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The U.S. has a fractional reserve banking system: for every dollar banks lend out, 85 cents comes from deposits and 15 cents from their own equity. The problem with deposits, as we saw with the demise of Silicon Valley Bank, is that depositors are fickle – they can ask for their money back at any time.
Banks lend your money to others. There is an inherent imbalance of liquidity in the banking system that we never notice, which is absolutely fine as long as banks have proper reserves, do not experience losses on their loans or investments that exceed their reserves, and, most importantly, society believes in the continuity of the banking system as a whole.
Bank runs occur when depositors lose confidence in the bank and demand their money, depleting the bank’s reserves (equity) and forcing it into bankruptcy. At the beginning of the 20th century, bank runs were common, leading to the establishment of the Federal Reserve in 1913. The Fed was created to act as a lender of last resort to help prevent bank runs from occurring.
Silicon Valley Bank’s failure was almost a traditional run on the bank, because SVB was functionally dead before the bank run occurred — prices of the bonds it held declined so much that its liabilities exceeded its assets. Unlike in a traditional bank run, most of its assets were not tied up in illiquid loans but in highly liquid mortgage-backed securities and U.S. Treasurys.
Bail or fail?
What makes the U.S. great it that it allows people to take risks and to fail. Business failure is painful; people lose their jobs; investors lose their life savings. Capitalism without failure is heaven without hell. Failure fertilizes the ground and allows the growth of new companies, which benefits society.
Bailing out equity- and bond investors introduces moral hazard; it changes investor behavior. It leads to an asymmetry of outcome — taking higher risk brings higher returns but the risk is socialized (shared) with people who are not going to reap the rewards. Bailouts create social tension.
Eventually, bailouts introduce so much risk into the system that failures and bailouts become too costly for the society to bear, government creates draconian rules trying to prevent them in future, which in turn kills innovation and the formation of new businesses, and the result is a stagnating economy.
There is an argument that depositors whose deposits exceeded the FDIC limit of $250,000 per individual ($500,000 per couple) at Silcon Valley Bank and other banks should not be bailed out as they are just another type of debt holder of the bank.
If you were to look at the bank’s balance sheet, debt holders and depositors are found on the liability side, with equity holders right below them. Thus, the argument is factually correct: there is a no significant difference between bondholders and depositors — both are lenders to the bank.
But, when people invest money in debt or equity, they should be analyzing a bank’s financial statements – the sort of analysis we perform at my firm when we buy any stock or bond. Most folks are not trained to do this type of analysis, and so they should entrust this task to those who capable of doing it — a mutual fund or financial adviser.
Investors can influence the behavior of a bank. Fearing loss, not just being jubilant about prospective gain, makes equity and bond investors extremely mindful about their investment decisions and in the end reduces risk in the system overall.
“ We want depositors to be mindless, not mindful, when they put money into a bank. ”
As a society, we want depositors to be mindless, not mindful, when they put money into a bank. People shouldn’t have to become financial analysts to buy a CD. You don’t want them guessing which bank is too big or too likely to fail, or which will be bailed by the government if it tanks and which one won’t. You don’t want grandmas and teenagers to be thinking about the credit ratings of the bank, the duration of its loan portfolio, its reserve ratio, or the aptitude of its management team.
Full faith and credit
The weekend that Silicon Valley Bank’s fate was being decided by regulators, I remember going to lunch and seeing a small bank I had never heard of in a small strip mall. I caught myself thinking, the beauty of our banking system is that I can open a checking account there right now and don’t need to spend hours studying that bank’s regulatory filings and loan book.
The banking system is the plumbing of our economy, akin to electric and water utilities. The banking system is responsible for creating money through generating loans, and it is our payment system as well.
Certain services like water, electricity, and the safety of your deposits are and should be provided by the government. This saves time for society to focus on more productive tasks – doctors healing patients, truck drivers driving trucks, and grandmothers worrying about how to spoil their grandkids.
There is another reason for mindless banking: Both trust and distrust are contagious. Until SVB failed, Americans for the most part were pleasantly infected by trust in our banking system. People weren’t worrying about their deposits, even if they were above FDIC-insured limits. If we lose trust in that system, what took more than a century to build would be lost in days and could bring down not only the banking system, but the entire economy.
The government must regulate banks in the same way it regulates nuclear power plants. Not by introducing a lot of unnecessary paperwork, but by programmatically making sure that if banks fail, there is enough equity so that deposits are not affected, by monitoring banks’ balance sheets in real time, and maybe finally doing something about rating agencies, which are a worthless racket that downgraded SVB from investment-grade to junk only on the day the government closed its doors.
There is another solution: Remove FDIC insurance caps. Banks can pay a fee to the FDIC based on the size of their deposits and pass that fee through to depositors. The more you have with the bank, the higher the FDIC insurance fee you pay.
Banks are utilities and should be regulated as such by the government. You may or may not like the fractional reserve system, but that is what we have and it must be protected at all costs.
Vitaliy Katsenelson is CEO and chief investment officer of Investment Management Associates. He is the author of Soul in the Game – The Art of a Meaningful Life.
Here are links to more of Katsenelson’s views of the inflation landscape (read, listen) and how to invest in inflationary times (read, listen). For more of Katsenelson’s insights about investing, head to ContrarianEdge.com or listen to his podcast at Investor.FM.
Also read: Banks managed credit risk, but not interest-rate risk. Now we’re paying the price.
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