Silicon Valley Bank: a modern-day crisis
Several months have now passed since the run on Silicon Valley Bank in March 2023. This column argues that now is a good point to reflect on the bank’s failure and the ensuing policy responses. Though this was a US banking experience, the lessons from the crash extend across borders, including Italy. In fact, some of the concerns over governments’ commitment to deposit insurance are perhaps even more of a concern for policy-makers in Europe.
In March 2023, there was a run by depositors at Silicon Valley Bank (SVB). The event sparked considerable attention for several reasons. First, bank runs were not supposed to happen given the presence of deposit insurance. Second, given the run, the decision of the US Government to extend protection to all depositors was contentious. Third, the instability of the bank seemed to come from unexpected sources: deposits tied to loans and the conduct of monetary policy.
Economists have been studying bank runs for a while now. Traditionally, bank runs have been explored through the work of Diamond and Dybvig’s (1983) model (known as the ‘DD framework’). Last year the committee for the Nobel Prize in Economics made clear that this was a fundamental contribution to our understanding of banks and their inherent fragility. But models are abstractions. And based on our recent experience, the DD framework needs to be enriched to provide both an understanding of these events and the policy responses.
In the DD framework, the problem of a bank run can be solved through the provision of deposit insurance. An iron-clad guarantee that the government will provide deposit insurance in the event of a run is sufficient to avoid the run. Theoretically, this is known as a commitment assumption. But what is important is that the government’s commitment to deposit insurance includes a willingness to use taxation to finance the insurance as needed.
Looking at the SVB experience, there are clearly some elements missing in the current framework. Economists should consider the following:
- Monetary policy and asset value. When the Federal Reserve raised interest rates it lowered the prices of liquid assets. All else the same, the reduction of the value of liquid assets makes banks such as SVB more vulnerable to runs.
- Deposit insurance. In the standard version of the DD model, once there is credible deposit insurance, runs no longer happen, as everyone is covered. But that is because it is assumed that all deposits are insured. The SVB episode shows that this is not the case.
- Equity. In the SVB episode, there was an attempt to raise more equity to meet the needs of depositors. But this source of funding evaporated. This episode makes clear the need to understand the interaction of the decisions of equity investors along with depositors.
- Depositors aren’t always households. For SVB, depositors were largely (tech) firms, with loans from that same bank. Evidently, and probably for incentive reasons, there was a link between making a loan to a firm and requiring funds to be deposited at the bank. This connection is absent from the standard DD model.
What are the main lessons for bank regulators and the US Treasury?
The policy response of the US Government (involving bank regulators and the Treasury) to the SVB failure can be summarised in two points:
- The cap on deposit insurance is (apparently) gone and all depositors are protected.
- Taxpayers are not at risk.
This looks too good to be true: does this package really stabilise the US banking system? This is an important question that cannot be neglected or put aside as all too often the policies that are adopted to deal with one crisis set in motion the next one.
Answering this question, and thus assessing the policies put in place, builds upon the lessons drawn from the DD model.
No cap anymore
The first part of a potential reform package extends deposit insurance to everyone, without limit. Given that the run at the SVB was in part driven by uninsured depositors, this appears to be an easy way to stabilise the banks. But it should be emphasised that it came after the crisis, undermining the credibility of the whole deposit insurance scheme.
While the response to the SVB run did not take away deposit insurance, the extension to supposedly uninsured depositors made clear that the guidelines for the provision of deposit insurance are, just that, guidelines. Clearly, the US government seems willing to decide after the fact exactly what insurance to provide. This raises doubts about the credibility of deposit insurance and is a potential cost to the intervention.
And this is related to the relaxation of the cap. A limit on deposit insurance also limits the funds that are transferred from the relatively poor households to rich depositors. An increase in the cap means more redistribution towards the rich. All else the same, this reduces the credibility of the promised deposit insurance.
No taxpayer at risk
Normally it is reasonable to think that in the event of a run taxpayers must bear some of the burden of providing deposit insurance. If the government has to provide, say, $10 trillion in deposit insurance, then one source for this must be taxation. It could be immediate taxation or debt financing of the deposit insurance today, with taxes coming later.
If, under the current US plan, taxpayers are off the hook for financing deposit insurance, then where will the resources come from? Could the answer be through the resources of the Federal Deposit Insurance Corporation (FDIC)? The fund is created through contributions of member banks. Depositors of these banks receive protection through this fund.
But the unfortunate reality is that the resources of this fund are small relative to potential depositor needs. From the FDIC, the fund has a target to be able to protect 2% of the deposits in the US. This is enough money if one bank fails. But it is far from enough if all banks fail.
So, what if taxpayers were not protected and instead the FDIC had the backing of the US government? That means the government would raise taxes or issue debt (i.e., raising future taxes) in response to a run. If this was credible, then that would be enough to avoid the run.
Is this promise credible? That is, would the government actually go ahead and raise taxes to pay off depositors?
This is exactly the question I have been trying to answer in joint work with Hubert Kempf. Crucially, the level of taxation needed to finance deposit insurance may entail a redistribution from poor (Main Street) to rich (Wall Street). The magnitude of this redistribution depends on the relative size of the deposits being insured and the progressivity of the tax system. If the tax system is not very progressive, then the provision of deposit insurance does imply that the rich get a lot more from their deposits being insured compared to the poor. This may be socially undesirable. If so, this means that in the event of a run, the government may not have the incentive to provide the promised deposit insurance.
Protecting deposits is vital for fostering trust within the banking system. If the SVB run has taught policy-makers anything, it should be that carefully designed insurance schemes and regulatory systems are essential. And, most importantly, they must be credible.
Author: Russell Cooper