caveat emptor, big depositors.
Greetings from the LHH! Technically we’re on break, so I’m writing to you from the LHH this week. We went to a classic Seacoast New Hampshire restaurant earlier this week, Newick’s Lobster House, and I was able to get this shot from our table looking out over Great Bay. Newick’s, IMHO, has the best fried seafood. If you come up this way, do yourself a favor and head to Newick’s for some fried clam strips - my personal favorite. It’s like eating a pile of deep-fried rubber bands - what’s not to like?! And you can look out over Great Bay and you might even see me out there in my kayak - it’s just a few miles from the LHH and I paddle in these waters regularly. It’s a Seacoast institution.
We got slammed with a nor’easter yesterday and had about eight inches of heavy, wet snow, followed by strong winds. I had to do two rounds of snow blowing. If you look at the tree trunk you can see the snow still coming down in the picture. And because it is March, today it is sunny and 45 degrees, so the snow won’t be sticking around.
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Soooo… we had a bank run and the Federal Government (through the Federal Deposit Insurance Corporation) took over a couple of regional banks, starting with the tech-bro bank, Silicon Valley Bank (SVB) that serviced a lot of Silicon Valley companies and venture capital funds. So why do we little people outside of tech-bro world care? I am not a banking expert by any stretch of the imagination, but here are my thoughts: 1) President Biden and down has promised that anyone with money at SVB will be made whole. This indicates a fundamental change in banking policy (unless Congress steps in, which I doubt it will); and 2) while SVB was overexposed to price risk, all banks are currently taking hits from increasing interest rates, so while this bank did some stuff to leave it especially exposed to interest rate changes, it could represent the tip of an iceberg of liquidity trouble in the banking industry overall, which could really hurt all of us.
I’m going to try to explain these two points the way I understand them. If anyone reading this is an actual banking expert, I welcome your corrections.
In today’s RWL, I am going to address point 1, why the Biden administration's actions are bad. I’ll answer point 2 on Sunday.
How Banking Works for Dummies
Here’s my shot at explaining basic principles by which banking in the US works. Banks are financial intermediaries, which means they go between two parties. Most people have a bank account where you have direct deposit for your paycheck or Social Security check or whatever other income you might receive. You put your money in the bank to keep it safe, and to earn some interest. Banks don’t pay interest on checking accounts because the money in those accounts is volatile. It comes in when you get paid, and it goes out as you pay your regular bills. However, banks do pay some interest on savings accounts, certificates of deposit, and other types of accounts. They are able to do that because they take your money and they lend it out to other people. If you bank at a local community bank, the money you deposit in your savings account is likely being loaned out to your neighbor so she can buy a new car or house. The bank pays you a small amount of interest, pools your money with other depositors, and turns around and loans your money (and other people’s money) to your neighbor at a higher amount of interest.
The taking in of deposits, pooling them, and then lending them out is the bank intermediation process. You could do this, too. You don’t need a bank to do it. You could go ask your neighbor if they need a loan and you could just write a contract to lend your neighbor your money. There are a couple of problems with that. First, your neighbor might not need a loan. Or she might need a lot more money than you have to offer, and for a lot more time. Second, you don’t have the skills to judge whether your neighbor is a good credit risk or a bad credit risk. Third, you don’t have experience writing legally enforceable contracts. The bank specializes in all three of these functions. People know they can borrow money from banks. Banks can pool funds from many savers. Banks are really good at evaluating the credit worthiness of borrowers. And banks specialize in writing these contracts that will stand up in court if you don’t pay them back. So instead of trying to do all these things yourself in your spare time, you just deposit your money in a bank and the bank pays you a smaller interest rate than you could (maybe) earn if you did it on your own. In a sense the bank rents your money from you, and then turns around and rents it out to someone else. The bank makes money by paying your, say, 2% interest, and then lending the money at 5% to a borrower. Their profit is in the spread - the 5-2 = 3%. That 3% has to pay for all of their operating costs - the tellers that take your money, the lending officer that makes a loan, the marketing, the big stoic buildings, etc., plus a profit for the bank owners.
Fractional Reserve Banking
When banks lend, it is typically for a fixed period - maybe five years for a car loan, ten years for an educational loan, or 30 years for a mortgage. However, when we make a deposit at a bank, even in our savings account, we don’t promise to leave our money with the bank for any particular period. The bank never knows how long it will have our money for, and it needs to be able to meet our unpredictable withdrawals at any time. Since they have to stand ready to meet a withdrawal request, banks don’t lend out all of the money they bring in. They have to keep some of that money on hand. This is the bank’s “reserve”. Let’s assume for simplicity that the bank maintains a 10% reserve policy. What that means is if the bank had deposits of $100M, it would lend out $90M and keep a reserve of $10M, either in vault cash (actual cash in their vault) or on deposit at the closest Federal Reserve Bank.
When you come into the bank to make a withdrawal (or you write a check or use your debit card), the bank would pay you with money from their reserves. A bank’s reserve cash is a bit like the water level in a tub. If you imagine you fill a tub part way, then simultaneously open the drain and turn on the spigot, as long as the water coming in matches the water draining out, the level of water in the tub would stay at the same level. As long as people trust the bank, they will keep depositing money (water into the tub), and keep withdrawing money at a relatively predictable rate (water draining out). Using our numbers from above, assume the reserve level is $10M, but $2M is withdrawn and $2M is deposited each week. As long as this holds true, the bank will have $10M in reserve at any given time. No problem.
Banking is based on trust. Before the Great Depression, banks deposits were not insured by the Federal Government through the Federal Deposit Insurance Corporation, FDIC). You loaned your money to the bank (that is what a deposit is - you loaning your money to the bank), and the bank would lend it out. If the bank made bad loans, it would lose money. If it lost enough money, eventually it would go out of business, and your money would go with it. Banks lose money all the time on bad loans (though hopefully they make more than they lose). That’s another reason for the reserve. When a bank makes a bad loan, it pays it out of its reserve. When a bank loses too much money, it can wipe out its reserves. When a bank’s reserves are wiped out, it can no longer pay customers withdrawals.
Let’s imagine a pre-FDIC bank. Let’s assume that there is a crash in the real estate market. Our bank has $10M in cash reserves and $90M in loans secured by real estate. As a result of the crash, the bank loses $12M on the loans - people stop paying, when the bank forecloses, it only gets $78M back. Now the bank has $88M in cash (assuming it converted all of its loans to cash) - $10M in reserves plus $78M in proceeds from the foreclosures, but it has $100M in obligations to depositors. If you are a depositor, and you hear that the bank is in trouble, what do you do? You go try to get your money out before the bank runs out of cash. But not just you. You and everyone else who has money in the bank. Everyone tries to get their money out all at once. This is called a bank run. Like this scene from It’s a Wonderful Life, except it doesn’t end happily.
Most likely, as a depositor, you would lose 22% of your deposits, assuming the losses are passed on equitably: the bank has $78M to pay out against the $100M in deposits - that is a 22% loss.
FDIC Insurance vs. Depositor Monitoring
The Federal Deposit Insurance Corporation (FDIC) was created in 1933 as part of the New Deal. It provided guarantees on deposits at insured banks up to a certain amount. Today that amount is $250,000. So if your bank fails, the FDIC will step in and make you whole for deposits up to $250,000. Technically you are not protected for losses on deposits over $250,000.
If you have deposits of less than $250,000 at your FDIC insured bank, you don’t worry too much about what kind of investments the bank is making. If the bank fails because their investments go bad, you can say, “gosh, that’s a shame”, and you will probably get notified that your money has been transferred to a new bank by the FDIC on your behalf. If you had deposits over $250,000, you would be subject to the losses I described above.
The idea behind having an upper limit on FDIC insurance is that those of us who are small depositors aren’t especially sophisticated and do not have the ability to monitor what the bank is up to. The bank would easily fool us and our aunt Gertrude and make us believe that the investments they were making were more sound than they actually were. If you have more than $250,000, you are assumed to be a sophisticated investor and you should have the ability to sniff out bankers who are taking bad or excessive risks.
Accounts below the insured amount tend to be quite stable. Depositors who know they are insured have no particular reason to monitor the behavior of the bank. Depositors who have large deposits - maybe millions of dollars - should be monitoring the bank and if they suspect the bank is at risk of failing, they are likely to yank their money to avoid losses.
Answer to Point 1: the Biden administration’s promise to make everyone whole, and why that is bad.
SVB took big losses on its investments as a result of increases in interest rates. I will address that in Part 2 of this discussion on Sunday. Let’s ignore how they incurred those losses and focus on the fact that they did.
SVB’s losses were big enough to wipe out their reserves and then some. SVB’s primary depositors were primarily big Silicon Valley businesses. These businesses had deposits in the millions or even billions based on what I am reading. A billion dollars is more than $250,000, just to be clear. Which means that these really big depositors were supposed to be guaranteed just a tiny percent of the amount they had loaned SVB, and the rest they had at risk - caveat emptor. The FDIC exists to protect small, unsophisticated depositors. If you have a billion dollars to deposit, or even a few million, you better be a sophisticated depositor. Since SVB’s depositors included venture capital funds, I would say, yes, they were sophisticated. They knew their deposits were not supposed to be insured by the FDIC. They gave the money to SVB anyway. And they should be taking losses on their deposits commensurate with the losses on SVB’s investments. However, according to a joint press release from the Secretary of the Treasury, the Federal Reserve Board Chair, and the Chairman of the FDIC, “Depositors will have access to all of their money starting Monday, March 13.” They followed this comment with a similar guarantee for a second, similar bank that failed, “All depositors of this institution will be made whole.”
The joint statement echoes President Biden, who claims that none of the bail out to depositors “will be borne by the taxpayer.” Instead “Any losses to the Deposit Insurance Fund to support uninsured depositors will be recovered by a special assessment on banks, as required by law.” What this means is banks will be charged by the FDIC to cover the cost of the bail out. If you are a customer of a bank, this means you will pay higher fees to your bank when it passes on these charges to you. That’s how these things work. There is no such thing as a free lunch. This promise is true only in the sense that taxpayers will pay for the bail out indirectly, rather than directly through a check from the Treasury.
Why do I object? Well, first of all, the sophisticated depositors should have done a better job monitoring their bank. Since they did not, they should pay the penalty. Second, this action is precedent setting. In the future, large depositors will assume that if they make a large deposit in excess of the $250,000 limit, they will be protected. This reduces their incentive to monitor in the future. Monitoring is not free, so this is a gift to big depositors. Big depositors will simply look to see if a bank is FDIC insured and dump however much money they want into the bank without worrying if the bank is sound, since they know that the FDIC will step in and make them whole.
Am I smarter than the Secretary of the Treasury, the Federal Reserve Board Chair, and the Chairman of the FDIC? Nope. I don’t know any of them personally, but I am 100% sure they are all smarter than me and know a lot more about banking than I do. I do think they are responding to different incentives than I have. Right now the whole banking industry is under a lot of pressure because of rising interest rates. SVB (and Signature, the second bank mentioned above), were uniquely positioned to show losses early. But there are thousands of banks, many bigger than SVB, that are losing money because of the rise in interest rates. As I said above, banking is based on trust. When depositors get scared, they run on the bank. A bank run can quickly exhaust a bank’s reserves and cause it to fail. By bailing out SVB and Signature, the Federal Government is hoping to quell depositor’s fears and prevent a large-scale bank run across the financial system that could lead to a financial crisis. This is a real concern and I don’t want to minimize it. I don’t know how likely that possibility was. I am reasonably sure the possibility is still with us despite the bailout of SVB depositors because rates are still rising.
I am concerned we are trading short-run safety for even larger long-run risk. That is my main objection. I think letting banks fail is a good signal to sophisticated investors that they need to get back to monitoring. I don’t think more regulation is the answer. Instead we need decentralized depositors who have an incentive to monitor the behavior of their banks. Without that, the FDIC, Federal Reserve, and Treasury are always going to be engaged in a game of financial whack-a-mole with people who are trying to make a quick buck - like the bankers at SVB.
OK - that’s it for me - I’ll be back Sunday with part 2 addressing why SVB failed, and why all banks are facing stress from rising rates.
As usual, willing good for all of you!
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