest rate risk. Over the last month, as the interest rate mismatch continued to take its toll, senior executives were unloading their stock. CEO Gregory Becker, who remarkably is also a board member of the Federal Reserve Bank of San Francisco, sold over $3.5 million worth of shares just days before the collapse. The executives even had the chutzpah to pay out bonuses on Friday, just minutes before the bank was shuttered.
SVB also had some, shall we say, unusual requirements for its customers. According to some reports, when SVB invested in a startup, it required that all those funds be held at SVB, and that the startup exclusively bank with SVB. In return, it offered concierge services, including below market rate mortgages and personal letters of credit for the startup executives and the venture capitalists whose deposits backed them. Considering that SVB apparently serviced around 65% of all new startups, it’s easy to see how SVB’s deposits nearly tripled from 2019 to 2021.
Those unusual requirements might also help explain why there were so many uninsured depositors with accounts holding more than the $250,000 FDIC insured limit. That limit is well-known and there are equally well-known work arounds for businesses that require higher funding requirements to still keep their accounts insured. Those work arounds include cash management accounts, insured cash sweeps, CDs spread across multiple issuing banks, or simply purchasing additional deposit insurance privately. It is understandable why SVB would not want to make these options available to their depositors, simply because not doing so allowed their deposit base to grow larger than it probably should have, enabling the potential for higher profits. In fact, SVB actually offered a cash sweep program that would have allowed depositors to diversify their cash holdings, but hardly any depositors took advantage of it for reasons currently unknown.
The bigger question is why our latest version of the “masters of the universe”, those visionary designers of disruption, those venture capital vultures, allowed their deposits to remain uninsured. Could it have been they were so easily bribed into not doing so by below market mortgages and some basic concierge banking services or are they actually so dense, or perhaps so entitled and arrogant, to think that the limit on FDIC insurance surely wouldn’t be applied to them. Based on their collective squealing on Twitter over the weekend, it surely seemed like the latter.
To borrow a phrase from Matthew Klein, the SVB collapse was both a “bank run by idiots” and a “bank-run by idiots”, in that the management was terrible and possibly corrupt and the depositors failed to realize that the capital needed to keep the bank going was probably just a fraction of the uninsured deposits they held there, as the value of the bank’s bond investments still probably held about 80% of their original value and would return 100% if they had been able to be held to maturity.
Beyond the issues with the bank management and its depositors lies the question of where the bank regulators were. After the financial crash, issues such as those occurring at SVB were supposed to have been dealt with more regulatory oversight, stress tests, and higher capital requirements, all required under the Dodd-Frank legislation. But in 2018, those rules got rolled back for smaller regional banks like SVB. The argument, made by SVB’s CEO Becker and many others, is that these onerous regulations were hurting the competitiveness of these smaller banks and were unnecessary because these banks posed no systemic risk to the banking sector as a whole. It took less than five years to prove that claim to be fantastically wrong.
More worrying is the fact that the Federal Reserve itself was the primary regulator for SVB. Considering that SVB’s CEO was a sitting board member at the Federal Reserve Bank of San Francisco, it defies credulity that the Fed was not aware of the stress that its higher interest rates were putting on banks in general, but SVB in particular. In addition, the Fed certainly is taking an expansive and largely unchallenged view of its legal authority in creating this new Bank Term Funding Agreement that will allow banks to borrow money from the Fed for up to one year using collateral priced at acquisition price rather than current market value. In addition, as usual in these business failures, the auditors were absolutely useless, having seen or hear nothing. KPMG was the auditor for both SVB and Signature and the accounting firm gave both banks a clean bill of health just 14 days and 11 days respectively before those two banks failed.
This was a crisis that never should have happened. We had supposedly smart, savvy depositors who refused, either out of greed or willful ignorance, to diversify their cash holdings. We had a bank management that did not manage its interest rate risk and diversify its client base, relying on one particularly risky and volatile sector for its deposits. And, again either out of incompetence or willful ignorance, a regulatory failure when a relatively minor capital infusion could have been forced on the bank, preventing the cascading crisis. Yes, there is a perfectly valid argument that, once the crisis had begun, it was better to guarantee those deposits and ensure that the myriad of workers whose salaries are paid by two large payments processors who used SVB actually get paid. But that does not detract from the fact that the crisis never should have occurred or that those depositors who ignored the basics of cash management risk have gotten bailed out.
What is more disturbing is that a small group of billionaires can basically collectively get together on a group chat and threaten the stability of the financial system. It is not only indicative of their outsized economic power but also their power of the bully pulpit through social media. The most disgusting and frightening aspect of that power was the incessant fear-mongering all weekend long, desperately trying to foment runs on other medium and small sized banks, in order to force the Fed to guarantee their deposits. And it basically worked. Yet the touchy tech bros insist they weren’t bailed out because the executives of SVB have been fired and the shareholders of SVB will get nothing. The bond holders will actually get most of their money back, if not made whole. Of course, the depositors have also been made whole because they managed to get the rules changed for themselves, rules that everyone knows wouldn’t have been changed if it was just you or I.
The hypocrisy of those venture capital vultures was also hard to swallow. Having spent years decrying regulation that they claim stifled their remarkable innovative powers, they went crying to the Feds to bail them out at the first sign of trouble and now whine that the lack of regulation actually fomented the very crisis they actually brought on themselves. In addition, the creations of these brilliant venture capitalists are hardly brilliant new discoveries but instead mainly just using technology to intermediate and rent-seek for services we’ve always had before – house rentals, car services, food delivery, etc. As Edward Ongweso writes, “For over a decade, low interest rates have allowed venture capitalists to accumulate huge funds to give increasingly unprofitable firms with unrealistic business models increasingly larger valuations—one 2021 analysis found that not only were 90 percent of U.S. startups that were valued over $1 billion unprofitable, but that most would remain so…To put it more plainly, for the past 10 years venture capitalists have had near-perfect laboratory conditions to create a lot of money and make the world a much better place. And yet, some of their proudest accomplishments that have attracted some of the most eye-watering sums have been: 1) chasing the dream of zeroing out labor costs while monopolizing a sector to charge the highest price possible (A.I. and the gig economy); 2) creating infrastructure for speculating on digital assets that will be used to commodify more and more of our daily lives (cryptocurrency and the metaverse); and 3) militarizing public space, or helping bolster police and military operations”.
The result of this weekend is that is apparently now, de facto if not de jure, Fed policy to guarantee all deposits, no matter what the size. That is probably not a good thing. Certainly, it appears to substantially reduce the moral hazard for bank executives who will now have more freedom to try and maximize profits through riskier investments. (Incredibly, or perhaps unsurprisingly, the moral hazard scolds who lecture us about forgiving student loans took up cry to guarantee the uninsured depositors over the weekend, telling us now, this time of crisis, was not the time to discuss moral hazard.) The knowledge that the Fed will step in and lend money based on the acquisition price rather than market value at the first sign of crisis will only embolden the risk taking engaged in by bank executives.
On the other hand, there has never been a better opportunity to finally separate basic cash management capabilities – simple payments processing – from the investment decisions of bank executives. As Nathan Tankus notes and the VCs discovered last week, “bank deposits [over $250,000] carry risk they have to manage. To businesses, they need to put their excess cash in ‘alternative’ financial assets if they want to be completely assured of safety. This is why short maturity treasury securities are such useful instruments. You can hold billions of dollars, without taking on the risk of a bank failing”. Many of the securitized products of the less regulated “shadow banking” system – the repo market, money market funds, commercial paper, etc. – are at least in part a response to dealing with the excess deposit risk. The additional appeal of these products is that they can often maximize the return on money, in this case deposits, that are not immediately needed.
However, since the government is now guaranteeing all deposits, no matter the size, then the rationale for providing direct government banking services in the form of bank accounts at the Federal Reserve or basic postal banking has never been stronger. As Tankus points out, “Once we separate and clearly distinguish payments processing from bank lending…bank accounts directly provided by the Federal Reserve to the public and/or postal banking is a feature not a bug”. The vast majority of Americans, and probably most small businesses, have checking and savings accounts that are almost exclusively used for payments, either incoming or outgoing. To use the lingo of the venture capitalists, postal banking or its equivalent will disintermediate the bankers and their inherent risk and exorbitant fees that stand between you and your money.
There are additional advantages to postal banking beyond able to avoid the risk of bank executives’ bad investment decisions. As Ryan Cooper details, postal banking or its equivalent would shrink the financial sector as a whole and the less regulated shadow banking system in particular. It could eliminate the account and transaction fees that banks love to add on. It would cut into the extortionate practices of the payday lenders and credit card companies. It would provide easy access to those 5% of Americans who are currently unbanked. It would actually speed up the flow of money as transactions could clear immediately as opposed to the potential days of delay seen currently with banks. It would offer the Fed a more direct method for interest rate changes to work through the economy as opposed to the current situation where banks cut interest rates immediately when the Fed Funds rate decreases but delay raising rates when the Fed Funds rate rises. Finally, it offers a seamless and efficient way for the government to get money to individuals when it is due them, such as Social Security payments, tax refunds, or pandemic relief.
And if we’re going to do postal banking, we might as well disintermediate the tax preparation business by allowing individuals to download the tax information the IRS has already compiled for them to help prepare their return. For those individuals who only have postal bank accounts and a W-2, simply checking a box that agrees with the IRS data and signing the document could be all that it takes to file a return. Any payment or refund could be processed directly through the postal banking account.
Of course, neither of these proposals is going anywhere – the lobbies for the affected business sectors are way too strong. Instead, we will see Congress attempt to revert back to the original Dodd-Frank legislation for these regional banks. In addition, the FDIC may substantially raise the guaranteed deposit limit, with tiered fees for increasing deposit amounts. Those will last until we forget the lessons of this crisis and the bankers convince Congress with a showering of donations that those regulations are too burdensome. And we’ll end up facing another crisis that looks very much like the one we are facing today.