COMMENTARY AND ANALYSIS: Observations on SVB and Possible Fallout

By SBE Council at 16 March, 2023, 5:23 pm

SMALL BUSINESS INSIDER

by Raymond J. Keating –

In my thirty-plus years of observing, analyzing and writing about the economy, I’ve learned a few lessons, including how to assess matters during a crisis.

First, don’t react in a knee-jerk fashion, thinking that the issues and causes are immediately clear, and likewise, don’t put too much stock in those who immediately proclaim that they know exactly what’s going on.

Second, understand that some “crises” will be short-lived – having little lasting effect, and largely being forgotten, sometimes in relatively short periods of time – while others, of course, will run deeper and have more lasting effects. During the first days of a crisis, it can be difficult to figure which path we might be headed down.

Third, markets work well, including the fact that when market participants make bad decisions, those decisions will need to be rectified or resources will get reallocated to endeavors that make economic sense. That is, markets are self-correcting.

Fourth, crises in the marketplace oftentimes find at least part of their origins in misguided governmental policies that distort incentives and decisions in the market, and, for good measure, political solutions to crises often wind up making matters worse and/or fail to address the actual causes of a crisis.

Silicon Valley Bank’s failure and the related fallout

First, the Fed’s actions on monetary policy from the past near-15 years once again have come into focus. The Fed ran unprecedented loose money from the late summer 2008 to late 2021. While this created underlying policy uncertainty, for a variety of reasons, the Fed’s loose money failed to generate higher inflation.

Instead, bank reserves exploded. Then the pandemic hit. Government doled out support checks, and demand was sustained or even increased, but businesses shut down and then supply chains were overwhelmed or seized up as things opened up. That perfect storm of loose money and supply challenges, combined with robust government money, ignited inflation. In turn, interest rates increased, especially with the Fed’s misguided attempts to slow the economy by dramatically pushing up the federal funds rate.

Second, as The Wall Street Journal ably explained, after the 2008 crisis, government – that is, politicians and regulators – made clear that Treasury bonds and mortgages backed by Freddie Mac and Fannie Mae were the keys to banks passing muster in terms of capital standards. After all, these securities have low default risk, and can be easily bought and sold. But then inflation hit and interest rates spiked, again thanks to the Fed, and the value of these “safe” securities plummeted. Depositors saw this with the Silicon Valley Bank and headed for the doors. Whoops.

As the Journal further spelled things out:

“U.S. accounting rules allow banks to avoid recognizing losses on assets they declare they’re holding to maturity, while they must mark-to-market assets they designate as ‘available for sale’ in case of distress. That mark-to-market requirement for liquid assets should give banks and regulators a clear view of the value of their liquidity cushions. But it creates an incentive for banks to shift more assets into the hold-to-maturity pool as interest rates rise. SVB was an extreme case in designating an outsized proportion of its assets as hold-to-maturity, meaning it faced crippling penalties if it had to sell bonds to satisfy deposit withdrawals.”

Third, the fallout on regional banks could have a negative effect on American small businesses. Regional banks are big lenders to small businesses, and if this episode translates into those regional banks becoming more cautious in lending, then small businesses could face constraints in terms of access to credit. That, in turn, adds to overall economic concerns regarding the U.S. heading back into a recession, and how deep that might be.

Fourth, regarding the Silicon Valley Bank and Signature Bank failures, the Fed has said that it will make depositors whole even beyond the federally insured limit of $250,000. That ramps up the moral hazard risks in the system, as we look ahead. For good measure, increased costs for the FDIC’s Deposit Insurance Fund will be felt beyond just banks themselves, contrary to claims by President Biden, given that increased insurance premiums paid by banks obviously mean less resources available for bank lending, and/or higher banking fees for customers.

Finally, facing considerable criticism for missing the warning signs, the Fed did announce that it plans to reassess its supervision of Silicon Valley Bank. As AP reported that Michael Barr, the Fed’s vice chair for supervision, who will lead the effort, said, “We need to have humility and conduct a careful and thorough review of how we supervised and regulated this firm, and what we should learn from this experience.”

That would be refreshing. Might the Fed get something right? Don’t hold your breath.

Raymond J. Keating is chief economist for the Small Business & Entrepreneurship Council. His latest book is The Weekly Economist: 52 Quick Reads to Help You Think Like an Economist.