Bank closings signal tighter lending, disinflationary trend

Newswise — David Andolfatto, professor and chair of the Department of Economics at the University of Miami Patti and Allan Herbert Business School, blamed the collapse on March 10 of the Silicon Valley Bank, a popular lender for Silicon Valley start-up tech companies, and two days later the Signature Bank in New York, on poor risk management and imprudent decisions relating to federal interest rate hikes. 

Federal regulators carried out a rescue of the two banks and issued a joint statement to explain that their action to close the two banks was meant to “protect the U.S. economy by strengthening public confidence in our banking system.” They promised that taxpayers would suffer no losses and that all depositors of the two banks would be “made whole.” 

The collapses and subsequent federal intervention rattled the financial system and caused the stock markets to tumble. As a result of the federal action, President Joe Biden said, “every American should feel confident that their deposits will be there if and when they need them." 

Andolfatto, who served previously as the senior vice president of the Federal Reserve Bank of St. Louis and the special advisor to Christopher Waller, the board’s governor, answered the following questions related to the government’s bailout. 

The Federal Deposit Insurance Corporation (FDIC) was established 90 years ago during the Depression and the most severe banking crisis in the nation’s history. What is its role, and how and when does it function?

The FDIC’s primary role is to ensure small depositors that their money is safe. When a bank goes bankrupt, the FDIC makes sure that the bankruptcy is resolved in an orderly manner and without disruption to the payments system. 

What sort of reserves does the FDIC have and how is it funded?

The FDIC is an independent government agency. It receives no funding from Congressional appropriations. The agency generates its reserves through the premiums it charges its member banks. 

What prompted the Silicon Valley Bank (SVB) in Santa Clara, California, and the Signature Bank in New York to close?

Essentially, these banks did not manage the risks on their balance sheets appropriately. They were betting that interest rates would not rise or, at least, not rise so dramatically. When rates rose sharply, the value of their long-duration (and unhedged) assets declined. Large (uninsured) depositors pulled their funding from these banks. 

In what ways is the closure of these mid-tier banks related to the Fed’s interest rate hikes to control inflation, which, since March 2022, have been the fastest clip since the 1980s?

It is highly related to the Fed’s interest rate policy. They were imprudently betting that rates would not rise or not rise as rapidly as they did. Nor did SVB submit to the Basel III (international agreed set of measures) requirements recommending a sufficient liquidity coverage ratio and net stable funding ratio. The former ensures that the bank has sufficient high quality liquid assets and the latter ensures that a sizable fraction of deposit funding is stable. 

Was the closure of banks foreseeable, not necessarily these two, but others, because of the rate hikes?

Regulators probably should have seen the risks, but it is difficult to predict the behavior of depositors. In the case of SVB, depositors turned out to be very skittish.

Is this the beginning of a trend of bank closures? To what degree should we be worried?

I doubt that most banks managed their risk as poorly as SVB. But what we should expect is that all banks will now try to repair their balance sheets to avoid a similar fate. This will mean tighter lending standards and a contraction in bank lending. The effect will be disinflationary, the trend for inflation rates to fall. 

Are there other components of the financial system that are vulnerable or will become vulnerable as a result of the Fed’s aggressive moves to control inflation?

Possibly in the shadow bank sector, as in 2008-09. But that sector is now better regulated since Dodd-Frank, the 2010 legislation that created the Consumer Financial Protection Bureau, the agency tasked to protect consumers from deceptive and predatory financial practices by ensuring that banks, mortgage and student loan lenders, and credit card companies play by the rules.

President Franklin Delano Roosevelt in the 1930s initially resisted signing the federal insurance Glass-Steagall Act 1933 because he believed it encouraged bad behavior. Do banking insurance programs encourage “bad behavior”?  

Economists refer to this as “moral hazard.” The phenomenon is not necessarily “bad” or “immoral.” What it refers to is the alleged propensity of insurance to encourage risk-taking. If a person has fire insurance for their home, they may be less likely to take precautionary measures that would prevent a fire, for example. While such behavior likely exists, there is much debate over how quantitatively important it is. The same is true with deposit insurance for banking.