Jakub Porzycki/NurPhoto via AP
This story is part of a Big Ideas series that brings together experts to offer steps that the government can take to protect the financial system, after the collapse of Silicon Valley Bank showed its inherent fragility. You can read all of the stories in this series here.
In the Great Financial Crisis of 2008, it was the globally significant banks. This time, the problem is in the regional banks. But the underlying issue is not that different. Banks finance very little of their assets with their own money. They rely heavily on debt, not equity. When the bets they have made lose value, and it looks like they might have trouble repaying their debts, creditors head for the exits. This reveals whether or not the bank is insolvent. If enough banks are in the same situation, there is contagion and financial crisis.
In the GFC, short-term creditors like “repo” lenders and buyers of asset-backed commercial paper kicked off the runs on Citibank, Lehman, and others. This time, the run was started by uninsured depositors at Silicon Valley Bank. But the outcomes were qualitatively similar, although not (yet) at the same scale. Federal regulators had to step in and take extraordinary efforts to contain threats to financial stability created by a creditor run.
The failure of SVB and two other regional banks led to the creation of a special Bank Term Lending Facility, which will make loans secured by Treasurys and other collateral. (The collateral will be valued at par, rather than market values, and will not be reduced by a “haircut” as is usual in collateralized lending.) There have also been post hoc guarantees to uninsured depositors, and generalized assurances that the banking system will be stabilized. In the GFC, after numerous “special-purpose vehicles” bought many billions in bank assets, a systemic meltdown was averted only by a more or less universal guarantee of all bank assets.
But why have federal regulators once again needed to invent a rescue package on the fly? Why couldn’t existing mechanisms, including enhanced regulatory power created by the Dodd-Frank Act in 2010, handle this run?
WE KNOW THERE ARE MECHANISMS to prevent bank runs from demolishing solvent institutions. If the bank’s creditors want cash, and meeting those demands would require loss-producing asset sales, the bank can take assets to the discount window at the Federal Reserve and obtain a secured loan, at an interest rate tied to policy rates. Because the window operates to protect the Fed from loss, the collateral is marked to market and then “discounted” to cover repayment risk.
Depositories also have access to cash via the Federal Home Loan Bank system. The FHLBanks provide loans to member banks, called “advances,” collateralized by mortgage loans and other acceptable assets. Like the Fed, the FHLBanks apply a discount to the market value of collateral they accept. Since the SVB collapse, banks have ramped up their usage of both the discount window and the FHLBanks by hundreds of billions of dollars.
Banks that are truly solvent—with a discounted market value of assets greater than debts to depositors and other creditors—can handle a surge in depositor redemptions, then, by obtaining collateralized loans. They can avoid realizing short-term losses on assets because of adverse market events. They can also buy time to raise new equity finance, if necessary, to assure depositors and others that they remain solvent.
In addition, regulators have rules in place that are intended to prevent insolvency. Among other things, they require banks to meet minimum ratios of equity to total assets. That is, they require that banks finance a minimum fraction of their assets with their own money.
These limits on bank “leverage” are a form of self-insurance against insolvency. If the banks finance a sufficiently large portion of their assets with equity, then they are able to borrow against or sell their equity-financed assets to help pay off the fixed claims of creditors. If this entails realizing losses, they would be borne by the bank owners, through loss of equity.
In the Federal Reserve’s most recent Financial Stability Report, issued in November 2022, the agency expressed confidence in existing leverage and risk capital requirements. “Higher levels of loss-absorbing capacity in the banking sector and among broker-dealers that have prevailed since the structural reforms introduced following the 2007–09 financial crisis signal resilience in those institutions,” the report concluded.
So why was SVB unable to meet depositor demands for cash? The answer is that the bank was insolvent, or nearly so, and any discount window or FHLBank loans for which it was eligible would have been insufficient to pay off all its creditors.
Available data illustrate this. A large part of the bank’s assets were Treasury bonds and agency mortgage-backed securities, bought between 2020 and 2022 as uninsured deposits increased dramatically. When interest rates increased, the market value of these and other securities declined. At the end of 2022, SVB accounting statements estimated unrealized losses of $15 billion on the “held to maturity” securities in its portfolio. Banks are not required treat these estimated losses as reductions in equity, even though in the case of SVB they nearly equaled its entire book equity of $16.2 billion. However, when the bank sold $21 billion in bonds to raise cash in 2022, and was forced to realize losses, its financial weakness became obvious, uninsured depositors ran, and the discount window and FHLBanks were no longer sustainable options.
It is quite remarkable that, while SVB was effectively insolvent in 2022, it was still in compliance with regulatory leverage requirements. A bank of its size is considered “well capitalized” if its equity is greater than or equal to 5 percent of its assets. At the end of 2022, SVB’s ratio was 7.96 percent. The fiction of solvency was maintained by the bank’s decision to designate lots of securities as “held to maturity.” This accounting maneuver is legal, and its effects are well understood by regulators. (It is becoming clear that the bank’s liquidity, or the amount of ready cash available to cover net cash outflows, was insufficient under the original rules of Dodd-Frank, before they were made weaker for large regional banks in a 2018 law.)
IT LOOKS LIKE THE FED SHOULD HAVE ACTED faster to close SVB, given what was observable. It is also apparent that allowing banks to ignore losses on securities by calling them “held to maturity” is a huge problem. According to the chair of the Federal Deposit Insurance Corporation, unrealized losses on both held to maturity and available for sale securities at the end of 2022 was $620 billion.
However, even if securities were always marked to market, regulators would never be able to monitor bank solvency with precision. There are too many banks, asset portfolios are far too complicated, and market values change far too fast.
If regulators really want to prevent bankers from moving into the neighborhood of insolvency, they need to set much higher equity requirements. When bankers have more of their own money at risk, they will take greater care. When they take losses, they will be more likely to bear them. Even when actual equity can only be approximately measured, higher requirements will reduce the probability that banks will fail.
Bankers have a well-rehearsed objection to higher equity requirements. They claim that equity is more expensive than debt, and raising equity requirements will raise borrowing costs for households and businesses, thereby raising the costs of home mortgages and capital investment, and generally gumming up the economic works.
This objection is rubbish. As Anat Admati and her collaborators have explained in detail, it rests on misunderstandings of basic finance. Moreover, since interest rates generally move with Fed policy rates, any effect on bank-mediated lending rates could be countered through monetary policy.
So as the Fed goes through its postmortem on SVB, and presumably on other banks like Silvergate and Signature that had similar fates, it has a great opportunity. It can modify regulations, using its existing authority, to reduce the likelihood that banks or depositors need to be bailed out. Significant increases in minimum equity ratios, which might be adjusted upward with the use of uninsured short-term borrowing, should certainly be on the table.
It is really important that the Fed uses this opportunity. The GFC led to the Great Recession and a host of other bad developments. The run on SVB and similarly situated banks hasn’t caused that kind of damage yet—although caution on the part of banks is likely to lead to tightened credit to businesses and households. But it shows that banks remain fragile and have the potential to destabilize the financial system. Financial regulators need to make changes to protect the real economy.
This article reflects the views of the author, and not necessarily those of the Center for American Progress.
