By Jonathan Movroydis
In this interview, Senior Fellow Amit Seru discusses his recent research that uncovers the underlying factors that are causing fragility within the financial system, as witnessed in the recent collapses of Silicon Valley Bank, Signature Bank, and First Republic Bank. For Seru, a large swath of the financial system is suffering not from liquidity issues but solvency issues, whereby the market value of assets in many US banks have been devalued. The amount of devaluation, more than $2 trillion, is of the same order of magnitude as the total equity in the banking system as of mid-March 2023. This major decline in asset values is a consequence of the US Federal Reserve’s steep interest rate hikes that were intended to curb the highest rates of inflation experienced by the United States in forty years.
A large portion of these recently collapsed banks’ clientele—including wealthy tech entrepreneurs and venture capitalists—held deposits that are uninsured, i.e., they were above the Federal Deposit Insurance Corporation (FDIC) limit of $250,000. Seru explains that because of the large losses on the asset side of many of the banks’ ledgers, enough uninsured depositors got spooked and caused a “solvency” run on many of the banks. Many other banks remain potentially insolvent.
Seru argues that state regulators may have failed to take action on insolvent banks because most of them were too big to fail for their local economies. The federal regulators may also have focused all their energies on rate increases to fight inflation and ignored the building interest rate risk on bank balance sheets. Instead of issuing bailouts and unlimited government support for these insolvent banks, which will introduce moral hazard, Seru recommends that in the short run, regulators should stress-test banks to separate the “solvent but illiquid” banks from the insolvent ones. Insolvent banks need to be consolidated or sold rather than provided with unlimited taxpayer-funded government funds. Solvent but illiquid banks should be asked to raise outside funds in order to access government funds. Over the long term, he argues, regulators should anticipate that they are unlikely to stay on top of all the risks that may impact the banking sector. They must therefore encourage the banks to raise more equity capital to absorb any losses from unanticipated risks.
Will you provide an overview on why Silicon Valley Bank, Signature Bank, and First Republic Bank collapsed?
Amit Seru: Over the last year, the Federal Reserve decided to raise the interest rates in the economy because we were facing a precarious inflation problem. As the interest rates were hiked up quite dramatically from near 0 percent to about 3 or 4 percent, what that did was deflate the value of the assets that banks had invested in. These were securities like Treasuries and residential bank mortgage securities but also loans that they had made which were fixed and long-term in nature. As anyone with basic finance knowledge knows, when interest rates rise, the market value of such assets goes down.
At the same time, a vast majority of the banks’ funding comes from depositors, and the depositors come in two flavors: If your deposit is below the FDIC limit of $250,000, then you are insured. If you're above that, you're uninsured (beyond the first $250,000). Given that a large portion of Silicon Valley Bank’s clientele are wealthy venture capitalists and tech entrepreneurs, a large portion of its deposits were in that uninsured category. And what you have when most of these banks’ funding comes from uninsured depositors are the conditions for a potential solvency run. In other words, if enough uninsured depositors think that the bank is not going to be able to pay back whatever they are owed, because of asset losses, they might have an incentive to run.
Why are we focusing on uninsured depositors? Because they have the most incentives to monitor the bank and to “run faster” than insured depositors. They're first in line as long as the bank is not “closed” by the FDIC. Insured depositors are considered to be sleepy. The FDIC could decide that the losses and withdrawals by uninsured depositors might result in insured deposits getting hurt. It is in this scenario that the FDIC decides to close a bank. When it does so, insured depositors become first in line and everybody else, including uninsured depositors, become lower priority. This is what gives uninsured depositors substantial incentives to monitor the health of banks.
A bank with large losses in the market value of its assets due to interest rate increases could ride the wave if no depositors ask them for money. The problem is, if enough uninsured depositors get spooked and worried about other uninsured depositors running, you could end up in a scenario where enough depositors line up and ask the bank for their funds such that the bank would have to sell those assets in the market and suffer losses. These losses would spook other depositors and trigger a self-fulfilling solvency run. This is effectively what happened at Silicon Valley Bank.
Ninety-eight percent of Silicon Valley’s depositors were uninsured. Sixty percent of First Republic’s deposit base was uninsured. There are many other banks in the US that are facing similar forces—turbulence on the asset side due to interest rate risk and flight risks on the deposit side due to a high uninsured deposit base. All of this means that while the government support has stemmed the contagion for now, there is still a lot of uncertainty in the banking system. Notably, we are not even talking about any credit risk associated with assets such as commercial real estate that can additionally add to the fragility in the banking sector.
Are these collapses the result of failed regulatory oversight?
Amit Seru: My view is that regulators have a lot of political constraints. Despite all the problems these banks have had, there was a primary reason why state regulators might have been softer on them: they were too big to fail for the local economies.
If you ask a local regulator, they will tell you, “Silicon Valley Bank and First Republic Bank are hugely important for start-ups.” Do state regulators, then, have the incentives to tighten the screws on these banks? Not really. From the regulators’ perspectives, these banks were supporting the financial ecosystem, especially as the economy was emerging from the pandemic shock.
At the federal level, the focus was on increasing interest rates to combat raging inflation. While doing so, it is very likely that federal regulators took their eyes away from the ball and ignored the basic interest rate risks that had built up on bank balance sheets.
Why don’t you believe the solution to banking fragility is to back up these uninsured deposits with liquidity provisions?
Amit Seru: What the government basically did was provide liquidity provisions to the banks. But what we are facing is not a liquidity problem. We are facing a solvency problem. Essentially the government said to banks, “If your assets are depressed, we will buy them at par value instead of the discounted value that the market is signaling.” The government has also said to uninsured depositors, “Hey, look, you don’t need to run. We will bail you out.” Ostensibly, that means all depositors are insured even if their accounts have more than the $250,000 FDIC coverage limit. At the same time, recall that many banks are insolvent—i.e., the market value of their equity, after accounting for mark-to-market losses, is below zero. This creates a similar scenario as the savings and loan crisis of the 1980s. What happened then was that we provided insolvent financial institutions with all the capital they needed, and that allowed these institutions to gamble for resurrection by taking risky bets on the asset side.
Why would this be? Think about a bank manager at an insolvent bank. Such managers would be more than happy if the risks panned out since they would get some part of the upside. But if the risks didn’t pan out, they were insolvent to begin with and would not be losing anything. This policy introduces what we call moral hazard. Bank managers in insolvent banks with a lifeline from the government would literally have nothing to lose.
In my view, the preferred policy in the short term should be to separate our “solvent but illiquid” banks from insolvent banks. A stress test to the entire banking sector would allow us to do this. We don’t want to support insolvent banks, because unlike solvent ones, they have no equity and no value. How could a solvent bank be supported? The government could require a market test, whereby it would provide banks with financial support but only if they would go to the market to attain private capital. Such a test would be passed by solvent banks but not insolvent ones.
Below is recent research coauthored by Amit Seru on the fragility of the US financial system.
Click here to read “US Bank Fragility to Credit Risk in 2023: Monetary Tightening and Commercial Real Estate Distress.”
Click here to read “Monetary Tightening and US Bank Fragility in 2023: Mark-to-Market Losses and Uninsured Depositor Runs?”
Click here to read “Resolving the Banking Crisis.”
