Real World Economics: A Necessary Primer on Bank Failures

Edward Lotterman

Suddenly, shaky banks are back in the news.

For codgers like me, 2008 isn’t that long ago, but for a significant proportion of the economically active US population, it can all be new and strange.

And even many economists might ask, is this the biblical “cloud no bigger than a man’s hand” suddenly rising from the sea and turning into a torrent of financial failures? Or are Silicon Valley Bank, Signature Bank, First Republic and Credit Suisse just anomalous visions that will be forgotten by Memorial Day?

Who knows? While experts debate whether this is a “bailout” that encourages “moral hazard” or a failure or regulation, it’s clear that many intelligent laypeople don’t really understand banking. So let’s take a step back and review the relevant basics.

Banks are financial intermediaries. They connect people who have money now but want to spend it later with others who want to spend now and are willing and able to pay it back later. The last group, the borrowers, pay interest. Savers can receive interest or simply benefit from payment services such as current accounts.

As intermediaries, banks also carry out transformations. These can be in size or denomination – on the one hand, thousands of household accounts, each with several hundred to several thousand dollars in savings, are converted into loans to buy $10 million of locomotives. On the other hand, $20 million in a single pension fund can be turned into thousands of credit card accounts with balances ranging from a few hundred to a few thousand dollars.

Transformations can happen over time. In the old savings and loan banks, most accounts could be emptied whenever the owner wanted, but the idea was that most kept their money long enough to make 30-year mortgages that went to those account holders’ neighbors. houses. This was not a problem as long as the overall deposit base remained stable, as it is for checking accounts used as a source of funds for longer-term business loans.

Finally, intermediation and transformation may be at risk. A tangible portion of mortgages, car loans and credit card accounts go unpaid – but a bank with thousands of such accounts and collateral can manage its prices to cover losses. Depositors are not at risk if their savings are below the amount covered by the Federal Deposit Insurance Corp. and a little more than that. Banks themselves pay the premium for this insurance, not taxpayers, but banks also charge fees to customers to protect their bottom line.

In addition, many thousands of households may have a money market fund in their retirement accounts. These funds can buy financial commercial paper sold by banks to obtain wholesale money to make consumer loans. Retirement account holders are risk-free because of two-stage intermediation, from retirement saver to mutual fund to bank to borrower.

Also understand that there are two ways a bank can “break”. One is illiquidity, the inability to turn assets such as collateral, loans and investments into cash quickly enough to meet the demand for cash, even if the value of the assets the bank has exceeds the liabilities it owes. The other is insolvency, when the amount a bank owes is greater than what it owns.

Many of the run-on-the-bank failures featured in the movie It’s a Wonderful Life are caused by a lack of liquidity. The fictional town of “Bailey Building & Loan” made mortgage loans that were repaid, but when all the depositors wanted to withdraw their savings at the same time, banker George Bailey could not demand that the mortgages be paid off early. His family’s savings and loan would be “crumbs”.

Then there are bank failures due to insolvency. In the 1980s, thousands of rural farm banks were closed by an FDIC team that showed up on a Friday afternoon with a locksmith and 20 pre-ordered pizzas. No depositors flocked out to claim their funds. But these banks had made land mortgages and operating loans to bankrupt farmers. Many of the loans were almost worthless. Banks were destroyed even though they had cash on hand to give to depositors.

Most of the bank failures of 2007-2008 were caused by insolvency due to the loss of mortgages and the moral hazard of bundling these loans into securities that were traded further up the financial food chain. So instead of Bailey Building & Loan, we had the failures of Wall Street stalwarts Bear Stearns and Lehman Brothers.

In the news this past week, Silicon Valley Bank, Signature Bank and First Republic all appear to be suffering from a lack of liquidity. Credit Suisse in Switzerland is a case in itself involving both illiquidity and insolvency.

In economics textbooks and past history, illiquidity was prevented by a “reserve requirement”. Banks were unable to lend 100% of their deposits. Some had to be held in reserve as ready cash to meet withdrawals. This is why our central bank is called the Federal “Reserve”. With adequate reserves, a bank could cover withdrawals under normal circumstances and, after 1913, could borrow from the Fed if necessary.

In introductory economics courses, this “required reserve ratio” is usually 10% to ease calculations for the teacher’s whiteboard examples. However, in practice, in our nation, it is effectively zero.

Federal Deposit Insurance was also instituted to reduce failures due to lack of liquidity. If the audience is confident that they will always get $10,000 or $100,000 or, these days, $250,000, don’t worry. There are no angry crowds outside the banks.

However, as Silicon Valley Bank has learned, business depositors with accounts in the tens of millions can and do rush to withdraw. Even a large bank can be shut down due to lack of liquidity within days.

The vaccine against insolvency is owners’ equity, the fraction of assets owed to no one. Bank regulators monitor capital adequacy against state and federal banking laws. Capital will not always protect a bank from failure, but it can give regulators time to shut down the bank while all depositors can be paid.

The last economic lesson is that the “par” or “face” value of a bond or promissory note and its market value on a given day can vary widely. The failure of SVB confounds many and is unique in that most of its assets were not risky loans to businesses or individuals, as in 2007-08. They were in long-term Treasury bonds. There has never been a case where such a bond failed to pay both interest and principal when due. US Treasuries are the quintessential zero-risk investment. And no one questions that in this case.

So what happened?

Well, if you have a piece of paper that says US Treasuries, 30 years, $10,000 at 2.98%, you’ll get $298 every year and $10,000 at the end of 30 years. No risk.

However, if interest rates rise, as they have for the past year, and investors can get other pieces of paper by offering $420 a year and $10,000 back at the end, and suddenly you need cash and have to sell your piece of paper to any willing buyer, no one will give you the face value of $10,000. Why should they get $298 a year instead of $420? So you should sell it for a lot less than you would get if you kept it for another 29 years. That 2.98% versus 4.2% is the spread on the 30-year Treasury between August and December 2022.

So SVB had assets that were perfectly “safe” to cover long-term deposit obligations, but could not sell its bonds to obtain short-term cash. And its Big Tech depositors—with more than 90 percent well over the FDIC-insured account limit—wanted their cash.

So all of this is background to the key policy question: When – and why – should the government, through its bank regulatory and insurance agencies, step in to prevent banks from failing? This is a complicated question that deserves its own column.

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