On Friday, March 10, Silicon Valley Bank (SVB) was closed by the California Department of Financial Protection and Innovation and went into receivership. To protect depositors, the Federal Deposit Insurance Corporation (FDIC) created the Deposit Insurance National Bank of Santa Clara so insured depositors could access their deposits. The standard deposit insurance amount is $250,000 per depositor, per insured bank, for each account ownership category.
SVB faced a liquidity crunch spurred by its failure to hedge against the Federal Reserve’s (Fed) aggressive but necessary increases in the federal funds rate. The Fed has been raising the federal funds rate to combat inflation.
The SVB clientele was too concentrated in venture capital (VC) firms and tech startups. Nearly half of VC-backed startups conducted business with SVB. According to one SVB senior executive quoted in the Financial Times:
It turned out that one of the biggest risks to our business model was catering to a very tightly knit group of investors who exhibit herd-like mentalities.
Tech startups have been burning through their cash deposits as liquidity has dried up because the Fed has been raising interest rates aggressively. Simultaneously, businesses withdrew funds to find other outlets for higher yields. Because SVB’s depositor base was primarily businesses and not individuals, they were more sensitive to the interest they were receiving on deposits. To stem outflows, SVB needed to pay higher interest on deposits (interest expense) but did not have enough capital to fulfill withdrawals from deposit accounts. SVB had already purchased billions of dollars in long-term Treasury bonds (interest income) that lost value when the Fed started raising interest rates. The difference between SVB’s interest income and interest expense, or net interest margin, exposed SVB’s billions of dollars in unrealized losses on its investment portfolio. This sparked concern with depositors who were concerned with financial stability of SVB.
The Treasury bond fire sale alarmed VC firms and their portfolio companies. Communication among the tight-knit tech community via social media platforms also exacerbated the crisis. Knowing that nearly 96 percent of deposits at SVB were above the FDIC’s $250,000 limit, depositors withdrew their cash, which tanked SVB.
On Sunday, March 12, the FDIC announced that the New York State Department of Financial Services closed Signature Bank (Signature) and placed it in receivership. The FDIC established a bridge bank to “stabilize the institution and implement an orderly resolution.” Former U.S. Congressman Barney Frank, a board member of Signature, stated “I think part of what happened was that regulators wanted to send a very strong anti-crypto message.” According to Frank, based on the fundamentals “there was no insolvency.” Exposure to cryptocurrency scared depositors. “In early 2022, some 27% of its deposits were from its digital-asset clients.”
According to the Wall Street Journal, Signature customers “told executives they felt more comfortable at giant banks.”
Like SVB, Signature also had a homogenous depositor base. The depositors were mostly businesses, which are more sensitive to interest rate returns than individuals, and “roughly 90% of deposits for Signature” were uninsured.
The Fed’s rate hikes have contributed to an outflow of deposits. S&P Global found that “U.S. banking deposits fell $166.38 billion sequentially in the fourth quarter of 2022…and that drain has continued so far in 2023, weekly data from the Fed shows.” In response to the Fed’s monetary policy, depositors have been searching for accounts that offer higher yields:
CD balances represented 9.6% of the total in the fourth quarter of 2022, up from a low of 6.8% in the first quarter of that year and the highest point since the third quarter of 2020. That includes a 22.4% sequential increase during the last three months of 2022 for time deposits in accounts with balances of less than $250,000, indicating a scramble to hold onto yield-seeking retail money.
By designating SVB and Signature as a “systemic risk,” federal regulators insured deposits beyond the $250,000 limit. Depositors will be fully reimbursed but SVB and Signature shareholders and bondholders will not be protected.
The Federal Deposit Insurance Corporation Improvement Act of 1991 created “an exception to the least-cost requirements, known as the systemic risk exception, that allows FDIC assistance without complying with the least cost rule if compliance would have ‘serious adverse effects on economic conditions and financial stability’—that is, would cause systemic risk—and if such assistance would ‘avoid or mitigate such adverse effects.’”
Taxpayers will be affected by the depositor bailout. The regulators have insisted that none of the losses associated with SVB and Signature “will be borne by the taxpayer,” but this statement ignores the increase in deposit insurance fees that banks will have to pay, which could be passed down to consumers in the form of higher fees. The FDIC stated that “Any losses to the Deposit Insurance Fund to support uninsured depositors will be recovered by a special assessment on banks, as required by law.” Taxpayers will ultimately pay more for banking services because of the regulators’ decision to fully insure all depositors, circumventing the $250,000 threshold.
In 2010, the Government Accountability Office (GAO) issued a report stating that “Regulators’ use of the systemic risk exception may weaken market participants’ incentives to properly manage risk if they come to expect similar emergency actions in the future.”
The report recommends that:
Congress should consider enacting legislation clarifying the requirements and assistance authorized under the systemic risk exception. Enacting more explicit legislation would provide legal clarity to the banking industry and financial community at large, as well as helping to ensure ultimate accountability to taxpayers.
Charles Calomiris, who is the director of the University of Austin’s Center for Politics, Economics and History and a professor of financial institutions at Columbia Business School stated in a recent article that “Virtually every academic study of deposit insurance shows that it promotes, rather than reduces, banking system fragility, with major costs borne by the insurers—which means ultimately by insured depositors and potentially taxpayers.”
Ken Griffin, the founder of Citadel Securities, condemned regulators’ decision to fully insure all deposits at SVB and Signature because of the moral hazard implications.
Keith Noreika, who formerly served as acting Comptroller of the Currency at the Office of the Comptroller of the Currency (OCC) told Semafor that:
“The FDIC and Fed had the chance to save the bank by allowing it to merge or finding a buyer for it, as they’re permitted by law to do. Had they done so, no uninsured depositor would be at risk. Instead, due to strong political pressure against merger approvals from the far left, they hesitated.
“Now they’re faced with the prospect of a full government bailout of uninsured creditors after the fact — which I am not even sure is permitted by law — and which could be quite expensive and set the future precedent that all deposits are insured, giving rise to moral hazard.”
Congress needs to crack down on the regulators’ “systemic risk” exemption and enforce the $250,000 barrier for deposit insurance. If regulators can remove the threshold at will, it will increase costs on banks and subsequently on consumers. Moral hazard is real and should be mitigated at all costs.
Bank regulators have increased capital requirements over the years, but still failed to stop the liquidity crunch. Banks such as SVB and Signature already had capital in excess of the stringent minimum requirements. According to SEC filings, Signature Bank was required to hold “Tier 1 capital to total risk-weighted assets of 8%.” As of December 31, 2022, Signature’s Tier 1 capital ratio was 11.20%. SVB was subject to a Tier 1 capital ratio minimum of 8.5%. SVB had a ratio of 15.26%. SVB’s equity capital-to-total assets ratio revealed infirmities in its investment portfolio. Former vice chairman of the FDIC, Tom Hoenig, aptly explained that “regulatory authorities need to stop pretending that their complex and confusing capital models work; they don’t.” It is abundantly clear that supervision, not regulation, failed.
Increasing capital requirements on small and regional banks will be detrimental to the economy. Andrew Ross Sorkin points out that “costs for businesses and consumers will go up in the short term” while the Fed continues to raise the cost of borrowing.
Regulators have piled on capital requirements for years and it did nothing to prevent this crisis. Poor investment decisions and management of interest rate risk coupled with shoddy bank supervision was a recipe for disaster. Regulators need to be held accountable for their failure to supervise and identify investment portfolio weaknesses and clientele homogeneity with SVB and Signature.
The knee-jerk reaction to rachet up regulations is a solution in search of a problem. Sen. Tim Scott (R-S.C.), ranking member of the Senate Committee on Banking, Housing, and Urban Affairs, hit the nail on the head by stating that “Building a culture of government intervention does nothing to stop future institutions from relying on the government to swoop in after taking excessive risks.”
In an attempt to stymie further deposit withdrawals at other banks, the Fed invoked its authority under Section 13(3) of the Federal Reserve Act to establish an emergency liquidity facility (“Bank Term Funding Program”) to backstop additional withdrawals. The Bank Term Funding Program (BTFP) will offer short-term loans to credit unions, banks, savings associations, and other depository institutions “pledging U.S. Treasuries, agency debt and mortgage-backed securities, and other qualifying assets as collateral” at par value. This new program acts as a form of quantitative easing, which could conflict with the Fed’s rate increases in an effort to combat inflation. Because the Fed is accepting collateral at par value, it will not be accounting for unrealized losses, which is risky but intentional.
Banks that have not yet failed are being propped up by the Fed’s BTFP. As Matt Levine points out, the creation of the BTFP “in some obvious sense amount[s] to a bailout of banks” and their shareholders and bondholders.
A note from Citigroup to clients highlighted concerns with continued outflows from bank deposits due to the continued quantitative tightening (raising interest rates). Even with the new BTFP, depositors could still be tempted to withdraw cash and park it at the overnight reverse repurchase agreement facility (ON RRP), which is offering an interest rate of 4.55%. One recommendation was to limit the amount of cash that be parked at the ON RRP.
The ON RRP, which was originally supposed to be a temporary liquidity facility, was never given a termination date. In 2014, the Fed intended to “phase it out when it is no longer needed to help control the federal funds rate.” With the increase in deposit outflows as a result of quantitative tightening, now is not the time to allow the Fed to expand the ON RRP and offer agreements with new entrants. Over time the Fed should find ways to conduct monetary policy without relying on the ON RRP.
ENVIRONMENTAL, SOCIAL, AND GOVERNANCE (ESG)
SVB placed a premium on woke initiatives. According to the Daily Mail, last year, SVB had no chief risk operator for as long as eight months, but committed at least $5 billion for clients’ sustainability initiatives. There is also speculation that SVB’s risk management boss in the U.K. branch, Jay Ersapah, was too focused on non-pecuniary initiatives and failed to hedge against increasing interest rates. All the while, Morgan Stanley Capital International (MSCI), which provides financial services analytics and ratings, adorned SVB with an “A” ESG rating.
Although the “A” rating is a nice PR stunt and surely attracted deposits from left-leaning tech startups, it did nothing to keep the bank solvent.
Inflation remains elevated, rising at a rate of 6%. Excluding energy and food prices, inflation is rising at a rate of 5.5%. Although slightly lower than inflation numbers in January, the rate remains significantly higher than the Fed’s average inflation target of 2%. It would be a bad idea to stop interest rate increases or reverse course just because a couple of banks conducted poor risk management and regulators failed their supervisory duties. There is no reason to fuel more inflation and harm the totality of the American economy.
As the next few weeks and months go by, the Fed will release a review of SVB’s supervision and regulation by May 1st; the FDIC will pursue another auction to finder buyers of SVB after the FDIC already rejected one offer; and the U.S. Department of Justice (DOJ) and the Securities and Exchange Commission (SEC) will investigate SVB and their executive’s stock sales prior to its collapse.
Watch ATR President Grover Norquist’s thoughts on Silicon Valley Bank.