Our recent post investigated the failure of Silicon Valley Bank (SVB). Bank regulation is designed to make failures like it rare and contained events, and the performance of the U.S. banking system following SVB’s failure provides a test of the regulatory framework.
Did bank regulators miss SVB early warning signs?
In February 2023, KPMG, SVB’s auditor, completed its review of the bank’s financial state and SVB published its balance sheet and other financial statements for 2022.
Table 1 shows the bank’s balance sheet on December 31, 2022.
Valuing the long-term securities held by SVB at book value, $91.3 billion, the bank’s value to its stockholders is $16.2 billion. But valuing its long-term securities at market value, $76.2 billion, the bank’s value to its stockholders is $1.1 billion.
SVB also borrowed $15 billion from the Federal Home Loan Bank of San Francisco, without which it would have had to sell low-priced long-term securities.
These features of SVB’s balance sheet indicate that the bank was in a weak state.
How was SVB able to get into such a weak state?
In 2010, U.S. Congress passed the Dodd–Frank Wall Street Reform and Consumer Protection Act, which aimed to strengthen the financial system and prevent a future crisis like that of 2008. The act required the banks with $10 billion or more in assets to maintain specified ratios of cash, liquid assets, and capital, and to conduct stress tests to demonstrate their capacity to withstand the largest shocks.
Between 2010 and 2018, SVB was restricted by Dodd–Frank. But in 2018, the rules changed. U.S. Congress radically weakened the provisions of Dodd–Frank with the Economic Growth, Regulatory Relief and Consumer Protection Act. Now, the Dodd-Frank rules kick in at $250 billion in assets, which exempts many small and regional banks, including SVB.
Free from the constraints of Dodd–Frank, as SVB’ deposit expanded, it invested in long-term securities that exposed it to the risk of rising interest rates.
How did the regulators respond to the collapse of SVB?
SVB is a state-chartered bank and its collapse brought swift action from both state and federal regulators.
On the morning of March 10, the California Department of Financial Protection and Innovation, the state regulator, seized SVB and placed it under the receivership of the Federal Deposit Insurance Corporation (FDIC), the federal regulator.
The FDIC was quick to announce that insured deposits (11 percent of total deposits) would be accessible on the morning of March 13.
If bank regulation is doing its job, these actions by state and federal regulators are all that are required, and SVB management, stockholders, and depositors are left with the consequences of their decisions. Management lose their jobs, stockholders bear the loss from fallen stock prices, and depositors with more than $250,000 in the bank end up with their share of the amount the FDIC can raise from selling the bank.
But that’s not what happened.
Secretary of the Treasury Janet Yellen and Federal Reserve Board Chair Jerome Powell were concerned that there might be contagion—that the collapse of SVB could ripple through the U.S. banking system like an infectious disease and cause other banks to fail. Already, a second bank, Signature, had been taken over by the New York state regulator.
So, on March 12, after consulting with President Joe Biden, Janet Yellen and Jerome Powell, joined by FDIC Chairman Martin Gruenberg announced further actions.
- The FDIC extended protection to deposits that exceeded the $250,000 maximum and thereby gave all SVB depositors access to their money from March 13.
- The Federal Reserve (or “the Fed”) created the Bank Term Funding Program (BTFP), which offers loans to banks pledging collateral valued at face value, enabling them to meet cash withdrawals of their depositors without the need to sell long-term bonds that have fallen in value.
- The Department of the Treasury made up to $25 billion as a backstop available for the BTFP, which the Fed does not anticipate it will need to draw.
Would SVB have failed if the March 12 package had been in place before?
Almost certainly not. SVB had $91 billion of long-term assets that it could have used as collateral for a loan under the BTFP, making it easy to pay $40 billion to depositors. And knowing this fact would have made it unnecessary for depositors to withdraw their funds.
Did the response of the regulators to SVB create moral hazard?
Moral hazard is a state in which a decision-maker is incentivized to increase its exposure to risk because it does not bear the full costs of that risk.
The FDIC’s decision to insure all deposits, regardless of their size, creates moral hazard. It increases the incentive to hold large deposits (greater than $250,000) by transferring the cost of bank failure from the risk-taking depositor to other banks.
And the Fed’s decision to create the BTFP creates moral hazard. It increases the incentive for banks to invest in risky assets whose market value might fall.
Did U.S. bank regulation pass its stress test?
Well, there was no contagion, which is a pass.
But the potential consequences of moral hazard created by the FDIC extending insurance to all deposits and the Fed’s BTFP will not be visible for some time.
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