Bankers and Regulators Fail Money and Banking 101

(Andrii Yalanskyi/Shutterstock)

Commentary

During the 2008 financial crisis, banks failed because they assumed too much credit risk by holding complex assets that defaulted. So far during the 2023 crisis, banks have failed because they took on too much interest rate risk by holding too much long-term fixed-rate debt, including U.S. Treasuries. That’s a mistake undergrad economics majors aren’t supposed to make, which raises the question of who’s running major financial intermediaries.

Bank regulators make mistakes. One of the most important goals of bank regulators (famously called a “crazy quilt” composed of the Federal Deposit Insurance Corporation (FDIC), the Federal Reserve, the Office of the Comptroller of the Currency, and/or state banking authorities) is to keep incompetent bankers out of the industry. They closely scrutinize the founders of brand-new banks and track the quality of management at established banks via the M in their CAMELS rating system (Capital adequacy, Asset quality, Management, Earnings, Liquidity, and Sensitivity). Not since the Savings and Loan crisis in the 1980s have regulators turned over the “keys to the kingdom”—deposits—to such unworthies.

Banks transform short-term liabilities, such as deposits, into long-term assets, such as loans and securities. Liabilities fund bank assets acquisition; cash flow from those assets allows banks to service their debts, including deposits and borrowings from other banks.

That might sound easy, but banks face two major challenges when it comes to intermediation and the related risks.

First, banks generally seek to diversify their pool of depositors and borrowers to manage liquidity and credit risk. If most of a bank’s depositors (and borrowers) are farmers, the bank exposes itself to the risk of unexpected depositor withdrawals and loan defaults if some shock strikes the agricultural sector.

Second, banks face interest-rate risk, or changes in the value of assets and liabilities due to changes in interest rates. When interest rates rise, the market price of its fixed-rate assets falls. That holds even for assets, such as U.S. Treasuries, safe from default risk. Interest-rate risk intensifies when a bank has more interest-rate-sensitive liabilities than assets, which raises the cost of maintaining demand deposits.

Silicon Valley Bank (SVB), Signature Bank, and First Republic Bank failed the first introductory lesson because, in each case, most of their deposits came from a few wealthy and cliquish investors.

Lisa Shalett, chief investment officer of Morgan Stanley Wealth Management, states that SVB clients had a “unique inter-relatedness.” These clients were mostly major private equity and venture capital firms who were managing the portfolios of numerous tech firms throughout Silicon Valley.

Rachel Louise Ensign and David Benoit of the Wall Street Journal point to similar factors with Signature. While Signature initially diversified and found success in its first two decades, digital- and crypto-asset companies controlled 27 percent of Signature deposits as of the early part of 2022. Those companies didn’t do well after FTX imploded in November 2022.

Similarly, Jesse Pound at CNBC states that First Republic catered to “high net worth individuals and their businesses.”

Most of the deposits in the failed banks were beyond the FDIC-insured limit (SVB, Signature, and First Republic had uninsured percentages of 94 percent, 89 percent, and 67 percent, respectively), not smaller, more stable retail deposit accounts. By way of comparison, in 2021 only 40 percent of all deposits in the U.S. banking system were uninsured by the FDIC.

The banks could have survived large deposit withdrawals, though, had they not inappropriately managed their interest-rate-sensitive assets and liabilities.

The Federal Reserve has increased its target interest rate 10 times over the last year or so, to between 5 and 5.25 percent today. Those increases alone shouldn’t have caused insolvency, given that everyone knew that rate increases were likely. Anybody who has passed Money and Banking 101 would know what to do: decrease fixed-rate long-term bonds and loans in favor of interest-rate-sensitive assets, such as short-term debt and variable rate loans, and use derivatives, such as interest rate swaps, to hedge any residual risk.

But the bankers didn’t do that. When SVB failed, for example, the bonds and mortgage-backed securities it owned had maturity lengths of 10 years or more. If they had had a larger portion of assets sensitive to interest rates, they might have fared better. First Republic was also inexplicably heavily invested in long-term assets. And each of the failed banks appears to have been focused on culture war issues instead of financial fundamentals.

We hope there aren’t further bank runs or FDIC takeovers, but other large commercial banks appear to also rely on a relatively few large depositors and long-term assets. Regulators need to be more careful about who they turn the keys to the kingdom over to.

Views expressed in this article are opinions of the author and do not necessarily reflect the views of The Epoch Times.