Blame, blame, blame — the media, Congress, and others are blaming bank supervisors, deregulation, and previous administrations in an effort to assign responsibility for the collapse and subsequent fallout from the demise of Silicon Valley Bank and Signature Bank. Interestingly, little blame has as yet been ascribed to the boards, owners, and managers of the banks. Why did these banks suddenly fall victim to runs on their deposits? The causes are not complex and are but a repeat of past history when banks took risks that made them vulnerable.
There are really four kinds of risks that banks face. The first is credit risk — banks are exposed to losses when borrowers default on their loans. This is what happened, for example, during the Great Financial Crisis in 2008. Real estate borrowers were highly leveraged and defaulted, imposing losses on institutions that had specialized in real estate lending. The second form of risk is interest rate risk that is incurred when lenders borrow short term and lend long term. When interest rates rise, short-term funding costs increase, while returns on assets don’t increase in parallel, putting a squeeze on profits and potentially resulting in losses great enough to cause an institution to fail. This is exactly what happened during the S&L crisis in the late 1980s and early 1990s, when nearly a third of all S&Ls failed. The roots of the crisis were deregulation of thrift institutions, aggressive lending into a real estate bubble that burst, and speculation. The third risk is liquidity risk, when institutions face withdrawals of funds and do not have access to sufficiently salable assets to meet withdrawal demands. Usually, liquidity risk results when institutions attempt to respond to the losses imposed when depositors realize that the costs of interest rate risks may impact their ability to access their funds and seek to withdraw them. Liquidity risk is especially important when institutions have large amounts of uninsured deposits. Finally, there is fraud risk when management engages in illegal activities. The way to deal with all but the fraud risk, according to Nobel Prize economist Doug Diamond, is to diversify, which, as we shall see, neither bank did (Shawn Tully, “The economist who won the Nobel for his work on bank runs breaks down SVB’s collapse—and his fears over what’s next,” March 15, 2023, Yahoo).
What do we know about the risks that SVB and Signature Bank took? It turns out there is really nothing new here. While credit risk was not an important factor, SVB was exposed to significant interest rate and liquidity risks that resulted in a run on the bank. On the asset side, SVB had 57% of its assets in Treasuries and agency securities booked at low yields before the Fed began raising rates, thus exposing the bank to significant interest-rate risk. The problem was made worse because about 94% of its liabilities were in the form of uninsured deposits. By comparison, the median percentage for the ten largest US banks is about 46%(calculations based upon https://www.businessinsider.com/signature-svb-us-banks-have-over-1-trillion-uninsured-deposits-2023-3). Again, this meant that the bank’s liabilities were not diversified and, as Diamond suggests, the key is to have a diverse depositor base, not only geographically but also including smaller retail accounts, which are sticky and not as likely to run. So, in SVB’s case, it committed two cardinal sins by shunning the principles of both asset and liability diversification, exposing the bank to interest-rate risk and runs.
Like SVB, Signature Bank had large, uninsured deposits accounting for about 90%, or $88 billion, of its deposits, of which $16.5 billion were crypto deposits. But Signature Bank did not have the asset concentration that SVB had. For example, it had about 27% of its assets in a mixture of Treasury and agency securities; about 30% were mortgages; and about 36% were commercial and industrial loans. When markets became aware of the large amount of uninsured deposits in Signature Bank on the heels of the run on SVB and realized that Signature did not have sufficient ability to liquidate assets to meet potential withdrawal demands, a run was triggered. In Signature Bank’s case the lack of deposit diversification and reliance upon large amounts of uninsured deposits were the causes of its ultimate takeover by the FDIC.
The downfall of both of these institutions reflects the failure to learn the lessons from past crises and what can happen when interest rates begin to rise — if there is a lack of diversification and insufficient liquidity to meet demands for funds. Some have blamed regulators for lax oversight, but deregulation laws promulgated by Congress removed some of the oversight of regional banks in 2018, when the size threshold for more stringent federal oversight was raised from $50 billion to $250 billion. Similar deregulation of the thrift industry clearly contributed to the S&L crisis of the late 1980s. History has repeated itself, only with different actors. But the causes are not new, nor are the remedies. This simply Banking 101.
One last point. When I was at the Federal Reserve Board in 1979, right before the FOMC began to tighten rates to stem the ramped up inflation we were experiencing, Chairman Volcker called me and one of my staff into his office and said that he wanted to know how much pressure in terms of interest-rate increase the money-center banks could endure without causing a crisis. I wonder who at the Fed may have asked what institutions, and in particular money-center and regional banks, might be vulnerable to a sharp rise in interest rates this time around.
Robert Eisenbeis, Ph.D.
Vice Chairman & Chief Monetary Economist
Email | Bio
Links to other websites or electronic media controlled or offered by Third-Parties (non-affiliates of Cumberland Advisors) are provided only as a reference and courtesy to our users. Cumberland Advisors has no control over such websites, does not recommend or endorse any opinions, ideas, products, information, or content of such sites, and makes no warranties as to the accuracy, completeness, reliability or suitability of their content. Cumberland Advisors hereby disclaims liability for any information, materials, products or services posted or offered at any of the Third-Party websites. The Third-Party may have a privacy and/or security policy different from that of Cumberland Advisors. Therefore, please refer to the specific privacy and security policies of the Third-Party when accessing their websites.
Cumberland Advisors Market Commentaries offer insights and analysis on upcoming, important economic issues that potentially impact global financial markets. Our team shares their thinking on global economic developments, market news and other factors that often influence investment opportunities and strategies.
