John Cochrane, who was today’s guest on Charlie’s podcast (listen here), wrote a blog post about a paper that four economists wrote over the weekend. They look at the question many people are now asking: How unusual was Silicon Valley Bank?
Every bank is dealing with the same Federal Reserve raising the same federal funds rate, but so far most have been fine. SVB was unusually dependent on long-term securities for its assets and unusually monolithic in its depositors, which were almost entirely tech companies. Other banks with more diversified assets and depositors shouldn’t have as hard a time.
That’s roughly what the paper found, although there do seem to be considerable risks going forward. The paper found that SVB was an outlier in how much of its deposits were uninsured. That’s because most of its customers were firms, not individuals, and firms regularly hold in excess of the FDIC’s $250,000 limit in their bank accounts. More ordinary banks with individual depositors holding less than $250,000 each are less prone to runs.
But they also found that the average bank in the U.S. has unrealized losses of about 10 percent when its assets are marked to market. That means rather than taking the face value of bonds that will be held to maturity, they are valued as if the bank were selling them immediately. As interest rates rise, the return on long-term securities falls. “Most banks operate with (to my mind) tiny slivers of capital — 10% or less. So 10% decline in asset value is a lot!” Cochrane writes.
Fortunately, the paper finds that about 90 percent of banks are better capitalized and have lower unrealized losses than SVB. But that means 10 percent are worse off on those metrics. Again, they don’t have the added kicker of almost entirely uninsured deposits, which means they are unlikely to experience runs similar to SVB. But those banks could still struggle going forward.
This is where Cochrane really brings it home:
How are 100,000 pages of rules not enough to spot plain-vanilla duration risk — no complex derivatives here — combined with uninsured deposits? If four authors can do this in a weekend, how does the whole Fed and state regulators miss this in a year? . . .
This debacle goes to prove that the whole architecture is hopeless: guarantee depositors and other creditors, regulators will make sure that banks don’t take too many risks. If they can’t see this, patching the ship again will not work.
This is the sort of thing the Fed should have been aware of when making monetary policy. While the FOMC meetings make the headlines, most of the day-to-day work at the Fed, especially at the regional Feds, is in bank regulation. They should have been better prepared for the inevitable consequences of the FOMC’s decisions.
And inflation still lurks, at roughly triple what it’s supposed to be. Real interest rates are still negative, and nominal GDP is still growing well above its pre-pandemic trend, which suggests that monetary policy isn’t even contractionary yet. As Scott Sumner wrote on his blog, nominal GDP growth was 7 percent in 2022, almost double what it should have been if it had returned to its pre-pandemic path.
The Fed has spent nearly all of its worrying over the past two years on rate increases causing unemployment. It has said hardly a word on rate increases causing a banking crisis. Yet unemployment remains historically low, and there’s potential for more banking problems in the future, even though SVB was an outlier.