Who dunnit?

March 18, 2023

Have you ever read an Agatha Christie novel — or watched Murder on the Orient Express? Then you know how her plots go. Right at the start, there is a body. A dead body. Then, the speculation starts. Who did it? Was it this one…or that one? And if they did it, how did they do it?

Dame Agatha has now been gone for a long time. But last week’s death of Silicon Valley Bank (SVB) made it seem as if she had just issued a new novel, perhaps her most puzzling one ever.

So, let’s quickly recap the plot. When the news first came out, it seemed the deceased was a poor innocent thing, done in by its former friends in Silicon Valley, who rushed to take all their money out, even as they told the world how much they loved the bank.

Then, later in the week, the news turned darker. News started rumbling out of Washington DC that the bank had lobbied successfully for a loosening of regulations in 2018, implying that the bank itself was up to nefarious activities, aided and abetted by some politicians.

So, who killed SVB? It’s “frenemies”? Its own management? And if the latter, what were these nefarious activities?

Have no fear. This blog will tell all, as the first installment in a series on the ongoing financial crisis. For those of you who feel swamped by all this banking stuff — and I don’t really blame you — let me get straight to the point. SVB was not killed by its frenemies. Nor was its management up to nefarious activities, not at least in the way we normally define nefarious. There were other deep forces at work. Very deep forces.

So, let’s try to ferret them out.

When banks get into trouble, it’s always for some combination of three reasons:

• Mistakes by the bank
• Mistakes by the bank supervisor
• Mistakes in economic policies

Most people focus on the bank’s mistakes, which often involve some monumentally bad lending decisions. For example, the 2008 crisis happened because banks got the brilliant idea of giving mortgages to anyone who asked for one, even those people who had no way of repaying the loans. After all, the banks reasoned, if the borrowers defaulted, the banks could just sell the houses and get their money back. What they didn’t consider what what would happen to housing prices when all this housing was put on the market. Big mistake. The banks proved unable to get their money back, and many went bankrupt.

This bitter experience taught bankers a painful lesson. So, when they were inundated by deposits during the pandemic, thanks to the government’s enormous transfer payments and the tremendous increase in share prices that encouraged firms to issue new shares and deposit the proceeds, they did not respond by lending wildly. No, they did not. Instead, they placed the funds in the safest investment they could find: US government securities.

So, um, then how on earth did SVB get into trouble?

Because there is safe, and then there is safe. You see, bonds are safe in the sense that the US government is not going to default. (Please note this point, all you naysayers. Default is just not going to happen. Period.) But they do have some risk, in the sense that their prices can go down. Let’s say you spend $100 to buy a a ten-year bond earning 2 percent interest. Then, interest rates go up to 4 percent. In that case, your bond will only be worth around $84. You have just lost 16 percent on your investment!

Why did bond prices go down? Because an investor can now buy a bond earning 4 percent, double what he would get on the “old” bond. So, there’s no way he would buy your “old” bond, except if you offered it at a substantial discount.

The risk that banks could lose money on their bond investments is known as “interest rate risk”. And it is this interest rate risk that got Silicon Valley Bank into big trouble.

During the pandemic, US treasury bonds were yielding very low interest rates. Even as late as the middle of 2021, for example, a two-year US treasury was yielding only around 0.25 percent. But in 2022, the Fed started to raise interest rates, so much so that by early March 2023 two-year yields had increased to 5 percent. So, the banks that were holding large amounts of bonds were sitting on huge potential losses.

Note the word “potential”. In fact, even as interest rates were increasing in 2022, banks were declaring large profits, not losses. This is precisely why the public was surprised to find out in March 2023 that some of these banks were actually in trouble.

Wait, how could banks declare large profits when they were actually getting into trouble? Because of the magic of accounting. You see, banks are allowed to classify bonds in a special category known as “hold to maturity”. When they do so, they can value the bonds at the price they paid, rather than the price they are actually worth. So, they didn’t need to record any losses.

That made the books look good. But reality was still the same: in reality, there was a problem. A big one. You see, because banks were earning so little on their bond investments, they couldn’t offer good interest rates on their deposits. And as treasury bond rates climbed toward 5 percent, customers started to wonder why they should be placing their money in banks that were hardly paying any interest, when they could get 5 percent in bond market mutual funds.

So, they started to shift their deposits. And this in turn forced banks to sell bonds to generate cash for the departing customers, thereby turning those potential losses into actual losses. In the case of SVB, the bank lost $1.8 billion selling some of their bonds, which spooked depositors, which then led to a run in which $42 billion — with a “b” — left the bank in just one day. That proved the end of SVB.

Was all of this inevitable, the easily-foreseen climax of a three-act tragedy? You know:

• Act I: An enormous macro stimulus, which floods banks with liquidity
• Act II: Inflation, which causes the Fed to raise interest rates
• Act III: banking collapse

Well, there’s certainly something to this story. That’s why I’m mentioning it! And so we’ll come back to it in later blogposts. But for the moment, let’s focus on the mistakes.

SVB knew in 2021 that by putting so much money into long-term government bonds it was running a huge interest rate risk. Initially, it must have thought that this risk was pretty low because, hey, wasn’t inflation completely dead? So, interest rates were going to stay low forever, right? It wasn’t an outlandish thought. It’s what many people thought at the time, including the Federal Reserve.

But by 2022 it had become clear that the central bank would need to raise rates substantially to bring prices under control. And even then SVB did nothing. It didn’t sell down its bonds, it didn’t buy insurance against the risk its bonds would lose value, it didn’t even try to raise additional capital until it was too late.

Why didn’t SVB do any of these things? We don’t know. But most likely it just assumed that depositors were so loyal that they would never leave the bank, even as it kept offering really low interest rates. In that case, it would never have to sell its bonds. It could just keep paying nothing on its deposits, earning some interest on its bonds, and pocketing the profit.

It turned out that assumption was wrong. And in retrospect it was a very silly assumption, since the vast majority of SVB’s customers were large companies, with smart corporate treasurers, who were happy to move their money if they could get a much better rate elsewhere. (And did I mention that these large deposits were uninsured?) So, yes, SVB made mistakes.

But what about the others? Where, for example, was the bank supervisor, the organisation in charge of making sure that banks are safe? Why didn’t it intervene and force SVB to minimize the risks it was running?

Some people are saying that the supervisor couldn’t act because it didn’t know what was going on at SVB. They argue that in 2018 Congress had exempted midsize (and smaller) banks from two critical indicators of banks’ health: the so-called “liquidity coverage ratio” and the “stress test”. As a result, they claim, the supervisor was flying blind.

It all sounds so horrible: regulations are eased, allowing banks to take big risks without anyone knowing what they are up to. But this claim is completely wrong. In fact, the absence of these regulations made no difference whatsoever. (See also this column by the redoubtable Charles Lane.)

Consider first the “liquidity coverage ratio”. The name is intimidating but the concept is simple. This is a rule that requires banks to have enough “liquid” (i.e., easily sellable) assets on hand to meet the demands of customers, should a certain fraction of them want to withdraw their money. In fact, SVB would have met this requirement easily. It had plenty of liquidity; it’s balance sheet was stuffed with highly liquid government bonds.

Let’s be clear: SVB’s problem was not that it had insufficient liquidity. It’s problem was solvency — it would take huge losses on the government bonds, should it ever have to sell them.

What about that “stress test”? Well, the key point to understand is that the stress test is an exam that the bank does on itself. Then, it reports the results to the supervisor. This certainly seems a strange way of doing things. After all, supervision is not the job of banks. It’s the job of bank supervisors to analyze bank data and try to figure out which banks are going to get into trouble.

So, why would a supervisor ask a bank to do a stress test on itself? The answer is that the bank has much more data than the supervisor. And in 2008 complex derivatives had hidden the extent of banks’ exposure to the subprime mortgage problem. So, the supervisor’s tests severely underestimated the banking problem.

But that was 2008. In this case, it was pretty straighforward to calculate interest rate risk. After all, there are only three parameters that matter:

·  The share of low-yielding securities in the bank’s asset portfolio (and the maturity of those securities);

·  The sensitivity of their deposits to increases in market interest rates

·  The size of the bank’s capital, that is their cushion to absorb potential losses.

Of these three, the first and the third parameters are known facts, while the second is unknown but reasonable assumptions can be made.

So, the lack of a bank-generated stress test was irrelevant; the supervisor could have calculated the risks all by itself. And surely it did. In particular, when it became clear the Fed was going to have to tighten monetary policy, the supervisor presumably ran scenarios to identify which banks would come undone when interest rates increased.

So, it’s safe to assume that the supervisor knew SVB was at risk. But it didn’t do anything — or at least it didn’t do anything that made a difference. For example, it didn’t even insist that they appoint a Chief Risk Officer. Yes, you read that right. For most of 2022 SVB didn’t even have a Chief Risk Officer. Surely, that alone must have been a red flag to the bank superisor!

This is important. So important that I will repeat the point. The problem was not a lack of regulation. It was not lack of data or analytical capability. The problem was that the supervisor failed to act in time.

What happened? Was there some misjudgement somewhere, or were there political impediments? We need to find out, so that mistakes like this can be prevented in the future.

The problem gets worse because, um, who was this supervisor that failed to contain the risks? Why, it was the Federal Reserve — the same organization that created the problem in the first place.

How did the Fed create the problem in the first place? By taking more than a year to react to the inflation that started materializing in 2021. Of course, the Fed didn’t know in 2021 how inflation would evolve. It consequently needed to weigh the balance of risks. There was a risk that if the Fed raised rates when the inflation was actually temporary, the action could knock the economy into a recession. Against this, there was a risk that inflation could prove durable, in which case a delay would necessitate large increases in interest rates, which could create stress in the banking system.

Did the Fed give due consideration to this second risk? In retrospect, it’s obvious the central bank did not. And even at the time, there were many people who felt the Fed was making a mistake, including — ahem — this blog.

So there we have it. The troubles that we are seeing today have nothing to do with insufficient regulation. They stem from:

• The delays of the Fed in responding to inflation, thereby creating the risk of large interest rate increases
• The failure of certain banks to respond to these risks
• The failure of the Fed to ensure that vulnerable banks were managing these risks

That’s a scary list of failures.

Looking forward, these failures will have profound consequences. They have damaged faith in both the banking system and the Fed — just at a time when the Fed had finally started to restore some of the credibility it had lost by taking so long to respond to the resurgence of inflation.

What comes next? Will the other banks fall like dominos? How can the US restore credibility in its banking system — and its central bank? These questions will be the subject of the next few blogposts.

In the meantime, you will at least know the answer to the who dunnit question. It wasn’t person A or B or C. They were all responsible. Even the “policeman”.