The shock collapse of Silicon Valley Bank has erupted in a volley of finger pointing at central banks, regulators, venture capitalists and governments. However, this is only part of the story. Until we understand the cyclical nature of financial crises, and take a step back to contextualise our current situation, we will always be on the back foot when it comes to preventing these crises, writes Huw Macartney.
We’re asking the wrong kind of questions surrounding the collapse of Silicon Valley Bank. Five main issues have emerged thus far: business models; stability; moral hazard; regulation; and tightening. With depositors’ money on the line and the potential failure of even more banks, these five immediate and pressing issues are understandable. But there is never a right time to ask a sixth set of questions – those around financial, regulatory and monetary policy cycles. Without considering the broader picture, we remain stuck in a Groundhog Day loop, where crisis follows crisis with disconcerting regularity and similarities, and yet the authorities (alarmingly!) seem repeatedly shocked when the loop repeats itself. Until authorities recognise and get ahead of the cyclical nature of financial crises, our responses to crisis will always be on the back foot. A new cyclical argument for regulatory politics needs to be built.
On Friday 10th March US authorities took control of Silicon Valley Bank. As the US Federal Reserve raised interest rates, holders of long-term government bonds saw the price of those investments fall. SVB had large holdings of these supposedly safe bonds and by Wednesday 8th the bank admitted that it had lost $1.8bn in attempting to offload these assets. The bank then declared that it would need to sell its own shares to cover losses. The following day its share price had fallen 60% as depositors rushed for the exit. This was – as you will almost certainly now be aware – the second biggest bank run in US history; a not insignificant achievement for a little known West-Coast bank!
Let us first consider the five issues that are dominating SVB coverage.
First, analysts are asking questions about the business model used by SVB. Why did it decide to pursue such a seemingly fragile investment strategy – whereby 95% of its deposits were effectively uninsured and it invested so heavily in long-duration bonds? To what extent did it function as a bank – which has less risk and more insurance – as opposed to something similar but notably different, like a money market fund – with more risk and less insurance? The aim, one supposes, is to get to the root of why this bank failed and how appropriate government rescue packages are.
We remain stuck in a Groundhog Day loop, where crisis follows crisis with disconcerting regularity and similarities, and yet the authorities (alarmingly!) seem repeatedly shocked when the loop repeats itself
A second line of questioning concerns the financial stability risks which may or may not stem from this particular failure. Here the question is whether or not this one, small(ish) bank might trigger wider systemic problems, either in the financial system or the tech sector. At the time of writing it is probably too early to answer those questions. But indications from the Biden administration and the Fed are that they stand ready to do “whatever it takes” to save the banks, and the rescue of Credit Suisse by Swiss authorities seems to confirm this claim. That kind of language has been used in recent history by other central banks, during the financial crisis, the eurozone crisis and the pandemic. The boldness of the language indicates how serious the US government and other western authorities are about preventing a wider crisis. Financial Armageddon is a long way off. The tech sector on the other hand was already struggling before the SVB collapse, and its future remains less certain.
A third set of questions involve moral hazard and the claim that the “non-bailout bailout” of SVB – by raising the deposit insurance limit to limit individuals’ losses but refusing to save directors and shareholders – effectively adds a further set of financial institutions to the systemically significant (SIFI) category usually reserved for only the largest banks. The freedom of a ‘free market’ would also include the freedom to fail though. At a deeper level, important questions are also being asked then about whether banks are in reality private institutions, given the fact that governments so readily step in to rescue them that the state has effectively underwritten the entire banking system.
A fourth set of questions concern regulation, spilling over from the previous SIFI issue and bringing us closer to our theme of cycles. Critics are asking why the Fed didn’t pay closer attention to the potential risks and whether it was prudent to recently relax regulatory requirements placed on these mid-tier regional banks. The way this question is framed harks back to the money market funds issue outlined above, and to the specificities of the funding models of the venture capital-backed tech industry. The aim here seems to be the search for culprits. Why didn’t authorities see this coming? We will return to that question below because it deserves closer inspection.
Finally, a fifth set of questions concerns tightening, and the role that Federal Reserve monetary policy plays in this debacle. Given that the Fed and other central banks have already hinted that they will ease off on tightening policy – meaning slower and lower interest rate rises – this suggests that the Fed also acknowledges its mea culpa as the blame game continues to unfold.
Of course, these are not unimportant questions. But I would like to suggest the need to combine questions four and five within a much broader frame of reference. The immediate concern – and rightly so – is how to protect depositors’ money; followed closely by the question of how to prevent contagion and the collapse of a further set of financial institutions. Yet I think it is equally important to situate these questions in the context of a theory of financial, regulatory and monetary policy cycles. Put differently, and at the risk of oversimplifying, if we took a step back and acknowledged the underlying pattern over recent decades, why is this latest bank failure such a surprise?
The pattern is actually rather simple: an economic or financial crisis occurs; what follows immediately is a government rescue package (to varying degrees and with different targets in mind); then follows a loosening of monetary policy (rates are lowered and – more recently – bond-buying programmes (QE) are launched), all in a bid to stave off recession and promote economic recovery. Next, in the medium term, regulators tighten their regulatory grip, reems of new legislation are passed, new institutions are created, and there is a “looking in the rear-view mirror” period of trying to make sure that we never experience such a crisis again. Gradually though, the economy starts to improve, partly induced by new lending stimulated by lower rates and increased liquidity, regulations are watered down or repealed, the finance industry presents a “we’re alright Jack” façade, and all seems well. Until… the next crisis hits.
The freedom of a ‘free market’ would also include the freedom to fail
Apply that cycle to the past twenty years and you can essentially explain the broad contours of the dot.com boom and bust, the low interest—low inflation nexus of the 2000s with its lending and credit boom, the financial crisis, the period of re-regulation and low(ered) interest rates that followed, the explosion of asset prices and corporate indebtedness of the 2010s, and the responses to COVID19. The pandemic is something of an anomaly insofar as it began as a global health crisis. But it quickly wreaked havoc in financial markets which was then accompanied by massive government spending packages, swollen central bank balance sheets, which – alongside the Ukraine war and global energy crisis – produced the rapidly rising inflation that required central banks to raise interest rates, the immediate trigger for the failed securities sales that lead to the collapse of SVB. Add to the mix the fact that the specifics of the regulatory cycle in the preceding years involved removing tighter regulations on regional banks like SVB – which were deemed to not qualify as systemically significant – and here we are again, with bank bailouts, central banks loosening monetary policy, and regulators on standby. Groundhog Day is coming around again.
So, with a theory of financial, regulatory and monetary policy cycles in mind, what are the right kinds of questions to be asking? Two spring to mind: one specific and one more general.
Specifically, in this instance, why were regulatory authorities not more prepared and alert to the fact, given the buoyancy of stock markets in recent years and the lending boom of the 2010s, that rising Federal Reserve rates would almost inevitably trigger the collapse of big financial institutions? This isn’t just a general question about how involved regulators should be in the private firms they supervise. This is a much more specific question of timing and sequencing. Increasing interest rates will almost certainly trigger financial instability, so why weren’t greater supervisory resources being deployed in areas such as macroprudential (stability ensuring) policy in this particular instance?
And more generally, why are we stuck with this crisis inducing regulatory and supervisory cycle? Under the current regime, the kinds of financial crises noted by economists such as Hyman Minsky are now the norm, fuelled by monetary policy and the boom and bust dynamics of the credit cycle. More perplexingly though, regulatory policy seems always to be chasing the last crisis and reinforcing the financial cycle dynamics, rather than leaning into the wind as history suggests it should.
What should we do differently? One obvious answer is to internalise the structural, cyclical factors into regulatory decision making. Major pieces of post-crisis regulation are consistently watered down at precisely the wrong moment in the financial cycle; at precisely the time when they are just about to be needed the most acutely. Armed with this knowledge, regulators should stand their ground against political pressure – “the time for tough regulation has passed” – and industry lobbying – “those regulations are hurting financial services and stymieing the economy”. More optimistically, even greater regulatory resources should be afforded the authorities as the financial cycle is on the up.