Are we headed for systemic financial distress?

The failure of several mid-sized US banks over the last few weeks has raised the spectre of a new financial crisis, even though many observers have pointed (correctly, in my view) to critical differences to 2008, including stronger capital and liquidity buffers and better supervisory preparedness. But parallels to previous episodes of monetary tightening are clearly there (including the S&L crisis).

How did we get here? As far as I can see, the problem in the failed banks has arisen from a maturity mis-match than cannot be addressed by the banks in the short-term. Banks heavily exposed to fixed-rate securities on the asset side of their balance sheet (such as government bonds) have incurred losses, due to rising interest rates (and thus lower bond prices).  While these losses can be considered book losses as long as the bonds are not being sold and do not have to be marked-to-market, liquidity pressures of these banks led to sales pressures and thus realization of losses. The problem is that informed large depositors and creditors can see these losses and react accordingly by withdrawing their funds even before realization of losses.

Sectoral specialization seems to be one driving force behind the failure of these banks at this specific point in time. Banks typically do not fund start-ups, especially those reliant on intangible assets, such as tech firms. That seems to be at the core of the reliance of many West Coast tech start-ups on specific lenders and their rush (or run) to withdraw funds when SVB got into trouble.  Exacerbating is the fact that the crypto and fintech sector has come under pressure as well.   When SVB in turn had to sell government bonds for liquidity purposes it incurred losses mentioned above, thus leading ultimately to solvency pressure and the intervention by the FDIC.

Ultimately, the US authorities decided to make all depositors whole (I am reluctant to call this a bail-out, to make the clear difference to a case where all debtholders, including non-deposit creditors or even shareholders are made whole), using the systemic risk exception. According to the FDIC, the gap will not be filled with taxpayer resources, but with future additional levies on the whole banking industry.  It is important to note that this is an approach that can work in idiosyncratic bank failures but not systemic banking crises. One wonders whether it is purely stability concerns or also political reasons and lobbying pressure of a well-connected tech sector that led to this blanket insurance.

Ultimately, this bank failure shows the three externalities of bank failure: the fridge problem (milk outside the fridge going bad), as borrowers of the tech sector lose access not only to their deposits but also external funding, which cannot easily be replaced; the hostage problem, as depositors run and put further pressure not only on the bank in question but similarly positioned banks; and the domino problem, as problems spread out through the banking sector, as seen in rapidly dropping bank share prices, in this context mostly through informational contagion.

The reaction by US authorities also shows that ex-ante commitment (e.g., with respect to limits for deposit insurance) and ex-post policy implementation show the usual gap. US authorities have invoked a systemic risk exception for making all depositors whole, including uninsured deposits. One could argue that this is constructive ambiguity, with the objective of fostering market discipline. One wonders whether such constructive ambiguity really works and if ex-ante insuring all deposits (at least the ones in transaction accounts) would be more honest. An alternative would be private insurance offered to large depositors – but not a realistic business proposal as long as there is a chance of the FDIC stepping in with blanket insurance.  I am not sure of the answer to this challenge but this this is a valid question to be discussed.

The current turmoil also raises additional challenges for central banks as they try to tighten monetary policy to stave off inflation and the risk of financial dominance: similarly as the Bank of England in September who had to pause its quantitative tightening programme. Similarly, the Federal Reserve’s new lending facility for banks against securities at face value goes against the idea of monetary tightening.

So far, there seems to be political consensus on the crisis management approach in Washington DC. I would not be surprised, however, if soon the bailout of primarily California-based banks will be used by Republicans (I can see the theme already: Florida and Texas taxpayers/bankers bailing out liberal/woke banks and tech firms on the West Coast).  After I wrote this sentence, I found this article in the Washington Post; voila!