the westminster news
Published by the students of Westminster School
By Mr. Blanton
Several high-profile banks, including Silicon Valley Bank (SVB), have recently failed. You may be asking yourself why? Good question. Your friendly neighborhood econ teacher is here with some answers.
Basically, banks are weird. Many people think a bank is like a storehouse, a personal vault. But when you open a checking account at a bank–in econ lingo, a demand deposit account–most of your money isn’t stored; it’s loaned. We call this practice fractional reserve banking. Banks only keep a fraction of your total demand deposit on hand at any given time–say 10%–and loan out the rest. So, if you deposit $10,000 into a checking account, the bank will only keep $1,000 in reserve and lend out the other $9,000.
Most of the time, this system works. Still, fractional reserve banking can be fragile, and it is easy to understand why. Since a bank will only keep a fraction of its total demand deposits on reserve, it will not have enough cash to pay all its customers simultaneously. If most of a bank’s customers demand their money back at the same time, the bank cannot pay its bills, and it defaults. This is called a bank run. If this happens to enough banks, it can spell trouble for the economy.
Bank runs and bank failures have preceded most major economic crises in American history, from the Panic of 1819 to the Great Depression. But only in the 1930s did the U.S. government create FDIC or the Federal Deposit Insurance Corporation. FDIC’s goal was to reduce the risk of bank runs. FDIC insures customers’ deposits up to a specific limit so your money will not disappear if the bank fails. The FDIC limit in the 1930s was relatively modest; currently, the FDIC limit is $250,000.
Despite its effectiveness, FDIC can only prevent bank runs sometimes, as we saw recently with SVB. SVB faced two significant risks. Many of SVB’s customers, including tech firms such as Roku, had deposits above the FDIC limit. These firms might keep more money in a checking account beyond the FDIC limit to meet company payroll, or they didn’t care. In any case, many of SVB’s deposits were uninsured.
SVB also miscalculated interest rate risk. When deposits at SVB increased significantly in 2020, SVB looked for ways to loan out those deposits. Since there was little demand to borrow and invest during the early phase of COVID, SVB used the influx of cash to buy ten-year U.S. Treasury bonds and other assets. Since bonds are loans, the length of time affects the interest rate–the price paid to the lender. At the time, these longer-term bonds paid a higher interest rate than short-term bonds, and government bonds are typically considered safe assets because the likelihood of the government not paying back the loan is very low. But SVB apparently did not consider what might happen if interest rates rose. When SVB purchased these government bonds, market interest rates were near zero. The Federal Reserve–the U.S. central bank–made it cheaper to borrow money to encourage new consumer and investment spending amidst the pandemic. However, in the last year or so, the Fed has raised interest rates from near zero to about 5% to combat inflation, which is like a price hike on all goods, not just some goods.
When interest rates rise like this, it often spells doom for bond prices. Here’s an example. Say I buy a $1,000 bond that pays a fixed 5% annual interest. That bond will pay $50 in interest every year. But if interest rates rise to 10%, the interest rate on my bond is still 5%. So the demand for my bond will fall because 10% is higher than 5%. To sell my $1000 bond, I have to reduce the price and take the loss. That’s what happened to SVB in a nutshell. They invested a lot of money in ten-year government bonds, but as interest rates rose, the market value of those bonds fell. When SVB reported billions in losses on its bond purchases, it sparked alarm among its customers that the bank may not have enough money on reserve to cover their demand deposits. People panicked — bank run.
What followed is unique and unprecedented in modern American history. The Federal Reserve and the U.S. Treasury acted to guarantee SVB’s deposits beyond the $250,000 FDIC limit. As an SVB depositor, you were safe. Good for Roku. Why did they choose to do this?
From the government’s perspective, bank failures pose a systemic risk. If one bank fails, it could spark a significant domino effect and undermine the U.S. financial system. The evidence of history offers some support for this view. Since bank failures sparked many significant economic crises, including the Great Depression, preventing that series of dominoes from falling was in the broader public interest. But there also is a moral hazard problem. If banks can be reasonably confident that if they fail and their customers’ deposits will be protected beyond FDIC limits, they may choose to take additional risks with their customers’ money. They’ll buy bonds today and Tesla stock tomorrow. In other words, the government might plug this hole in the dam, but its actions might create conditions for additional cracks in the future.
Both perspectives–team systemic risk or team moral hazard–are up for debate. Still, I would like to leave you all with this thought: what creates systemic risk is the fractional reserve banking system. As long as banks can take our money and transform it into financial assets such as bonds or mortgages, there will always be a risk of bank failure. SVB showed us that. So what’s eating the banking system? Itself.