The sudden collapse of a Silicon Valley bank on March 10 drew an equally swift response from US regulators, who announced plans to make all depositors, including uninsured ones, whole. But the failure of SVB was immediately followed by the collapse of Signature Bank of New York on March 12 and the problems of Credit Suisse a week later.
The latter, once the world’s largest investment bank, is now being taken over by UBS at a huge discount. Assuming media coverage tells the whole story, there is a clear reason for these unexpected failures. SVB took many large deposits from technology companies (over the $250,000 limit insured by the Federal Deposit Insurance Corporation) and used those funds to buy long-term bonds. But after the US Federal Reserve began rapidly raising interest rates last March, the market value of those bonds fell and unrealized losses on SVB’s balance sheet grew. Although SVB announced that its bonds would be held until maturity, it had to sell some of them at a loss to free up liquidity. When the losses were reported, depositors — fueled by warnings on social media — feared the worst and rushed to withdraw their deposits, triggering a classic bank run. Once the run was underway, a “fire sale” of excess bonds to free up liquidity became inevitable, and SVB’s liquidity crisis became an insolvency crisis.
It is not controversial to bail out all SVB depositors, including those whose deposits exceed the FDIC cap. Critics of the ex-post guarantee argue that the state imposes the rules as such and induces moral hazard (irresponsible behavior in the future).
While proponents of the bailout, including Treasury Secretary Janet L. Yellen and Federal Reserve Chairman Jerome Powell, acknowledge these problems, they are far more concerned about systemic risks. They have a point. After all, a botched bank robbery at a major institution can set off a domino effect and derail the broader banking and financial systems. Indeed, some banks are too big to fail, and systemic risk is fatal to any economy. We saw this firsthand during the US savings and loan crisis in the 1980s, the Japanese banking crisis of 1997-1998, and the US subprime mortgage crisis of 2008.
However, the temporal inconsistency of policy making (inventing new tools and rules after the fact) creates a difficult problem. In this case, the bank suddenly made the optimal policy—limited deposit protection—suboptimal. However, by breaking their own rules, regulators risk losing their credibility. This is where moral hazard comes into play. Now that the US authorities have issued a retroactive cover guarantee, all depositors expect that all deposits will be protected. They correctly invest deposits in institutions offering higher interest rates, but banks with weak liquidity limits usually offer such competitive rates for large deposits. These depositors of weak institutions can now anticipate that they will become bankrupt if the institution fails.
Consequently, they no longer have oversight of the financial system. And make no mistake: bank managers are motivated to take a lot more risk. On the other hand, if their risky loans do not become delinquent, their institutions make great profits and receive handsome compensation. On the other hand, if their loans go south, they simply leave the bank and move on to the next thing (remember, SVB paid bonuses the same day it failed).
There are ways to mitigate moral damages. First, depositors should be guaranteed capital but not interest payments (or at least higher than average payments). Second, the salaries of bank managers from the pre-crisis period—for example, the three previous years—should be recovered, and all pending bonuses should be cancelled. One of the reasons the 2008 bank bailout was so unpopular was that executives continued to receive bonuses. This must not be repeated in the current crisis. What happens next? It is reasonable to expect that as interest rates continue to rise in the US and Europe, more banks will experience higher unrealized losses on their long-term bonds. As with SVB, all it takes are rumors or fear about a bank’s solvency to trigger another rally, especially when there is still uncertainty about how far regulators are willing to go.
In Japan, where inflation is much lower than in the US and Europe, the rise in long-term bond yields (which reduces the market value of previously purchased bonds at lower prices) is very limited. The Bank of Japan continues to intervene in the market to limit the ten-year bond rate by 50 basis points. But if Japan’s inflation rate continues to rise for the rest of the year, some of Japan’s regional banks could face a liquidity crunch that could trigger a bank run. Although this is far from the main scenario, it cannot be ruled out.
