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.
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?
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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.
Simply, Dodd-Frank, in its feigned brilliance in correcting early deficiencies, missed the mark of monitoring “interest rate risk,” now the bane of the current banking environment.
Further, SVB is not alone in its broken-gilt affair. Reviewing call reports of the top two hundred banks in the US, nearly two-thirds find themselves in a comparable position with pro forma capital impairment. In fact, in April 2023, the Federal Reserve Bank of Kansas City reported that as of quarter three of 2022, 722 banks in the US reflected unrealized losses of over 50 percent of their capital. An industry in distress? You betcha.
Banks are highly regulated, compelled to ongoing reporting and subject to strict regulation and legislative tomes like Dodd-Frank. There are a battery of regulatory bodies overseeing them, from the Office of the Comptroller of the Currency to the Federal Reserve Bank, the Department of the Treasury, the Consumer Financial Protection Bureau, the Federal Financial Institutions Examination Council, and others. Yet, disturbingly, in their collective wisdom, they did not see the confluence of balance sheet composition, high leverage, and no reserve requirement in the wake of the rapid Federal Reserve rate hikes. Couple this with the rising risk in loan portfolios, particularly commercial real estate and consumer portfolios, and it’s powder keg time.
These are not “aha” observations. Banks report, and the regulators have a fiduciary responsibility to monitor and manage the space. Portfolio quality and monetary policy should not be surprises. Events are dynamic. Yet, one wonders whether the industry status is the result of regulator ignorance bordering on insanity, or might this be something orchestrated with intent?
Recall the Bidenette nominee for the Office of the Comptroller of the Currency, banking’s primary regulator, Saule Omarova. She had some unique views on how the economy and the banking system should run and authored an intriguing paper entitled “The People’s Ledger: How to Democratize Money and Finance the Economy.” Simply, her proposition involved moving all customer deposits held at our four thousand plus banks to be redeposited onto the Fed’s balance sheet, where everyone would hold their account.
It would then become easier for the government to “drop in” helicopter money and facilitate payments. And with banks no longer holding deposits, such would tap into the Fed, borrowing funds so to make loans to their respective borrowers, all in the spirit of efficiency and targeting funds into the economy where needed.
Panacea?
Consider, also referenced in the paper, how the Fed would have the ability to drop money into accounts directly. Alternatively, it could remove money from accounts if the Fed and the govvies believe that there are inflationary pressures and there’s a need to restrict the money supply. On the lending side, due to the “mother, may I” nature of banks borrowing from the Fed to lend to their borrowers, policy makers could weigh in. Industries in favor, like the green industry, would have access to credit, whereas industries out of favor, like fossil fuels, may need to borrow outside the banking system. Ms. Omarova’s People’s Ledger bank could embark on redlining.
In effect, Ms. Omarova’s postulate seems Orwellian—the centralization of the banking spigot under the auspices of efficiency and fairness. Ultimately, she withdrew her nomination as it became clear she would not be confirmed.
But her paper resonates as she envisaged a centralization, consolidating an industry for policy purposes. There are certainly those who subscribe to central control; thus, might not a banking crisis (i.e., reducing bank numbers) allow the People’s Ledger to manifest?
So, do we find a crisis due to exogenous circumstances or thoughtful endogeny? A crisis of neglect or one carefully planned?
Finally, it is noted that the release of FedNow, the Federal Reserve’s payment platform, is scheduled for July 2023, which looks incredibly like the People’s Ledger.
Coincidence?
