When the business day ended on March 9, 2023, Silicon Valley Bank had cash payment obligations that exceeded its cash reserves by close to $1 billion. The following morning, depositors attempted to withdraw $42 billion, a quarter of the bank’s total deposits. SVB couldn’t get the cash to pay its depositors and the Federal Deposit Insurance Corporation took control of the bank.
Sources: Financial Times, March 10, 2023 and Fortune, March 11, 2023.
Why couldn’t SVB get enough cash to pay its depositors?
When a bank needs cash to pay depositors who want to withdraw funds, it sells assets. The first assets to be sold are short-term loans like 3-month Treasury bills. If more cash is needed, long-term securities must be sold. SVB found itself in this situation on March 10. But the market value of SVB’s long-term bonds, which had been bought for $91 billion, had fallen by $15 billion. If SVB sold enough of those bonds to pay its depositors, it would have a negative net worth and be insolvent.
The bank had planned to raise more capital by selling its own bonds and issuing more shares to enable it to hold on to its long-term bonds until they reached maturity. But this plan failed. The prices of SVB bonds plunged and trading in its shares halted after they had fallen more than 60 percent lowering its market value by $9.6 billion.
Why did the market value of SVB’s long-term bonds fall?
The market value of SVB’s long-term bonds fell because the Federal Reserve (or “the Fed”) unexpectedly raised interest rates, and there is an inverse relationship between the price of an asset and its interest rate. To see why, think about a bond that promises to pay its holder $5 a year forever. What is the interest rate on this bond? It depends on the bond’s price. If you could buy this bond for $250, the interest rate would be 2 percent per year:
Interest rate = ($5 ÷ $250) * 100 = 2 percent.
But if the price of this bond were $100, its interest rate would be 5 percent per year:
Interest rate = ($5 ÷ $100) * 100 = 5 percent.
This relationship means that the price of an asset and the interest rate on that asset are determined together—one implies the other. If the interest rate is 2 percent, the bond price is $250, and if the interest rate is 5 percent, the bond price is $100.
This relationship also means that if the interest rate on a bond rises, the price of the bond falls, debts become harder to pay, and the net worth of the holder of the bond falls. Insolvency—when the value of a bank’s liabilities exceeds the value of its assets—can arise from a previously unexpected large rise in the interest rate.
When SVB invested in long-term bonds, interest rates were close to zero and expected to remain low for some time. When the Fed unexpectedly raised interest rates, billions of dollars were wiped off the market value of long-term bonds. SVB became insolvent.
What did the FDIC do when it took control of SVB?
The Federal Deposit Insurance Corporation (FDIC) insures depositors against the risk of bank failure on deposits up to $250,000. When it took control of SVB, it informed insured depositors they could access their funds on the following Monday, March 13.
The FDIC also organized the sale of SVB’s assets and the distribution of the proceeds to uninsured depositors.
Why aren’t banks required to keep 100 percent cash reserves to prevent them from failing?
The banking system is fractional-reserve banking, a system in which banks keep a fraction of their depositors’ funds as a cash reserve and lend the rest. It was invented by goldsmiths in sixteenth-century Europe. It contrasts with 100 percent reserve banking in which banks keep the full amount of their depositors’ funds as a cash reserve.
The most unrelenting advocates of 100 percent reserve banking are a group of economists known as the Austrian School, who say that fractional-reserve banking violates property rights. A deposit, they say, is owned by the depositor and not the bank, and the bank has no legal right to lend the deposit to someone else.
Some mainstream economists, including Irving Fisher in the 1930s, Milton Friedman in the 1950s, and Laurence Kotlikoff today, support 100 percent reserve banking. They say it enables the Fed to exercise more precise control over the quantity of money as well as eliminating the risk of a bank running out of cash. But most economists say the requirement to hold 100 percent reserves would prevent banks making loans and lower their profits, which would weaken rather than strengthen them. The demand for loans would be met by a supply from unregulated institutions, and they might be riskier than fractional-reserve banks.
How are fractional-reserve banks regulated in the United States?
Banks are engaged in a risky business, and a failure, especially of a large bank, could have damaging effects on the entire financial system and the economy. To make the risk of failure small, banks are required to hold levels of reserves and owners’ capital that equal or surpass ratios laid down by regulation.
If a bank fails, its deposits are guaranteed up to $250,000 per depositor per bank by the FDIC. And if a bank appears to be heading toward failure, the FDIC can take control of it.
This regulatory framework is designed to make failures like that of SVB rare and contained events.
The performance of the banking system over the weeks following the SVB failure will provide a test of the regulatory framework.
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