The world struggles to predict financial fallout from California bank collapse

When the millionaire depositors at Silicon Valley Bank got all their money from US government agencies, there was no doubt a sense of relief among the bank’s customers who were about to suffer financially.

Until the US government swooped in on Monday, it included the majority of deposits in SVB, which caters to Silicon Valley startups and venture capital firms. Deposits over $250,000 US are not insured by the Federal Deposit Insurance Corporation or the FDIC.

Even the conservative-leaning Wall Street Journal, which returned to the hundreds of billions of dollars given after the 2008 banking crisis, debated whether support for uninsured depositors in the second largest bank failure in US history should be declared a “bailout.”

One concern is “moral hazard,” the concept that giving money to people who should lose it in free market transactions means they will be reckless in the future, and that banks may become even more reckless.

But this was only one among many financial considerations which were suddenly altered by the unexpected capitulation of a prominent banker in early California.

Perhaps the biggest question raised by the collapse that caused the sell-off in global markets, including Canada, is why haven’t we seen this? Also, the question is what unexpected things could happen as the world grapples with inflation and higher interest rates?

Bank stocks stumble

Libertarian ideologues in the venture capital community who might quote Ronald Reagan’s famous bon mot, “The nine scariest words in the English language are: I’m from the government, and I’m here to help,” money.

The U.S. Federal Deposit Insurance Agency, which effectively took over the failed bank’s assets quickly, announced on Sunday that all insured depositors would have immediate access to their cash. On Monday, uninsured depositors, who have more than $250,000, will also get their money back. But he said taxpayers won’t be on the hook.

“Any loss to the Deposit Insurance Fund to support uninsured depositors will be recovered by a special assessment on the banks, as required by law,” the FDIC said in a Monday release.

Despite the swift action, bank stocks around the world declined.

The Canadian Big Five were down between two and four percent as the day began although they recovered most of their losses later in the day. Some smaller U.S. banks are having a tougher time because the FDIC and the U.S. government say their decisions to return uninsured deposits are special cases and won’t apply to everyone.

Rates too high too fast?

The failure of a large bank is a worrying signal for all financial markets, but for banks in particular the manner in which SVB collapsed is particularly troubling. And it all has to do with interest rates.

One of the main lessons for banks is that the rise in rates means that depositors at SVB have started looking for better returns on their savings. This can be a problem for any bank because, although only a few months ago there was so much money circulating in the economy willing to accept a low rate of return, suddenly using and lending people’s money can become more expensive.

Sometimes it is easy to forget the important rule that banks take deposits and then lend the money for a longer period of time at a higher interest rate. If people start withdrawing their deposits, as they did at SVB last week, the bank realizes that it cannot call on the loan quickly enough to pay off the loaned money.

In general, this is not a problem because the depositors are confident that the bank is well managed and that everyone does not want money at the same time. Not only that but banks keep cash reserves and assets like cash to satisfy the sudden increase in people who are worried about withdrawing.

And here the interest rate reaches SVB twice. Some of those cash assets are in bonds bought a few years ago when interest rates were low. Held for the life of the bond, the bank will get all that money. But because of the sometimes confusing way the bond market works, bonds sold before maturity can be priced lower.

When depositors heard that SVB took a drubbing on the sale of bonds that were necessary to pay depositors, they rushed to get out. In California’s tech culture, they don’t wait in line at the bank like they did in the old banks. Instead, they use mobile phones to transfer money quickly. But by protecting himself, he made things worse.

Private gain, socialist loss

Should the FDIC’s move be considered a bailout, critics will likely say that bailing out multimillion-dollar businesses is another example of “the gains of privatization and the losses of socialization.”

However, as in 2008, there are some good reasons for governments and central banks to show their support.

Some commentators, including John Rapley writing this weekend in the Globe and Mail stated that businesses should be allowed to fail, the idea that only the crisis allows the cleaning action of “creative destruction” where businesses collapse to make room for new and better businesses.

Obviously there are many others who have decided that preventing the destruction of an entire generation of dynamic young tech companies due to the odd bank failure is more important than some hard economic principles.

The question remains, however, whether the collapse of SVB was a quirk or some kind of systemic problem. And if we don’t see that coming, are others peeping?

Of course the market is now betting that interest rates will not continue to rise as quickly as Federal Reserve chairman Jerome Powell predicted. Whether by luck or good management, the recent hiatus announced by Bank of Canada Tiff Macklem seems prescient.

As economic historians have pointed out in the past, financial crises often come unexpectedly, the cause of which can only be understood.

Regulators, who are supposed to defend us from crisis, will scan the horizon for more.

So will the investor. And the unpredictability of how to respond is one of the reasons why what happens next remains difficult to predict.