Banks in centuries past were often formidable buildings, with large columns in the front and big, stout doors. There was a reason for this: Banks were meant to represent a safe place to put one’s money. Although the shape and size of banks has changed, they maintain a central role of inspiring confidence and trust. In early 2023, however, the failure of Silicon Valley Bank (SVB) injected a queasiness into financial markets, raising questions about confidence in the banking sector. This was reinforced by the failure of two more banks in quick succession, Silvergate Financial Corporation and Signature Bank.
Silicon Valley Bank’s Failure: A Shattering Event in the Crypto Realm
SVB’s failure was caused by the role the bank played in the cryptocurrency world, its heavy dependence on the tech sector, and rising interest rates. All of these factors were mismanaged by a yield-hungry leadership. Positioning itself as an alternative to the large money center banks, SVB made itself the place to go for venture capital linked to Silicon Valley’s tech companies and as a safe harbor for cryptocurrency companies while maintaining an important role for local businesses, in particular vineyards and wineries. By the time of its failure in March, SVB was the largest bank in Silicon Valley, an important region for the Californian and U.S. economies.
SVB’s connection to the cryptocurrency sector worked well for the bank until the spectacular collapse of Sam Bankman-Fried’s crypto exchange FTX in November 2022. This quickly rippled through the crypto sector, raising questions about SVB’s exposure. What appeared to have been a great business decision suddenly proved to be a major blunder.
By early 2023 SVB faced a major cash crunch. The situation was made worse by the bank’s portfolio of long-term municipal and government agency bonds, which were hit by the Federal Reserve’s aggressive rate hikes. As the bank increasingly came under pressure to meet short-term obligations, it conducted a fire sale of that portfolio, taking a $1.8 billion hit, which prompted regulatory action.
What Has Made SVB’s Failure Such a Concern?
Part of the shock is that SVB was the 16th largest bank in the United States, with assets of $212 billion as of Dec. 31, 2022. It is the largest bank failure in more than a decade.
Prior to 2023, Americans became accustomed to a low level of bank failures. Tighter bank regulation since 2008, despite some loosening during the Trump administration, helped reduce the number of bank failures, and those that have occurred have been relatively small. According to the FDIC, bank failures declined from a peak of 157 in 2010 to zero in both 2021 and 2022, while the total assets involved have radically declined. Consequently, SVB’s failure is causing considerable anxiety.
While the large money center banks appear well capitalized, questions are now being raised over regional banks. This concern was brought into sharper focus by the failure of two other banks, California-based Silvergate Financial Corporation (with assets of $11.4 billion at year-end 2022) and New York-based Signature Bank ($109 billion). Both of these banks were closely associated with the cryptocurrency sector.
Concern over contagion in the banking sector prompted regulators and the government to act quickly. In the case of SVB, there was considerable apprehension that deposits over $250,000 would not be insured by the FDIC, as well as worries about knock-on effects on the local economy. However, on March 13, President Joe Biden assured the nation that the banking system is safe, indicating that all deposits at the bank would be guaranteed, though no protection will be given to the banks’ investors. He also stressed that no losses are to be borne by taxpayers. The FDIC receives its income from premiums that banks and savings associations pay for deposit insurance coverage. Additionally, the leaderships at SVB and Signature were fired, and investigations have been initiated.
Equally important in the government’s response was that the Federal Reserve announced the establishment of a Bank Term Funding Program that will act as a source of liquidity for financial institutions to avoid fire sales a la SVB’s bond sale. It will be backed by $25 billion from the Treasury’s Exchange Stabilization Fund.
Where Has This Left the U.S. Financial System?
Uncertainty over contagion lingers. Contagion has an element of the cockroach theory: Where there are one or two cockroaches, there are likely to be more. Regional banks are under considerable scrutiny related to their exposure to crypto and asset-liability mismatches, the factors that sank SVB. JPMorgan has already stepped in to provide extra liquidity to San Francisco-headquartered First Republic Bank, which is the nation’s 14th largest bank by asset size ($212 billion). Although First Republic’s business is not deeply tied to tech and crypto, in the past it lent to Mark Zuckerberg (Facebook’s founder), and part of its marketing pitch includes products for “innovators.” While the government has taken quick and forceful action, the nervousness over regional banks is not going to dispel quickly, and there could be other casualties before the situation passes. Who else has exposure to crypto or has mismanaged their portfolios during the Federal Reserve’s rate hikes?
The bank turmoil also opens another door to greater political gamesmanship in Washington, especially with the 2024 elections on the horizon. There is already criticism that the guaranteeing of all SVB deposits is being done to help Democratic donors in Silicon Valley. At the same time, the Democrats have sought to cast blame on the Trump administration’s 2018 loosening of the Dodd-Frank Act pertaining to regional banks. More broadly, a banking crisis would be bad news for the Democratic Party’s 2024 prospects. Ultimately, the three bank failures set the stage for greater debate over just how much regulatory supervision is needed to ensure a safe and sound banking system.
Another important political angle is that the decision to extend coverage of all deposits at SVB and Signature Bank opens a can of worms for regulators and beyond them Washington’s political class. This comes in two ways. First, it sends a signal that the banking system may be more fragile than it is, helping maintain the fear factor in markets and with people who use regional banks. Second, as the former head of the FDIC Sheila Bair notes, there is a risk that regulators “will have to pick and choose who they want to help. If there are more failures, who are they going to bail out? Anyone over $100 billion?”. Remember, many of the depositors at SVB were sophisticated investors, venture capitalists who were supposed to be on the razor’s edge of investment and risk management. Is the same treatment going to be given bank depositors in Kansas or Maine? This is decidedly a moral hazard issue here, which Washington cannot ignore
Another possible consequence of the turmoil in the banking sector is that it could slow the Federal Reserve’s interest rate hikes. Although February’s inflation rate fell to 6.0 percent (from 6.4 percent in January), it remains too high. The federal Reserve faces a major challenge in bringing inflation back to its target of 2 percent. Yet, tightening liquidity is not going to help banks struggling to bolster capital. The next FOMC meeting is scheduled for March 21-22, and there is growing speculation that the Federal Reserve will pause its hikes. If so, U.S. inflation is likely to remain higher for longer, which corrodes the buying power of most Americans. It also further opens the Federal Reserve to sniping by both parties over its monetary policy. In a sense, Chairman Jerome Powell is damned if he raises rates or if he pauses them, considering the politicization of any bank failure. That said, it should be remembered that U.S. bank regulatory policy is heavily influenced by the 2008 Lehman failure, where the financial company was allowed to fail, which set off a major crisis in confidence and a bruising, global economic downturn.
Finally, the failure of the three banks raises more questions over the crypto sector, especially concerning financing and regulation. The large money-center banks are not likely to warm up to the sector. Indeed, JPMorgan’s CEO Jamie Dimon stated on Jan. 19 that, “Crypto is a decentralized Ponzi scheme…It’s a pet rock.” While there is widespread acceptance of blockchain technology, cryptocurrencies are likely to find the ride ahead much more challenging and will face tighter regulation.
The current round of bank failures is problematic and should concern regulators and policymakers. Weakening confidence for reasons real or imagined (many of them regarding cryptocurrency and interest-rate mismatches in bond portfolios) could push weaker institutions into the abyss like so many dominoes. Indeed, Signature Bank might not have failed if SVB did not fail. Confidence proved fleeting once Signature was perceived as a crypto bank. Although the U.S. financial system is generally healthy and should ride through the current storm, confidence is going to remain fickle. There are going to be troubles in the banking sector until the Federal Reserve’s hiking cycle ends and regulators instill greater confidence in their ability to supervise crypto. The situation is further complicated by politics, growing moral hazard issues, and an undercurrent of a Federal Reserve seeking to regain its credibility after having let inflation get out of control.
Stay tuned, there is more to come.
Dr. Scott B. MacDonald is Chief Economist at Smith’s Research & Gradings. Prior to this, he was Senior Managing Director and Chief Economist at KWR International, Inc (KWR). Prior to KWR he was the Head of Research for MC Asset Management LLC, an asset management unit of Mitsubishi Corporation based in Stamford, Connecticut (2012-2015) and Head of Credit & Economics Research at Aladdin Capital (2000-2011) and Chief Economist for KWR International (1999-2000). Prior to those positions he worked at Donaldson, Lufkin & Jenrette, Credit Suisse and the Office of the Comptroller of the Currency (in Washington, D.C.). During his time on Wall Street, he was ranked by Institutional Investor magazine as one of the top sovereign analysts.