Three lessons that should be learned from this week’s bank failures
Published Mar 16, 2023 • Last updated 1 day ago • 4 minute read
A Silicon Valley Bank office in Tempe, Arizona. Photo by REBECCA NOBLE/AFP via Getty Images files We all know the old expression, “waiting for the other shoe to drop.” Well, the shoes are now dropping following governments’ excessive deficit spending during the pandemic.
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Access articles from across Canada with one account Share your thoughts and join the conversation in the comments Enjoy additional articles per month Get email updates from your favourite authors The first shoe was runaway inflation, which by June of last year had reached 9.1 per cent in the U.S., 8.6 per cent in Euroland and 8.1 per cent in Canada. To get it back down to two per cent, central banks have been hiking interest rates. On Tuesday we learned that U.S. inflation is still six per cent year-over-year, so the Federal Reserve has a way to go yet. Six per cent was down, which is good, but February’s inflation (seasonally adjusted) was 0.4 per cent, slightly above the average of the previous six months. Not good news for Main Street.
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This past week, the second shoe dropped, with three mid-sized U.S. banks failing and several more under stress, including rapid deterioration in their share prices. Ten-year old Silvergate Bank, which ceased operations March 8th, catered to institutional investors moving currency in and out of crypto exchanges, including FTX. SVB’s collapse arose from its exposure to start-up companies in its home base of Silicon Valley. As interest rates rose, SVB was caught by tech companies withdrawing deposits to cover cash shortages, forcing it to sell longer-term treasury bills and mortgages at a loss. Regulators closed Signature Bank on Sunday as investors withdrew their deposits in a panic due to its exposure to the crypto businesses that accounted for 27 per cent of its deposits.
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Article content The Biden administration having declared the failed banks systemically important, even uninsured depositors — those with balances of more than US$250,000 — will be fully protected, which is good news for the crypto and Silicon Valley companies that had large, in some cases very large, deposits with these banks. That helps Wall Street, not Main Street.
A painful irony is that all this is happening near the anniversary of Bear Sterns’ collapse 15 years ago today (on March 16, 2008). To stop contagion then, the Federal Reserve arranged for JP Morgan Chase to buy Bear at a fire-sale price of US$236 million. When six months later Lehman Brothers went bankrupt without a rescue, stock prices plummeted and several large financial institutions had to be bailed out. The direct cost of the bailout, as measured by MIT’s Deborah Lucas, was a cool $US500 billion.
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Article content Although the institutions involved are much smaller the U.S. faces a similar situation today. When governments — read “taxpayers” – act as lenders of last resort, they hope to keep depositors from losing confidence in other banks. Yet bailouts carry their own risks. A financial crisis can lead to a major downturn in the economy. But if people learn central banks will always cover their losses, banks, investors and depositors will take on more risk. Yes, management can make mistakes, but investors also have a responsibility to ensure they are dealing with sound banks. Or should have. If bailouts are guaranteed, however, why bother?
With low interest rates since 2009, caution has been cast to the winds. The market has been irrationally exuberant over lightly-regulated crypto. Start-up tech shares were bid to dizzying levels even when companies had no earnings. Regulators treated government bonds as “safe assets” when judging bank capitalization, yet these assets lost value as interest rates rose.
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Article content Curb evasion with simpler taxes, not more auditors: Opinion Freezing insurance premiums won’t work: Opinion Personal health spending accounts deserve a close look: Opinion Three lessons should be learned from this week’s bank failures.
First, with taxpayers as the lender of last resort, policies need to curb moral hazard. When things go bad, bank managements should be replaced, and, unlike in 2008, bond and equity owners should lose their wealth. Stress testing and higher capital requirements should be extended to the larger mid-sized banks, which were previously exempt.
Second, past errors in monetary policy have contributed to today’s problems. Central bankers must be held accountable for both the recent inflation and the higher interest rates that have been necessary to fight it. Being fired by politicians who, given the state of public finances today, are at least equally to blame may not be appropriate. But management compensation could be made to depend on hitting inflation targets. It certainly shouldn’t be indexed!
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Third, politicians need to be wary of stoking inflation with either higher government spending or taxes that deaden the private economy’s capacity to expand supply. Last week, President Biden presented a dead-on-arrival 2023 budget replete with spending hikes and large tax increases on employers. The likely outcome is another bi-partisan compromise to extend the debt limit but little action to reduce either spending or taxes.
Given the Biden bailouts, the market will likely settle down. But it will worry that if the Federal Reserve continues to hike interest rates to speed inflation’s decline, more banks will fail and even bigger shoes drop.