Arnold Kling: We Just Nationalized the Banking System—Now What?

Arnold Kling holds a PhD in economics from MIT. He has worked at the Federal Reserve and later at Freddie Mac. In 1994, he started a web-based business. He used to blog at EconLog, and now writes at ArnoldKling.substack.com.

Links & Transcript

* arnoldkling.substack.com

* Reason forum hosted by Zach Weissmueller,

* The Big Short

* It’s a Wonderful Life - Bank run scene

How did SVB (almost) Go Under?

Bob Zadek: (01:49): Arnold, let's talk about Silicon Valley Bank, founded around 40-50 years ago—a new bank compared to our first bank formed by Alexander Hamilton around the country's founding.

Silicon Valley Bank was doing fine until recently. It was the 16th largest bank, with plenty of funds and public shareholders. It specialized in startups, especially biotech and tech companies, and was a favorite of venture capitalists in Silicon Valley. Then suddenly, Silicon Valley Bank collapsed.

So far there hasn't been a run on the bank, perhaps because the Fed intervened. But how could a successful, well-established bank fail so quickly? Arnold, tell us how a bank could go from thriving to defunct overnight.

Arnold Kling (03:47): As Ernest Hemingway said, “Gradually, then suddenly.”

I think that captures the story here. They gradually lost money because they held a huge portfolio of long-term mortgage-backed securities and Treasury securities on their books from a couple of years ago before interest rates went up. The value of that portfolio went down.

Then they went bankrupt suddenly because over 95% of their deposits were not insured. The typical customer had $3 million to $4 million that they used to make payroll and other expenses. That's way above the insurance limit of $250,000. Those people saw the bank was underwater, and no one wanted to be the last one left holding the bag. They started a run on the bank.

Bob Zadek (04:56): The public believes that when you deposit money in the bank, the bank somehow keeps it in a shoebox under the counter. But nothing could be further from the truth. In fact, when you deposit money in the bank, you are making an unsecured loan to the bank. Unlike a bank that lends you money with the collateral of your home or car, you are just the lowest form of creditor—an unsecured creditor.

We don't want all depositors withdrawing their funds at once. That's called a "run on the bank,” as Jimmy Stewart explains in It's a Wonderful Life. If everyone who lent you money demanded their money back at once, even if you have assets, they're not in cash. So you'd default. After the Great Depression, the government decided to avoid bank runs by guaranteeing deposits up to $250,000.

The problem was that millions and millions of dollars were deposited in Silicon Valley Bank, but then bad things started to happen. The bank had invested much of their money in federal securities, so it didn't have enough cash on hand to give everyone their deposits back right away. The federal securities that banks invest in are usually very safe. This caused even more panic and worsened the run on the bank. In short, too much money chasing too few safe investments led to a crisis of confidence in Silicon Valley Bank.

Arnold Kling (09:13): In a way, this is a rerun of the savings and loan crisis of the 1970s and 1980s.

If you lent me money for a mortgage a few years ago at 3% interest, you're probably not happy collecting only 3% now that mortgage rates are closer to 6%. On the other hand, I'm delighted to pay only 3% and have no desire to sell my house and take on a new mortgage at 5%. So what's good for me is bad for you as a lender.

Silicon Valley Bank lent heavily when interest rates were low. As a result, the mortgage securities and long-term bonds they purchased declined in value. However, there is no risk of default on my 3% mortgage, so I am happy to repay it. Similarly, there is no way the federal government will default on the 20-year bonds paying one and a half percent interest. You need not worry about default in that sense. Though you may believe these investments are safe, they have lost value. If you had to resell them to someone else today, you might get only 50 to 60 cents on the dollar. That is exactly the problem Silicon Valley Bank faced.

There was some ordinary deposit runoff because the tech boom was fading, so some of these companies were starting to spend their money. Instead of having 3 million in their account, they might have take it down to 2 million. So they're asking for a million dollars back, and the bank to meet that has to sell some of its portfolio. With its portfolio being worth 50 or 60 cents on the dollar, it's starting to book losses.Then these depositors start to worry: What if I need my money when it's my turn? Will they still have it?

Insolvency vs. Illiquidity

Bob Zadek (11:44): Imagine you own a house worth $1 million. You owe $500,000 on the mortgage—that's your only debt. Your net worth is $500,000. You're financially secure. But if the mortgage holder demanded repayment the next morning and you can’t pay, you'd be insolvent. That's what insolvency means: owing more than you can repay.

Arnold Kling (12:58): I would call that illiquid.

If you had to sell everything immediately and pay off your mortgage, you wouldn't be insolvent. If you sold your house for $1 million, you could pay the $500,000 mortgage and have $500,000 left over. You'd be insolvent if your house was worth $400,000 and the mortgage was $500,000.

Silicon Valley Bank was illiquid and insolvent. They lacked the funds to repay the depositors demanding their money back. They were also insolvent because selling their bond portfolio would not have raised enough money to repay all deposits.

Bob Zadek (14:23): I noticed that the Moody's rating for Silicon Valley Bank dropped from an A to a C rating overnight. The rating agencies, which were one of the main culprits of the 2008 financial crisis, seem to have again fallen asleep at the switch with Silicon Valley Bank, as with First Republic. The rating agencies are supposed to sound the alarm, but they're paid by the companies they rate, not the people who rely on them.

Arnold Kling (15:50): In addition to the rating agencies, there were actually all these people, either in the private sector or government regulators—the California Home Loan Bank Board, the FDIC, the auditor—who signed off on everything. None of these people did anything until the crisis was over, even though there were short sellers who could see this happening.

I believe bank examiners noticed issues about a year ago—saying that their growth was problematic. Banks aren't supposed to triple in size organically. SVB had $60 billion in deposits in early 2020 but around $180 billion by late 2022.

If you're running a bank, you cannot keep your management controls operating with growth at that rate. You're going to have junior managers managing four or five times more than they’ve ever managed. You're going to be throwing new hires in there the way Putin's throwing untrained soldiers at Ukraine.

Bank examiners saw the problems, and that was even before considering the interest rate risk. They also saw the interest rate risk, but did nothing. We think that if there are enough regulations, these issues won't happen. But they certainly don't prevent everything. Regulations alone are not enough.

Bob Zadek (17:59): As a lawyer and lender in commercial credit, I have often heard those seeking loans present themselves with unusual growth, boasting, “We have grown so fast.” My response is that there is natural growth one would expect in companies or living things. But there can also be extraordinary growth—we call that “cancer.” It is unhealthy, whether financially or physically.

Arnold Kling (19:51): I'm actually surprised the FDIC didn't have a veteran regulator involved. There had to be people at the FDIC who could see there was a problem. It would be interesting to file a Freedom of Information Act request for all the memos written about Silicon Valley Bank, because I bet there was some old curmudgeon writing things like "Why don't we shut this bank down? Why don't we make them hedge their interest rate risk? Why don't we do this? Why don't we do that?"

Someone higher up probably said, "No, we don't need to do any of that."

Why not let SVB fail?

Bob Zadek (20:45): The federal regulators took action that they vehemently deny was a bailout. Putting aside labels, they stepped in over a weekend and prevented an obvious outcome: letting the bank fail. There's nothing wrong with a bank failing. Depositors put money in a bank, presumably making an informed decision. They don't qualify as victims. Small depositors are protected by insurance. Just let the bank fail. Let companies unwise enough to leave money with the bank lose it, since they made a bad loan.</