The Silicon Valley Bank fiasco is an old story with a social media twist

Banks, like all companies, usually fail after a long period of poor performance. But SVB, the country’s 16th-largest bank, was stable and highly profitable just months earlier, after posting roughly $1.5 billion in profit in the last quarter of 2022.

However, financial history is full of examples of apparently stable and profitable banks that unexpectedly failed.

The decline of Lehman Brothers and Bear Stearns, two prominent investment banks, and Countrywide Financial Corp., a subprime mortgage lender, during the 2008-2009 financial crisis; the savings bank crisis in the 1980s; and the complete collapse of the US banking system during the Great Depression was not exactly so. But they had something in common: an unexpected change in economic conditions led to an initial bank failure or two, followed by general panic and then full-scale economic distress.

The main difference this time, I think, is that modern innovation may have accelerated the decline of SVB.

Great Depression

The Great Depression, which lasted from 1929 to 1941, epitomized the public damage that bank runs and financial panics can wreak.

After a rapid expansion of the “Roaring Twenties,” the US economy began to slow in early 1929. The stock market crashed on October 24, 1929 – a date known as “Black Tuesday”.

The massive losses suffered by investors weakened the economy and led to difficulties for some banks. Afraid of losing all their money, customers started withdrawing their funds from the weaker banks. These banks, in turn, began rapidly selling their loans and other assets to pay their depositors. These quick sales pushed prices further down.

As this financial crisis unfolded, depositors with accounts at nearby banks also began lining up to withdraw all their money, in a typical bank run that culminated in the collapse of thousands of banks by early 1933. Shortly after President Franklin D. Roosevelt’s first inauguration, the federal government resorted to closing all banks in the country for a full week.

These defaults left banks unable to lend money, leading to more and more problems. Unemployment rose to around 25% and the economy shrank until the outbreak of World War II.

To avoid a repeat of this debacle, the government tightened banking regulations with the Glass-Steagall Act of 1933. It outlawed commercial banks serving consumers and small and medium-sized businesses from investment banking and created the Federal Deposit Insurance Corporation, which covered deposits up to a certain threshold. This limit has grown significantly over the past 90 years, from $2,500 in 1933 to $250,000 in 2010 – the same limit in place today.

S&L crisis

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 1980s, hundreds of the small banks known as thrifts failed. Savings and loan associations, also called “savings banks,” were generally small local banks that primarily made mortgage loans to households and collected deposits from their local communities.

Since the savings and loan industry was not directly connected to the big banks of the day, its collapse did not lead to runs on the larger institutions. Still, the S&L collapse and government regulatory action reduced the supply of credit to the economy.

As a result, the US economy experienced a mild recession in the second half of 1990 and the first quarter of 1991. However, the banking system evaded further troubles for almost two decades.

The Great Depression

Against this backdrop of relative stability, in 1999 Congress repealed most of Glass-Steagall — removing Depression-era regulations that limited the scope of deals in which banks could be involved.

These changes contributed to what happened when the entire financial sector panicked at the onset of a recession that began in December 2007.

At the time, large banks freed from Depression-era securities trading restrictions, as well as investment banks, hedge funds, and other institutions outside the traditional banking system, had invested heavily in mortgage-backed securities, a type of bond pooled mortgage payments by many homeowners. These bonds were highly profitable in the midst of the real estate boom of the time, helping many financial institutions achieve record profits.

But the Federal Reserve had been raising interest rates since 2004 to slow the economy. By 2007, many households with adjustable rate mortgages could no longer afford to make their higher than expected home loan payments. This led investors to fear a spate of mortgage defaults, and the values โ€‹โ€‹of mortgage-backed securities plummeted.

As with the Great Depression, the government responded to this financial crisis with significant new regulations, including a new law known as the Dodd-Frank Act of 2010. It imposed tough new requirements on banks with assets in excess of $50 billion.

Closely connected customers

Congress reversed some of Dodd-Frank’s key changes just eight years after the measure was approved by lawmakers.

Notably, the strictest requirements were now reserved for banks with more than $250 billion in assets, up from $50 billion. That change, passed by Congress in 2018, paved the way for regional banks like SVB to expand rapidly with much less regulatory oversight.

But still, how could the SVB collapse so suddenly and without warning?

Banks accept deposits in order to make loans. But a loan is a long-term contract. Mortgages, for example, can run 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 funds for their customers.

In the case of SVB, the bank invested heavily in US government bonds. These bonds have no risk of default as they are debt instruments issued by the federal government. But their value falls when interest rates rise because newer bonds pay higher interest rates compared to older bonds.

Will more shoes drop?

The government failed SVB, which is being sold to First Citizens Bank, and Signature Bank, a smaller financial institution. But it agreed to repay all depositors โ€” including those with deposits over the $250,000 limit.

Although the authorities have not explicitly guaranteed all deposits in the banking system, I see the rescue of all SVB depositors as a clear signal that the government is ready to take extraordinary steps to protect deposits in the banking system and prevent a general panic.

I think it’s too early to tell if these measures will work, especially as the Fed is still fighting inflation and raising interest rates. But for now, the big US banks appear safe, although there are growing risks at the smaller regional banks.

Rodney Ramcharan is Professor of Finance and Business Administration at the University of Southern California.

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