The bankruptcy of Silicon Valley Bank on March 10, 2023 came as a shock to most Americans. Even people like me a scholar of the American banking system who has worked at the Federal Reserve did not expect the collapse of the SVB.
Usually banks, like all businesses, go bankrupt after a long period of lackluster performance. But SVB, the 16th largest bank in the country, had been stable and very profitable just a few months earlier, after making about $1.5 billion in profits in the last quarter of 2022.
However, financial history is full of examples of apparently stable and profitable banks that went bankrupt unexpectedly.
The demise of Lehman Brothers and Bear Stearnstwo leading investment banks, and Rural Financial Corp., a subprime mortgage lender, during the financial crisis of 2008-2009; the Savings and loan banking crisis in 1980; and the complete collapse of the US banking system during the Great Depression did not unfold in exactly the same way. But they had something in common: an unexpected change in economic conditions first caused a few bank failures, followed by general panic, and then widespread economic problems.
The main difference this time around, in my opinion, is that modern innovations may have hastened SVB’s demise.
The Great Depression, that lasted from 1929 to 1941epitomized the public damage that bank runs and financial panic can cause.
After a rapid expansion of the “Roaring Twenties”, the US economy began to slow in early 1929 stock market crashed on October 24, 1929 – a date known as “Black Tuesday”.
The huge losses suffered by investors weakened the economy and led to problems for some banks. Fearing that they would lose all their money, customers began withdrawing their money from the weaker banks. Those banks, in turn, quickly began selling their loans and other assets to pay their depositors. This rapid sale pushed prices further down.
As this financial crisis spread, savers with accounts at nearby banks also began lining up to withdraw all of their money. in a typical bank runculminating in the bankruptcy of thousands of banks in early 1933. Shortly after President Franklin D. Roosevelt’s first inauguration, the federal government resorted to closing all banks in the country for a whole week.
Due to these bankruptcies, banks could no longer borrow money, which led to more and more problems. The unemployment rate peaked at about 25%, and the economy shrank until the outbreak of World War II.
Determined to prevent a repeat of this debacle, the government tightened banking regulations with the Glass-Steagall Law of 1933. It prohibited commercial banks, which serve consumers and small and medium-sized businesses, from engaging in investment banking and created the Federal Deposit Insurance Corporation, which insured deposits up to a certain threshold. That limit has risen considerably in the past 90 years, from $2,500 in 1933 to $250,000 in 2010 – the same limit that is in effect today.
The country’s new and improved banking regulations ushered in a period of relative stability in the banking system that lasted about 50 years.
But in the eighties hundreds of the small banks known as savings and loans associations failed. Savings and loans, also referred to as “savings”, were generally small local banks that primarily provided mortgage loans to households and collected deposits from their local communities.
Beginning in 1979, the Federal Reserve began raising interest rates very aggressively high inflation rates that had become entrenched.
By the early 1980s, Congress began allowing banks to pay market interest rates on depositors’ accounts. As a result, the interest S&Ls had to pay their clients was much higher than the interest income they earned on the loans they made in previous years. That imbalance caused many of them to lose money.
Although about 1 in 3 S&Ls failed between about 1986 and 1992 – about 750 banks – most depositors in small S&Ls were protected by the FDIC’s then-current insurance limit of $100,000. In the end, resolving that crisis cost taxpayers the equivalent of approx $250 billion in today’s dollars.
Since the savings and loan industry was not directly tied to the major banks of the time, their collapse did not cause a run among the larger institutions. Nevertheless, the S&L collapsed and the government regulatory response reduced lending to the economy.
As a result, the US economy went through a mild period recession in the second half of 1990 and the first quarter of 1991. But the banking system escaped further distress for nearly two decades.
Against this backdrop of relative stability, Congress withdrawn most of Glass-Steagall in 1999 – eliminating Depression-era regulations that limited the scope of banks’ activities.
Those changes contributed to what happened when, at the start of a recession that started in December 2007, the entire financial sector panicked.
At the time, major banks, freed from the Depression-era restrictions on securities trading, as well as investment banks, hedge funds, and other institutions outside the traditional banking system, had heavily invested in mortgage-backed securities, a type of bond backed by bundled mortgage payments from many homeowners. These bonds were very profitable during the housing boom at the time, and they helped many financial institutions are posting record profits.
But the Federal Reserve had been rising interest rates since 2004 to slow down the economy. In 2007 many households had variable rate mortgages could no longer afford to make their higher-than-expected mortgage payments. That led investors to fear a wave of mortgage defaults and the value of mortgage-backed securities plummeted.
It was not possible to know which investment banks owned many of these vulnerable securities. Rather than wait to find out and risk not getting paid, most savers rushed to get their money out in late 2007. This rush led to successive failures and the federal government in 2008 and 2009 responded with a series of major rescue operations.
Even the government saved General Motors and Chryslertwo of the country’s three largest car manufacturers, in December 2008 prevent the industry from going bankrupt. That happened because the big car companies relied on the financial system to provide credit to potential car buyers to buy or lease new cars. But when the financial system collapsed, buyers could no longer get credit to finance or lease new vehicles.
The Great Recession lasted until June 2009. Stock prices decreased by more than 50%And unemployment peaked at around 10% – the highest percentage since the early 1980s.
As with the Great Depression, the government responded to this financial crisis with major new regulations, including a new law known as the Dodd-Frank Act of 2010. It imposed strict new requirements on banks with assets in excess of $50 billion.
Congress reverted some of Dodd-Frank’s major changes just eight years after lawmakers approved the measure.
Notably, the strictest requirements were now reserved for banks with more than $250 billion in assets, up from $50 billion. That change, which Congress passed in 2018, paved the way for regional banks like the SVB expand rapidly with much less regulatory oversight.
Still, how could SVB collapse so suddenly and without any warning?
Banks take deposits to make loans. But a loan is a long-term contract. For example, mortgages can last for 30 years. And deposits can be withdrawn at any time. To reduce their risks, banks can invest in bonds and other securities that they can sell quickly if they need money for their customers.
In the case of the SVB, the bank invested heavily in US government bonds. Those bonds have no default risk as they are debts issued by the federal government. But their value falls as interest rates riseas newer bonds pay higher rates as compared to the older bonds.
SVB bought a lot of government bonds it had on hand when interest rates were close to zero, but the The Fed has been steadily raising interest rates since March 2022, and the yields available for new Treasuries sharply increased over the next 12 months. Some savers worried about that SVB may not be able to sell these bonds at a price high enough to repay all its customers.
Unfortunately for SVB, these savers were very tight-knit, with most in the tech sector or startups. She turned to social media, group text messages and other modern forms of rapid communication to share their fears – which quickly went viral.
Many big savers all rushed to get their money out at the same time. Unlike what happened almost a century earlier during the Great Depression, they generally tried to withdraw their money online – without forming chaotic queues at bank branches.
Will more shoes fall?
The government allows SVB, that will be sold to First Citizens BankAnd signature bank, a smaller financial institution, go bankrupt. But it agreed to refund all depositors — including those with deposits above the $250,000 limit.
Although the authorities have not explicitly guaranteed all deposits in the banking system, I see the bailout of all SVB depositors as a clear signal that the government is ready to take extraordinary measures to protect the deposits in the banking system and prevent general panic.
I think it’s too early to tell if these measures will work, especially as the Fed is still battling inflation and rate hikes. But for now, the major US banks appear safe, although there are growing risks in the smaller regional banks.