Home / Opinion / Columns /  It takes a foundation of trust to prevent SVB-like runs on deposits

Silicon Valley Bank (SVB) was ranked among the top 20 by Forbes magazine in its ‘America’s 100 Best Banks’ annual list published on 16 February. This ranking is based on the performance and credit quality of all large publicly-traded banks in the US. In less than three weeks of Forbes’ grand anointment, SVB has crashed to zero value. This is the fragility of trust. A precious asset that a bank must have is intangible and not visible on its balance sheet. It resides in the minds of its depositors but can be destroyed by mere whispers.

SVB’s implosion was a classic bank run. When all depositors rush to the bank to withdraw their savings, only the first few lucky ones can get out their full amount. The rest get a small amount insured by the US Federal Deposit Insurance Corporation (FDIC) and can potentially lose everything else. Fearing this, there is a stampede to be the first and beat others in the queue. What can cause such a stampede? Gossip, misinformation, rumours. It could be deliberate or organic. Just as there is no smoke without fire, rumours too often have a basis in something rotten in the bank’s assets.

But here’s the thing. A bank can be fundamentally sound, and can still be felled by a roaring fire of panic caused by a small tinder of gossip. This is called a “self-fulfilling prophecy" of doom, to which a bank is most susceptible. This vulnerability to a bank run is due to the inherent nature of the banking business model, which is heavily leveraged. It uses only 10% as owners’ capital. The rest of what it deploys are funds borrowed from the public in the form of deposits, of which only a small part is insured. Deposits can be demanded back on short notice, whereas the assets of the banks (i.e. loans) cannot be liquidated easily. This is the basic maturity mismatch between assets (loans) and liabilities (deposits). In normal non-panic times, banks don’t need too much liquidity to cater to the demands of depositors. The public thinks their deposits are safe because others think so. This is a fragile equilibrium. The fact that small deposits are insured (in the US up to $250,000 and in India up to 500,000) helps keep avoid bank runs.

But in SVB’s case, 93% of the deposits were uninsured. How did the bank get away for so long with such a large portion of uninsured deposits, presumably from informed and savvy large depositors? Because it was offering higher rates than other banks. Hence, there was a deluge of deposits, mostly from startups that had generous funding from venture capitalists, of nearly $200 billion. The bulk of these deposits were parked in mortgage-backed securities, i.e. bonds based on home loans. The value of that home loan portfolio crashed thanks to rising interest rates. This meant that in a bank-run type panic, SVB would not be able to return all its depositors’ money. The FDIC decided to shut down SVB fearing a contagion that could spread to other banks as well due to herd behaviour.

Last year’s Economics Nobel Prize was given to folks who developed a mathematical model that explains this very behaviour. The remarkable thing is that such herd behaviour can bring down even a healthy bank. But alas, FDIC’s action did not douse the flames of panic. There was a danger of large amount of fund withdrawal, and soon other banks would be singed by this fire. SVB is the most dramatic bank failure since the implosion of Lehman Brothers back in 2008, but nowhere close to causing systemic risk. And that this happened despite thousands of pages of new regulation since then in the form of the Dodd-Frank bill is proof that greed and panic can always destabilize banking. American regulation believes that banks should be allowed to fail, and depositors ought to know that their money in the bank is not without risk. But yet again, depositors of SVB and Signature Bank (another one that crashed) have been assured that their entire deposits would be returned.

The federal government of the US has said that this is not a taxpayer-funded bailout. The Federal Reserve will provide cheap loans to help SVB pay back all its depositors. One fails to see how this monetary camouflage of a fiscal bailout is not taxpayer funded. The bank’s shareholders have lost all value, and its new owners will get to run the bank. So, yet again, private losses have been socialized through government action.

In India’s case, since the government is the dominant owner, a wipe-out of shareholders in a bank run-type failure would mean that the Centre would take the hit. And new capital infusion too would require government funds. Either way, it is taxpayers who carry the burden. By containing the SVB crash, US regulators have prevented contagion, but at a big public cost. President Joe Biden has promised to punish the guilty. He may discover that at guilt here is the basic banking model, which rests on the fragile confidence of depositors. The security of this confidence requires extra-vigilant regulators. For example, how did the FDIC miss that SVB was sitting on 93% of uninsured deposits? How did US regulators miss that SVB had huge exposure to bonds which would lose value rapidly with rising interest rates? Why did almost the entire startup community park its idle funds with just one bank? And how is it that only the losses of banks are socialized, but not profits? In America, taxpayers bear these failure costs indirectly through bailouts, whereas in India’s public sector-dominated system, there is a direct burden through capital infusion and bad loan write-offs. Either way, maintaining confidence is costly

to the exchequer.

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