This has not been a good year for U.S. banks. Silicon Valley Bank and Signature Bank saw depositor runs in early March, which were soon followed by regulators seizing both banks and wiping out shareholders. Within two months, First Republic Bank also saw a depositor run, and was itself seized by regulators.
If not for the swift and robust regulatory response – which saw the Federal Deposit Insurance Corporation (FDIC) ensure all deposits at both Silicon Valley and Signature banks in mid-March — the country’s economic situation would now be much worse.
But what economic policies and corporate decisions got us here? And was the regulatory response justified or will it ultimately make matters worse?
Setting the stage
The story starts in 2020 with the COVID-19 pandemic. The Federal Reserve, trying to stave off imminent economic collapse, quickly cut short-term interest rates to zero. When short-term rates are low, it is easier for consumers and companies to borrow, and the Fed hoped that such monetary stimulus would help ward off a potentially severe recession.
A consequence of the Fed’s monetary accommodation was that short-term interest rates fell, while longer-term rates remained relatively high. By early 2021, 2-year Treasury
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yields were at 0.10%, while 30-year Treasury yields
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hovered around 2%. An investor who put $100 into a 2-year Treasury bond in early 2021 would have received 10 cents in interest per year, while an investor who put $100 into a 30-year Treasury bond would get $2.
Obviously, if bond prices remain unchanged, the 30-year Treasury bond was a more attractive investment. You could borrow $100 and pay 10 cents annually on this loan, while reinvesting the same $100 in the 30-year Treasury bond to collect $2 in interest. This trade would make you $1.90 per year. Of course, the problem with this arrangement is that bond prices rarely remain unchanged, especially not those of 30-year Treasury bonds, which experience dramatic increases and falls as interest rates fluctuate.
Good rule, bad outcome
But what if there was an investor for whom such price fluctuations did not matter? Through the magic of hold-to-maturity accounting, it turns out that banks can buy Treasury bonds, clip the coupon, and pretend that those bonds do not fall in price if interest rates increase, as long as the banks intend to hold these Treasurys until they mature. In one respect, this is a sensible rule because it allows banks to ignore market gyrations in the price of Treasury bonds which are, after all, backed by the full faith and credit of the U.S. government. On the other hand, taken too far, this rule can lead to bad outcomes.
In 2020 and 2021, with short-term interest rates close to zero, banks could effectively borrow for free by taking in deposits. For many banks, the combination of held-to-maturity accounting rules, free deposits and relatively high longer-dated interest rates proved to be an irresistible combination.
Consider that Silicon Valley Bank massively increased its holdings of held-to-maturity investment securities from 2020 to 2021. Silicon Valley’s exposure to this trade was extremely large. The orange line in the chart above shows the book value of shareholder equity in Silicon Valley Bank. While its book equity doubled from 2020 to 2021, the growth in its Treasury holdings dwarfed the growth in shareholder capital.
Silicon Valley Bank was hardly alone in availing itself of this borrow short (through deposits), invest long (in longer-dated U.S. Treasurys) opportunity. The same trade, in varying degrees, permeated the balance sheets of all U.S. banks heading into 2022.
Loose money and fast slides
In 2022, the Fed’s very loose monetary policy, combined with severe COVID-19-induced supply-chain disruptions and a spike in energy and commodity prices caused by the start of the Ukraine war, resulted in the largest jump in U.S. inflation since the early 1980s.
The Fed quickly pivoted and started to hike short-term rates. As these rose, longer-term rates did as well, and bond prices began to fall. The U.S. Treasury positions that had been built up in the U.S. banking system experienced large price drops. For a sense of scale, some 30-year Treasury bonds fell from above $100 in market value in late 2021 to below $60 in late 2022.
What forced banks to monetize these losses despite held-to-maturity accounting rules was that investors started to pull their deposits. In the case of Silicon Valley Bank, many depositors were venture-capital (VC) funded startup technology firms that kept large sums of money — far above the $250,000 FDIC insurance limits — in the bank.
As the small group of VCs who advised these startups began to appreciate the magnitude of the mark-to-market losses sitting on Silicon Valley’s balance sheet, they advised firms to move Silicon Valley deposits to safer hands.
As deposits fled, Silicon Valley Bank was forced to sell the same Treasurys it had bought in 2021, but at large losses. The bank quickly ran out of investor capital, at which point, regulators seized it. A similar set of dynamics would soon play out with First Republic. An exacerbating factor for First Republic was the emerging recognition by depositors that the rates of return available from money-market funds and Treasury bills are considerably higher than what can be earned from bank deposits.
Did regulators do the right thing?
It is noteworthy that, despite the banking-sector tumult, the S&P 500
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has rallied. A major reason for this happy situation is that regulators quickly guaranteed all Silicon Valley Bank deposits, including ones that were not FDIC-insured. A critique of this policy is that bailing out depositors reduces their incentive to monitor banks, reduces the interest rate at which banks can borrow, and increases banks’ willingness to make shoddy loans. There is some validity in this critique, and economists and policymakers will undoubtedly debate its merits over the coming years.
But there are three compelling reasons for why guaranteeing all deposits was the right thing to do.
First, these guarantees averted a large-scale bank run that might have incapacitated the entire U.S. regional baking system. From a systemic risk point of view, the depositor backstop was a major success.
Second, it is unlikely that depositors in Silicon Valley Bank or First Republic — even sophisticated institutional ones — understood enough about these banks to effectively monitor them. I’ve had many conversations with business owners concerned about the state of their banking deposits, and none of them have a thorough enough understanding of how banks operate to effectively monitor management teams.
Third, it must be recognized that stock investors in Silicon Valley Bank and First Republic lost their entire investments. The market capitalization of Silicon Valley Bank fell to virtually zero at the end from $40 billion in early 2022. The shareholders of First Republic Bank lost just under $40 billion. In addition, both banks had senior unsecured bonds, which also suffered losses.
Equity and debt investors in banks, who commit billions of dollars of capital to these firms, are clearly the constituents who are most incentivized and most able to effectively monitor bank management teams. That they did not do so this time around suggests that regulators should require banks to have more capital that is junior to bank deposits. Such capital has every incentive to ensure that the mistakes made by U.S. banks in 2021 are not repeated.
Harry Mamaysky is a professor of professional practice at Columbia Business School.
More: Local banks are lifeline for small business — America’s economic engine. They need government support.
Also read: The Federal Reserve is trapped in a deep hole — and it has only itself to blame
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