Arnold Kling holds a PhD in economics from MIT. He has worked at the Federal Reserve and later at Freddie Mac. In 1994, he started a web-based business. He used to blog at EconLog, and now writes at ArnoldKling.substack.com.
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How did SVB (almost) Go Under?
Bob Zadek: (01:49): Arnold, let's talk about Silicon Valley Bank, founded around 40-50 years ago—a new bank compared to our first bank formed by Alexander Hamilton around the country's founding.
Silicon Valley Bank was doing fine until recently. It was the 16th largest bank, with plenty of funds and public shareholders. It specialized in startups, especially biotech and tech companies, and was a favorite of venture capitalists in Silicon Valley. Then suddenly, Silicon Valley Bank collapsed.
So far there hasn't been a run on the bank, perhaps because the Fed intervened. But how could a successful, well-established bank fail so quickly? Arnold, tell us how a bank could go from thriving to defunct overnight.
Arnold Kling (03:47): As Ernest Hemingway said, “Gradually, then suddenly.”
I think that captures the story here. They gradually lost money because they held a huge portfolio of long-term mortgage-backed securities and Treasury securities on their books from a couple of years ago before interest rates went up. The value of that portfolio went down.
Then they went bankrupt suddenly because over 95% of their deposits were not insured. The typical customer had $3 million to $4 million that they used to make payroll and other expenses. That's way above the insurance limit of $250,000. Those people saw the bank was underwater, and no one wanted to be the last one left holding the bag. They started a run on the bank.
Bob Zadek (04:56): The public believes that when you deposit money in the bank, the bank somehow keeps it in a shoebox under the counter. But nothing could be further from the truth. In fact, when you deposit money in the bank, you are making an unsecured loan to the bank. Unlike a bank that lends you money with the collateral of your home or car, you are just the lowest form of creditor—an unsecured creditor.
We don't want all depositors withdrawing their funds at once. That's called a "run on the bank,” as Jimmy Stewart explains in It's a Wonderful Life. If everyone who lent you money demanded their money back at once, even if you have assets, they're not in cash. So you'd default. After the Great Depression, the government decided to avoid bank runs by guaranteeing deposits up to $250,000.
The problem was that millions and millions of dollars were deposited in Silicon Valley Bank, but then bad things started to happen. The bank had invested much of their money in federal securities, so it didn't have enough cash on hand to give everyone their deposits back right away. The federal securities that banks invest in are usually very safe. This caused even more panic and worsened the run on the bank. In short, too much money chasing too few safe investments led to a crisis of confidence in Silicon Valley Bank.
Arnold Kling (09:13): In a way, this is a rerun of the savings and loan crisis of the 1970s and 1980s.
If you lent me money for a mortgage a few years ago at 3% interest, you're probably not happy collecting only 3% now that mortgage rates are closer to 6%. On the other hand, I'm delighted to pay only 3% and have no desire to sell my house and take on a new mortgage at 5%. So what's good for me is bad for you as a lender.
Silicon Valley Bank lent heavily when interest rates were low. As a result, the mortgage securities and long-term bonds they purchased declined in value. However, there is no risk of default on my 3% mortgage, so I am happy to repay it. Similarly, there is no way the federal government will default on the 20-year bonds paying one and a half percent interest. You need not worry about default in that sense. Though you may believe these investments are safe, they have lost value. If you had to resell them to someone else today, you might get only 50 to 60 cents on the dollar. That is exactly the problem Silicon Valley Bank faced.
There was some ordinary deposit runoff because the tech boom was fading, so some of these companies were starting to spend their money. Instead of having 3 million in their account, they might have take it down to 2 million. So they're asking for a million dollars back, and the bank to meet that has to sell some of its portfolio. With its portfolio being worth 50 or 60 cents on the dollar, it's starting to book losses.Then these depositors start to worry: What if I need my money when it's my turn? Will they still have it?
Insolvency vs. Illiquidity
Bob Zadek (11:44): Imagine you own a house worth $1 million. You owe $500,000 on the mortgage—that's your only debt. Your net worth is $500,000. You're financially secure. But if the mortgage holder demanded repayment the next morning and you can’t pay, you'd be insolvent. That's what insolvency means: owing more than you can repay.
Arnold Kling (12:58): I would call that illiquid.
If you had to sell everything immediately and pay off your mortgage, you wouldn't be insolvent. If you sold your house for $1 million, you could pay the $500,000 mortgage and have $500,000 left over. You'd be insolvent if your house was worth $400,000 and the mortgage was $500,000.
Silicon Valley Bank was illiquid and insolvent. They lacked the funds to repay the depositors demanding their money back. They were also insolvent because selling their bond portfolio would not have raised enough money to repay all deposits.
Bob Zadek (14:23): I noticed that the Moody's rating for Silicon Valley Bank dropped from an A to a C rating overnight. The rating agencies, which were one of the main culprits of the 2008 financial crisis, seem to have again fallen asleep at the switch with Silicon Valley Bank, as with First Republic. The rating agencies are supposed to sound the alarm, but they're paid by the companies they rate, not the people who rely on them.
Arnold Kling (15:50): In addition to the rating agencies, there were actually all these people, either in the private sector or government regulators—the California Home Loan Bank Board, the FDIC, the auditor—who signed off on everything. None of these people did anything until the crisis was over, even though there were short sellers who could see this happening.
I believe bank examiners noticed issues about a year ago—saying that their growth was problematic. Banks aren't supposed to triple in size organically. SVB had $60 billion in deposits in early 2020 but around $180 billion by late 2022.
If you're running a bank, you cannot keep your management controls operating with growth at that rate. You're going to have junior managers managing four or five times more than they’ve ever managed. You're going to be throwing new hires in there the way Putin's throwing untrained soldiers at Ukraine.
Bank examiners saw the problems, and that was even before considering the interest rate risk. They also saw the interest rate risk, but did nothing. We think that if there are enough regulations, these issues won't happen. But they certainly don't prevent everything. Regulations alone are not enough.
Bob Zadek (17:59): As a lawyer and lender in commercial credit, I have often heard those seeking loans present themselves with unusual growth, boasting, “We have grown so fast.” My response is that there is natural growth one would expect in companies or living things. But there can also be extraordinary growth—we call that “cancer.” It is unhealthy, whether financially or physically.
Arnold Kling (19:51): I'm actually surprised the FDIC didn't have a veteran regulator involved. There had to be people at the FDIC who could see there was a problem. It would be interesting to file a Freedom of Information Act request for all the memos written about Silicon Valley Bank, because I bet there was some old curmudgeon writing things like "Why don't we shut this bank down? Why don't we make them hedge their interest rate risk? Why don't we do this? Why don't we do that?"
Someone higher up probably said, "No, we don't need to do any of that."
Why not let SVB fail?
Bob Zadek (20:45): The federal regulators took action that they vehemently deny was a bailout. Putting aside labels, they stepped in over a weekend and prevented an obvious outcome: letting the bank fail. There's nothing wrong with a bank failing. Depositors put money in a bank, presumably making an informed decision. They don't qualify as victims. Small depositors are protected by insurance. Just let the bank fail. Let companies unwise enough to leave money with the bank lose it, since they made a bad loan.
But the regulators didn't do that. Instead of the obvious choice to let the bank fail, they intervened to avoid it.
Tell us why regulators did not let the free market run its course?
Arnold Kling (22:40): Something pretty striking happened this weekend: The U.S. banking system was nationalized. The government now controls our banking system like in China. Why did this happen? It wasn't just about bailing out SVB. It was about bailing out every other bank because around 25% of banks—maybe more, maybe less—are in bad shape. They hold too many long-term bonds and may be insolvent. Even solvent banks have uninsured deposits and large accounts. If SVB had failed, the consequences would have hurt not just SVB's creditors.
“Something pretty striking happened this weekend: The U.S. banking system was nationalized. The government now controls our banking system like in China.”
So I believe if they had done nothing Monday morning, we would have descended into chaos. The financial system could have completely collapsed. I don't think they had a choice.
Had nature run its course, there's a strong likelihood of widespread financial collapse. You might have had to sell apples from a cart on the street just to earn a living.
Though they had to take action, they didn't just say, "We'll ensure uninsured depositors get their money back."
They said, "From now on, every uninsured depositor will be made whole at every bank. We'll provide lending so any bank can borrow to meet cash needs. If there's a run on your bank, we'll make sure they can pay your deposit."
Effectively, they said they'd protect everything. What follows from that as night follows day is tighter regulation. They're going to exert more control over what the banks do, in some ways legitimately, because they have become the ultimate backstop for every bank.
So the government can legitimately say, "Since we're backing your risky bets with taxpayer money, we should control how much risk you take and who you lend to." That's why I say the banking system is essentially nationalized. As surely as night follows day, regulators will realize they need to closely monitor banks once they grasp how much risk the FDIC and Fed have assumed by backing all these banks. We'll have a highly-regulated banking system where government regulators dictate who banks can and can't lend to. That gets back to something that resembles China.
We Ain’t Seen Nothing Yet
Bob Zadek (26:37): We already have a highly regulated banking system, and you ain't seeing nothing yet.
Due to my professional life, I have frequent contact with bankers in many roles. Many of the decisions bankers make seem to be explained apologetically as "Well, we're just doing what the regulators require.”
Arnold Kling (27:44): SVB is an example of that. Why do they buy long-term bonds and mortgage-backed securities? Because the government says that's how you minimize your capital requirements. That's how you can grow without continually going out to the capital market and asking shareholders to put up more money.
We're already regulating that way. It's going to be less and less room within the regulations for banks to do private sector type lending and more and more of a focus on lending to the government. It's like you say, you ain't seen nothing yet.
Bob Zadek (28:30): One can easily list examples of the forced partnership between government and banks. We are all at least vaguely familiar with regulations from the late 1970s that began in Chicago called the Community Reinvestment Act. The government had a social problem: lack of housing. It was part of our national ethos that it's more American to live in a private house than to rent. So the government pushed banks to give mortgages to people who couldn't necessarily afford them to live in private houses. Banks were coerced to make bad loans to people who didn't deserve them. I'm not criticizing any group, but banks were told, "You need favors from us, the regulators. If you want favors, you have to scratch our backs.
I did a show about how regulators often guide banks to stop providing accounts to lawful businesses like gun shops through unofficial guidance. Though not explicitly required, banks follow this guidance to avoid trouble. So much for separation of church and state or private business and government.
Arnold Kling (31:06): The government prefers to channel credit toward its own spending and away from certain private sector businesses like gun shops. Until 2008, housing generally received substantial government subsidies and support.
However, since the 2008 financial crisis, much of that support has been scaled back. Credit standards for borrowers have tightened significantly. This has gone from requirements that were too loose to ones that are now too tight. Consequently, over the past 15 years, housing starts have not kept up with population growth in any single year. Rents and home prices have risen due to the government no longer favoring the housing market in its financial policies.
So the question is: who will the government target next as it directs more and more credit to its preferred uses? Will it still support venture capital and private sector investments in energy? Or will the government increasingly control where banks lend money, like in China where banks are technically private but the government dictates exactly where they should put their funds.
Who will foot the bill?
Bob Zadek (32:46): One cynical aspect of the government's plan to insure bank deposits up to $250,000 is that, according to Janet Yellen and President Biden, it will cost consumers nothing. As Federal Reserve Chair Yellen explained, banks will pay for deposit insurance through fees based on their size. So if claims need to be paid, "don't worry, the banks will pay." This explanation seems utterly cynical, if not dishonest. Obviously, insurance has costs, including the likelihood of claims. Deposit insurance won't just materialize out of thin air. Either consumers will pay higher fees or get lower interest rates, or taxpayers will end up footing the bill if the insurance fund runs out of money. Yellen's assurance that "consumers aren't going to pay" is hard to believe. The idea that "it will not cost us" anything is dubious at best. As always, there is no such thing as a free lunch.
Arnold Kling (34:16): That's just a classic demagogic lie to say that no people will pay for a tax. Politicians levy taxes at a business level and say, "Don't worry, it's a business tax, you won't pay it," not realizing that all taxes ultimately are paid by people. You can call it a corporate tax, or a payroll tax.
Bob Zadek (35:16): At least 10 years ago, I did a show where we spent an entire hour discussing who pays corporate income taxes. It was clear from data that the lowest 25th percentile of income earners bear the brunt of all corporate taxes. Since they spend all of their money on consumer goods, the cost of taxation gets passed into the product prices.
Arnold Kling (36:06): And they're also their workers, and the corporate income tax reduces investment, which raises the productivity of workers along with wages. That's a classic difference in economics between where you place the tax and who bears the burden of the tax.
For example, the payroll tax is split evenly between employers and employees legally. But economically, the employee pays all of it. Because if I'm an employer and I know that hiring you means I'll have to pay X percent of your salary to the government, then that's less money I can afford to pay you.
The Moral Hazard
Bob Zadek (37:21): A concept of ‘Moral Hazard’ was in the news every night during the 2008 financial crisis and the era of the movie The Big Short, my favorite film about economics and finance. It refers to the bailout of Silicon Valley Bank, Signature Bank, and perhaps First Republic Bank and other banks that may follow.
Arnold Kling (38:18): The concept originates in the insurance industry. For example, let's say you're going to build a house in either western Florida near the Gulf coast or a mile or two inland. If you have flood insurance, you might as well build it on the coast. It's much nicer there. Flood insurance creates an incentive for you to overlook or downplay the risk of your house flooding.
We still need insurance, but when we have insurance, we need to be aware of this reduced the disincentive to take risks.
In banking, deposit insurance is insurance. I have the choice as the owner of a bank between being prudent and careful—not paying too much to depositors to lure money away or investing in the riskiest loans— or gambling—making risky loans and luring other depositors away from other banks with higher interest rates.
The risky bank is subsidized by deposit insurance. It's a “heads I win, tails the FDIC loses” situation.
Therefore it becomes incumbent on the insurance company—in this case the FDIC—to regulate banks. Let's say a company's going to to give you fire insurance. It's going to make sure that you follow building codes, that you have a sprinkler system, etc.
With car insurance you pay different rates depending on what kind of safety features you put in place.
The insurer always wants to regulate the person they're ensuring. The moral hazard in this case gets exacerbated because there are a lot of banks that are not in his extreme position as svb, but they're in a milder version of it where their portfolios are a little underwater and they have a lot of these what were formally uninsured depositors.
Now that they have insurance backing, theoretically there's nothing stopping them from attracting billions of dollars in deposits and essentially gambling with them. If they win big, shareholders and executives reap huge rewards in the form of profits and bonuses. But if they lose, it may not really hurt them because if they're already struggling, they can't pay out big dividends or bonuses anyway. So they don't have much to lose. The moral hazard in the whole system has increased dramatically. Mostly, it will be exploited by the owners and managers of unstable banks - what we used to call "zombie banks" in the 1980s. These were banks that didn't really generate their own profits.
Bob Zadek (43:12): As I recall, Texas was the epicenter of the savings and loan crisis. This was because Jim Wright, a Congressman from Texas and Speaker of the House, had significant influence over banking regulations. He ensured favorable treatment of Texas S&Ls.
I believe corporate treasurers who deposited large, uninsured sums with Silicon Valley Bank assumed that the government would bail them out if needed. They assumed Silicon Valley Bank was "too big to fail," even though it wasn't actually that large. Banks were thus able to attract more deposits than their balance sheets warranted. In my view, the "moral hazard" of expecting government bailouts led treasurers to make riskier decisions and gave banks an unfair advantage in attracting deposits.
Arnold Kling (45:03): Well, yes, you could have a banking system where you penalize them as a lesson. You could say, "Okay, we'll allow corporate treasurers to wait while we liquidate SVB. We'll see how much they get—80 cents on the dollar, 60 cents on the dollar."
I think the problem with that is, at least with how banking works today, it's really difficult to expect even a professional corporate treasurer to walk into a bank and examine everything to figure out how risky it is. I couldn't do it—I certainly don't have the knowledge or expertise. Just look at things like really complicated banks with derivatives or even a bank like SVB. You'd have to understand that they're not properly hedging their portfolios, unlike other banks with just as many long-term bonds but that also do things like interest rate swaps.
As a corporate treasurer, I don't want to have to analyze the derivatives positions of every bank I do business with and determine how those positions might change under different scenarios. I don't believe the banking system can be organized in that way. Instead, I think we need to organize the system so that private sector actors have "skin in the game." I don't want the FDIC to be solely responsible while everyone else is risk-free. However, this would require significant changes to the banking system.
The proposal I like best is to issue contingent capital in the form of long-term bonds held by banks. If a bank's net worth falls below a certain level, ownership of the bank would transfer from shareholders to bondholders. Bondholders would then be responsible for evaluating and monitoring the bank's risks. I think this is the only viable way to transfer that responsibility to the private sector. It would be very difficult to transfer it to depositors.
Bob Zadek (47:46): My proposal is for private deposit insurance, similar to how commercial credit insurance works. A private insurance company would ensure bank deposits and have the means and motivation to thoroughly assess risks, unlike a bank treasurer. Deposit insurance premiums would be tiny but rated based on the bank chosen. Banks would then compete based on credit quality to attract deposits. Unfortunately, I need your support to promote my plan so we can partner to privatize deposit insurance now.
Arnold Kling (49:25): Private insurance has worked in the past. Banks even formed mutual insurance companies. In fact, that's essentially what First Republic is doing now. Although I don't know how the banks providing liquidity to First Republic are being compensated.
Just because it's worked before doesn't mean it will happen here. Politically, that won't happen. As I’ve already said, our banking system is becoming increasingly nationalized.
Follow Arnold on Substack
Bob Zadek (50:53): What are the types of topics you like to cover on Substack?
Arnold Kling (51:04): Some of my work focuses on abstract libertarian ideas and the challenges of putting libertarian principles into practice. That's what I try to do most of the time. I generally avoid commenting on whatever issues happen to be popular on Twitter or in the mainstream media at the moment. However, the situation with SVB was in my area of expertise. I have a long background in finance, financial regulation, interest rates, risk, and so on. Even though I usually steer clear of trending topics, I felt compelled to weigh in on this.
Bob Zadek (51:42): You have provided a wealth of wisdom on a complex and important topic. Most people's eyes glaze over when I bring these issues up with them. The subjects you discuss are fascinating and have significant ramifications that affect each and every listener, each and every American, and could determine the path of our nation's political and economic future. So please continue to closely monitor these issues on behalf of all of us.
Arnold, we are deeply grateful for your contributions. And friends, thank you again for joining us.
Arnold Kling (52:35): Thanks Bob.
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