The Silicon Valley Bank collapse brought back to life old controversies about the way we want banks and their supervisors to act. Political pressure for tighter regulation, broader protection, or closer supervision is no surprise — that’s what has always been done before. But blame games do not get to the heart of this recurring problem. It’s not enough to recognize that some banks took excessive risks or that some supervision was lax or ineffective. Most of the problematic behavior is just human nature, the predictable result of unhealthy incentives created by the existing system.
Still no recession. More penetrating government control of the banking industry will not change human nature. What it will do is to degrade the economy by increasing the cost of banking. More likely than not, it will produce more emergencies down the road. Still, capital-market price data are not signaling a recession. Up to now, there has been little change in the Baa-Aaa yield ratio, and only a small increase in the VIX index.
Not only is the situation made urgent and fast-moving by investor responses and public psychology, but the task of fixing the problem is faced under extreme pressure and political duress. That makes it the kind of economic problem that is even less likely to be solved than most. Efforts to think through the challenge of preventing bank runs require what is a very scarce resource in a time of crisis: patience.
If any sound solution can be derived from this experience, it will have to come from a deeper understanding of the chain of causation and its roots. Business enterprise necessitates risk-taking, and unavoidably results in occasional loss. In response to a large enough failure, government is called on to compensate current losers and protect future losers. Ironically, that makes it safer for banks to subject the system to more risk next time around.
One essential point for a better understanding is recognition that the economy’s stock of capital — its capacity to grow and prosper — is little damaged. That’s good as far as it goes. What’s changed is the way that capacity is going to be managed going forward. If unwise choices are made, that’s the bad part.
How we got here. Second, the economy has fallen into a rare trap of high inflation and near-zero growth. Those who control large pools of capital that would normally be invested in equity or debt are naturally intent on reducing duration risk. Hence the pileup of large corporate cash balances at the banks. Inflation has induced the Fed to boost the flight to cash by increasing the target interest rate on which money-market pricing is based. Predictable responses on both sides. But that might help explain why bank runs are occurring now rather than at some other time.
The third point is less obvious still. What is a slam dunk decision for particular investors is not an option for the investment industry as a whole. From the economy’s point of view, risk can be redistributed, but not eliminated. At whatever prices the situation dictates, someone has to own all the equity and all the debt. This further means that there’s an illusion involved when a depositor holds large cash balances at a bank. By its nature, a bank is an institution that invests the deposits of its customers in longer-term debt. By proxy, such a depositor is continuing to fund longer-duration assets, perhaps without realizing it.
Capital-market risk has simply been transferred from one group of players to another. In the course of a flight to cash, the financial markets redistribute risk from a large body of investors who are now uncomfortable owning stocks or long term debt to other investors who are willing and prepared to ride out the storm. These will inevitably include a few, like SVB and Signature, who were all too willing but not adequately prepared.
Economic implications. Bank runs and financial panics lead to short-term thinking and knee-jerk action on the part of both private enterprise and government. Understandably, investors are eager to get out of danger and public officials are desperate to restore calm as quickly as possible. Rather than favorable circumstances for careful analysis and accurate solutions, these crises are an occasion for actions that may well increase the chances of more emergencies down the road.
Consequences include increased distrust in the financial system, more skepticism about political leadership, and more private effort diverted from productive enterprise to compliance. Further declines of public confidence in the monetary system will be inflationary. The Silicon Valley Bank incident may lead to a decline in an already unsatisfactory economic growth rate. But capital markets are telling us that it’s not a large enough crisis to produce a recession.
Long before this turmoil began, investors were well advised to stay out of the stock and bond markets. This advice remains sound for the time being. Investors who have been investing in “hard” assets which are promoted by inflation, such as commodities and precious metals, will continue to benefit.
Public policy implications. Financial runs and panics originate from a chain reaction of risk-taking, protection, and regulation. The root of this vicious cycle is a well-known moral hazard: the more people are exonerated from the negative consequences of their actions, the less they will be motivated to act with restraint in the future.
To terminate the malfunction would require a profound reversal of government policy. That’s a tall order and needs to be approached gradually. To get policy on a different footing in the future, Washington should step back from bailouts and reduce its presence in the financial markets. A parallel banking system that is exempt from both deposit insurance and regulation should be permitted to exist in parallel with the existing system.
A financial crisis is not the best of times to hear from political authorities a sincere and realistic account of what’s wrong. So it is with this one. Washington is not only prepared to “do whatever it takes” to restore order, but assures taxpayers that whatever public money has to be spent will not come at their expense. This is ludicrous.
