A needed primer on bank failures – Twin Cities

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Edward Lotterman

All of a sudden, shaky banks are back in the news.

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

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

Who knows? As pundits by the score debate whether this is a “bailout” that incentivizes “moral hazard,” or a failure or regulation, it is clear that many intelligent laypersons don’t really understand banking. So let’s step back and review relevant basics.

Banks are financial intermediaries. They link 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 latter group, borrowers, pay interest. Savers may receive interest or may simply benefit from payment services such as checking accounts.

As intermediaries, banks also perform transformations. These may be in size or denomination — on one hand, thousands of household accounts, each with a few hundred to a few thousand dollars saved, get turned into loans to buy $10 million locomotives. On the other, $20 million from a single pension fund may be transformed into thousands of credit card accounts with balances of a few hundred to a few thousand bucks.

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

Finally, intermediation and transformation may be in risk. A tangible fraction of mortgages, auto loans and credit card accounts don’t get paid — but a bank with thousands of such accounts, and collateral, can manage its pricing to cover losses. Depositors run no risk, if their savings are under the amount covered by the Federal Deposit Insurance Corp. and little above that. Banks themselves pay the premium for this insurance, not taxpayers, yet banks also charge customer fees to protect their bottom lines.

Moreover, many thousands of households may have a money market fund in their retirement accounts. Those funds may buy financial commercial paper banks sell to get money wholesale to make consumer credit loans. The people with the retirement account run no risk because of the two-stage intermediation, retirement saver to mutual fund to bank to borrower.

Understand also, that there are two ways a bank can “go bust.” One is illiquidity, the inability to turn assets like collateral, loans and investments into cash rapidly enough to meet demands for cash, even if the value of 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 bank failures of the “run-on the bank” type shown in the movie “It’s a Wonderful Life,” are caused by illiquidity. The film’s fictional small-town “Bailey Building & Loan” made mortgage loans that were being repaid, but when all the depositors wanted to withdraw passbook savings at the same time, banker George Bailey could not demand that mortgages be paid early. His family’s savings and loan would “go bust.”

Then there are bank failures due to insolvency. In the 1980s, thousands of rural agricultural banks were closed by an FDIC team that showed up on a Friday afternoon with a locksmith and 20 pre-ordered pizzas. No depositors crowded outside demanding their funds. But these banks had made land mortgages and operating loans to farmers who were going bankrupt. Many of the loans were near worthless. The banks were busted even if they had cash in the tills to give to depositors.

Most of the bank failures in the 2007-08 era were caused by insolvency from mortgage loans going bad, and the moral hazard of bundling those loans into securities that were traded ever higher 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 seem to suffer from illiquidity. Switzerland’s Credit Suisse is a case by itself involving both illiquidity and insolvency.

In econ textbooks and past history, illiquidity was prevented by a “reserve requirement.” Banks could not loan out 100% of their deposits. Some had to be held in reserve as ready cash to satisfy withdrawals. That 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 needed.

In intro econ courses, this “required reserve ratio” usually is 10% to ease calculations for the prof’s blackboard examples. However, in practice in our nation, it is effectively zero.

Federal Deposit Insurance also was instituted to reduce failures due to illiquidity. If the public is confident they will always get their $10,000 or $100,000 or, nowadays, $250,000 out, they don’t worry. There are no angry crowds outside banks.

However, as Silicon Valley Bank found out, business depositors with accounts in the tens of millions can and do rush to withdraw. Even a large bank can be illiquidity-busted in a couple of days.

The vaccine against insolvency is the capital of the owners, the fraction of assets that is not owed to anyone. Bank regulators monitor capital adequacy relative to state and federal banking law. Capital won’t always protect a bank from failure, but it can give regulators time to close the bank down while all depositors can get paid.

The final econ lesson is that the “par” or “face” value of a bond or promissory note and its market value on any particular day can vary widely. The SVB failure puzzles many, and is unique, in that most of its assets were not risky loans to businesses or persons, as in 2007-08. They were in long-term Treasury bonds. There never has been a case in which such a bond did not pay both interest and principal when due. U.S. Treasury bonds are the zero-risk investment par excellence. And no one is questioning that in this case.

So what happened?

Well, if you have a piece of paper saying U.S. Treasury, 30 years, $10,000 and 2.98%, you will get $298 interest every year and $10,000 at the end of 30 years. No risk at all.

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

So SVB had assets that were perfectly “safe” to cover deposit liabilities in the long run, but could not sell its bonds to come up with cash in the short run. And its Big Tech depositors — more than 90% far exceeding the FDIC’s insured account limit — wanted their cash.

So all this is background to the key policy question: When — and why — should government, through its bank regulating and insuring agencies, intervene to keep banks from failing? That is a complicated question meriting a column of its own.

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