by Steven Cinelli, Mises Institute:
As a banker and economist, I am riveted by the expeditious demise of Silicon Valley Bank and other institutions. Were these crashes due to bank mismanagement, as many pundits as well as regulators have posited? Were they due to not managing risk, not hedging, and unfettered exposure to sectors of concern? Or maybe something else is afoot, a movement that may have begun a decade ago.
Recall the Great Recession (2008–10), buoyed by a housing and mortgage crisis created by imprudent lending practices, and then the music stopped. In its inimitable wisdom, the government came in legislatively and regulatorily, via Dodd-Frank, crafting what they thought was a belt-and-suspenders approach to avoiding another debacle.
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Certain banks were redefined as systematically important financial institutions (SIFI), to be protected at all costs, while establishing a guided risk regimen. Whether due to the additional compliance costs of Dodd-Frank or demographic changes in the market or the need for better economies of scale, we witnessed a consolidation of smaller banks, reducing the gross number from 7,700 to 4,200 over the subsequent ten years.
The US banking system—with its diversity of institutions, from money centers to community banks, harboring in urban and rural settings—is unique on the world stage. We have vastly more banks than any other country, both by design and opportunity. This has contributed to entrepreneurship through local lending, supporting farming communities, and a general competitive economy.
Figure 1: What country has the most banks?
Source: National Statistical Office, Helgi Library. Asterisks denote data from 2020.
The increasingly reductive nature of this industry doesn’t appear to be just another macroshakeout. Silicon Valley Bank (SVB) was a well-run institution, yet within days, it went from hero to zero. CEO Greg Becker and his team were accused of mismanagement, including being accused of precipitously monetizing stock options.
Hopefully, a little perspective will be insightful.
SVB, like most US banks, has seen over the last twenty years a consistent reduction in relative lending activity, as measured by loan-to-deposit ratios. Decades ago, the typical bank targeted a ratio of 80 to 90 percent; the spread between interest collected on loans and interest paid on deposits was the core bank revenue model. To manage lending and overall balance sheet levels, the regulators would toggle the “reserve requirement“—namely, the amount of on-hand cash that would be needed to address deposit withdrawals.
To stimulate the economy with new lending, the regulators gradually reduced the reserve requirement to zilch, nada, zero, meaning that the banks no longer had to maintain a level of ready cash for withdrawals. Now consider that with the proliferation of nonbank lenders, the current loan-to-deposit ratio sits at roughly 62 percent nationwide. With no cash requirement, the banks (including SVB) have built extensive securities portfolios, largely gilts (treasury- and government-guaranteed mortgage securities). Reallocating the asset side of their balance sheets into purportedly risk-free assets should have been considered a very conservative portfolio move. In fact, looking at the SVB balance sheet at the time of its takeover, its loan-to-deposit ratio was a mere 43 percent. Most would say, “Good on you.”
Page back to Dodd-Frank and its imposition of stress tests, capitalization levels, and risk assessments. It failed significantly in addressing the changing balance sheet composition of banks, from ledgers dominated by “credit risk assets” (i.e., loans) to the significant inclusion of assets subject to “interest rate risk.” With the recent quantitative tightening (i.e., rising rates), so-called risk-free assets were fixed rate, longer duration investments, which moved inversely with interest rates. As such, the “conservative gilt” portfolios ended up as a financial hara-kiri. By recognizing the current value of the “gilts” given rate moves, such portfolios incurred billions of dollars of losses. And based on the size of such portfolios vis-à-vis overall asset levels, coupled with leveraged banks’ equity, to which the losses are allocated, banks would find themselves either capital-impaired or rendered insolvent.
