Bank Failures: Frequently Questioned Answers

Correcting five myths about the recent bank failures.

By Robert Thorpe

You can learn a lot by reading about the recent banking crisis.  Unfortunately, more than a few journalists and commentators have got the wrong end of the stick.  This article is about some bad answers I've seen to questions about the financial crisis.

1. The Bank Failures We've Seen So Far Were Bigger Than 2008.

I have read several articles and infographics comparing the bankruptcies we've seen so far to 2008.  The idea is simple, taken together Signature Bank, Silicon Valley Bank and First Republic Bank had about $548.5B in assets[1].  This is more than the $373.6B of assets associated with failed banks in 2008.  For example, Investopedia gave us this.  Others will tell you that even if you adjust for inflation the 2023 bank failures were bigger than 2008. For example, the New York Post mentioned that and so did the New York Times.

To be fair, most of these articles are careful enough to discuss the differences between today and 2008.  The problem with these pieces though is that they discuss only commercial banks.  In 2008 two large Investment Banks failed - those were Bear Stearns and Lehmann Brothers.  Then there was the bailout of the insurer AIG.  As 2008 progressed the two mortgage securitization companies Fannie Mae and Freddie Mac got into trouble and were taken in the "conservatorship" of the Federal Government.  Any one of these collapses was much bigger than what has happened so far in 2023.  In inflation adjusted terms even Bear Stearns had assets-under-management of $571B and it was the smallest of the businesses I've mentioned here[2].

2. We’ll Look Back and Talk About the Bank Failures of Spring 2023.

Some people are rushing to label bank failures a thing of the past.  I've already heard people talk about them as though there will be no more of them.  We're not out of the woods yet, there could still be more.  The finances of some banks (and other financial institutions)[3] are still looking shaky.  The Federal Reserve may well stop raising the interest rate, but that doesn't mean they will start cutting the interest rate.  In addition more and more people are choosing to save by using money-market-funds instead of banks.

3. Banking Regulation Has Generally Worked Well.

After the First World War military planners prepared for future wars.  Some of them believed that future wars would be like WWI.  As it turned out, the Second World War was very different.  A similar problem has occurred in bank regulation.

In 2008 the big problem was bad loans - it was credit risk.  More homeowners were delaying payment or fully defaulting on their mortgages. That in turn dragged down mortgage backed securities.  What has happened this time is very different.  Many securities pay fixed returns; bonds are the best example of that.  As other competing assets provide higher returns that reduces the price of bonds.  I explained this in my earlier article on Silicon Valley Bank.  The problem this year has been interest rate risk.

Recent US banking regulations have done very little about interest rate risk.  The Fed applies stress tests to banks.  It turns out that the Fed wasn't even looking at interest rate risk.  Patrick Honohan is the former head of the Central Bank of Ireland.  He wrote about this in an article for the Peterson institute[4].  He tells us that none of the Fed's stress tests examined higher interest rates.

Indeed, every severely adverse scenario used by the Fed since 2015 has the 3-month Treasury bill rate ending up at 0.1 percent. Many historic episodes of severe economic downturn have indeed been accompanied by low interest rates, as the Fed used its policy tools to support aggregate demand. But it is a bit strange that not since 2015 has a stress test involved rising interest rates.

Jamie Dimon of J.P.Morgan-Chase mentioned the same thing in a recent letter.  This is the classic problem of regulators looking in the rear-view-mirror.

4. Trump-Era Regulation Rollbacks Made Banks More Reckless.

The Dodd-Frank partial repeal happened in 2017 and 2018, through the "Financial Choice Act" and the "Economic Growth, Regulatory Relief and Consumer Protection Act".  After that, banks with less than $250 billion in assets were no longer required to undergo annual stress tests.  Before that it was only banks with less than $50 billion in assets that were exempt from stress tests.

Because of the $250B cut-off First Republic Bank, Silicon Valley Bank, Signature Bank and Silvergate did not have to do all the same stress tests that larger banks had to do.  However, as discussed in the above question, those stress tests did not test rising interest-rates!  The one thing that has been crucial to the 2023 bank crises was the one thing not tested.  All of the banks I mentioned would have looked very good with the sort of scenarios where the 3-month treasury bill rate fell to 0.1%.

The weakening of the "Volcker rule" may have made a difference in the cases of Signature Bank and Silvergate Bank.  However, the loosening of the Volcker rule was an initiative of the Fed *itself*. It was also done much later, in 2020.

5. Things Will Be Better in the Future.

In all of the recent bank failures the customers were all paid.  Every person and business that had an account at Silvergate, Signative, SVB and First  Republic has lost nothing.  The Federal government ensured that through the Federal Reserve and the Federal Deposit Insurance Corporation (FDIC).  Normally, the FDIC only guarantees up to $250,000 for each person and each company.  In all of the banks that have failed there were many customers that were keeping much higher balances.

On the surface this is good and it probably helped prevent a stock-market crash.  In the long run though, it creates a perverse incentive.  Big businesses usually look closely at the banks they use.  They examine the solvency of those banks carefully.  After all, they stand to lose a great deal in a bank failure.  Often large firms employ a corporate treasurer.  That person spreads out the firm's money across several banks which the treasurer believes are safe.  The FDIC guarantee amount of $250K is small in the scale of big businesses that hold millions.  This fact creates a layer of checking separate to regulation.  Banks that are risky would attract fewer customers.

The recent actions have taken away the incentive to do this.  In the four recent bank failures nobody with an account lost anything.  So, businesses may reasonably take the view that this will happen again in the future.  They may assume that they will not have to bother checking the safety of banks in the future.  What I wrote in the paragraph above may become a thing of the past.

The investor and economist Cliff Asness put it like this:

The moral hazard here is we’ve greatly reduced the incentive for depositors of any size now … to actually give a moment’s thought to the riskiness of where they’re putting their money.

This is storing up problems for the future.

[1] - The figure is $532B according to some sources.

[2] - If you're interested in reading about this in more detail, the Wall Street Journal have an article on it.

[3] - The "other financial institutions" bit is important.  Many financial businesses that are not banks do not have access to the "Bank Term Funding Program" - the emergency program that the Fed, Treasury and FDIC created this year.

[4] -  In another article Honohan describes the SVB failure from his perspective as a technocrat.