Has Moral Hazard returned to US Banking?

A bank run is when a significant number of bank customers withdraw their deposits at the same time for fear of a bank failure. The fear may be based on factual information or mere rumours. As more depositors withdraw their funds, the bank can suffer severe cash shortfalls, which can lead to an actual bank collapse.

To put this in perspective, SVB with total assets of $US 212 billion as at 31 December 2022 is larger than Australia’s Macquarie Bank based on total assets and is the second largest US bank failure following the bankruptcy of Washington Mutual in 2008. Lehman Brothers, although larger was not classified as a bank at the time of its collapse.

The possibility of a contagion, meaning the risk of a bank run spreading to other banks in the US and potentially around the world like a series of falling dominos, prompted a joint statement by the US Treasury, Federal Reserve, and Federal Deposit Insurance Corporation (FDIC). The announcement stated that “Depositors will have access to all of their money starting Monday, March 13.”

Under the US Depository Insurance Scheme, in the event of a US bank failing, the FDIC protects the deposits of bank customers up to a limit of $US 250,000 per customer, a similar level of protection afforded to Australian depositors by APRA under its ‘Financial Claims Scheme’. The extraordinary case here is that the US regulators’ moved quickly to extend this protection beyond the $US 250,000 ceiling to cover all depositors – insured and uninsured. The regulators cited a ‘systemic risk exception’ as justification for a broader bailout of all depositors so as ‘to protect the U.S. economy by strengthening public confidence in the banking system’.

Weighing on regulators’ minds would have been the fact that 95% of deposits at SVB exceeded the $250,000 limit, thereby rendering most of SVB’s depositors uninsured.

As shareholders and some classes of unsecured creditors are excluded from this safety net, the US government’s action cannot be viewed as a strict ‘bailout’ as was the case for some financial institutions during the GFC. But it seems that large depositors (i.e. those over $US250,000) have been given a ‘get out of jail free’ card.

What does this mean for the US Banking sector and the behaviour of bank executives?

Moral Hazard Revisited

Moral hazard describes a situation in which one party engages in risky behaviour or fails to act in good faith because it knows that another party will assume the financial losses of their behaviour. It encourages further risky behaviour in the knowledge of either a consequential ‘light touch’ response or none at all. We witnessed this in the lead up to the GFC when bank executives were happy to reel in millions in bonuses on the back of risky decision-making in the face of a benign and some might even say, complicit regulatory framework.

The bank run at SVB was not accidental nor based on unfounded rumours. The forty year old Californian based bank which was the 16th largest in the US had succumbed to poor management practices, in essence risky behaviour.

^{Dr Paul Mazzola is an expert in banking and finance from the UOW Faculty of Business and Law}

What was the root cause of SVB’s failure?

Was the collapse of SVB really a surprise? Depositors were already jittery following news a few days earlier of the collapse of Silvergate Capital, a small California based bank with total assets of $US 11.3 billion as at 31 December 2022, that suffered overwhelming losses through its exposure to crypto companies, including exchanges like FTX, which filed for bankruptcy in November 2022. Meanwhile, New York based Signature Bank which also had many clients involved in crypto was hit by a similar bank run on fears that it too was afflicted by the same problems as SVB given their common customer base.

However SVB’s problems were different to Silvergate’s. As the banker of choice to more than half of Silicon Valley’s start–ups, SVB amassed close to $200 billion in deposits in recent years as new ventures raised money for their Hi-tech projects. This enabled SVB’s total assets to grow almost fourfold over the last four years to December 2022.

Unfortunately, SVB wasn’t able to write loans at the same rate as the rapid inflow of deposits and instead purchased government bonds and other long dated fixed rate securities during the prevailing low interest rate environment.

It’s well known by financial market participants, that when interest rates increase, the market value of fixed rate bonds generally decrease, and vice versa – it’s a mathematical relationship. However whilst SVB had been accumulating an oversized portfolio of high grade bonds, thinking it was a safe way to invest the bank’s excess funds, it seemingly paid no regard to the adverse impact the Federal Reserve monetary policy tightening which led to rapid interest rate hikes, would have on the market value of its bond portfolio. This is a common and fundamental risk encountered by most banks known as ‘interest rate risk’.

So when depositors came rushing to the door to withdraw their funds, and cash was urgently needed, the bank was forced to sell a sizeable portion of its bond portfolio at a heavy discount incurring a substantial loss of $US 1.8 billion in the process. This news derailed an attempted $US 2.25 billion share issue intended to raise funds to shore up SVB’s balance sheet and on the 9th March ultimately led to a 60% crash in the bank’s share price. The following day the company’s shares fell under a trading halt and the authorities finally stepped in.

In response to a fear of other mid-sized banks experiencing the same liquidity issue, the authorities also announced a ‘Bank Term Funding Program’ (BTFP) to provide qualifying US financial institutions with loans for terms of up to one year to be secured by either mortgage backed securities, government treasuries or other qualifying assets as collateral.

The BTFP measure will hopefully prevent major losses by banks on sale of bond portfolios that were purchased before the rapid rise in interest rates.

A balancing act – Moral Hazard versus System Stability

The US authorities were between a rock and a hard place. Should they allow market discipline to wield its nasty stick and sacrifice uninsured depositors and in the process risk exacerbating market nerves and a worldwide contagion? Conversely, step in as they did and protect all depositors as a ‘systemic risk exception’. The problem with their current action is that the authorities have now unleashed the ‘moral hazard’ genie from its bottle. It does beg the question of which is the lesser of the two evils?

Ultimately, the downside of an unchecked international contagion event leading to another GFC is unfathomable. If regulators allow business customers and potentially other banks to be punished by one bank’s mismanagement, then the scale of a relatively minor banking crisis can expand exponentially in a matter of hours. So perhaps the authorities were right.

On the plus side, this time the US government has made two points clear. Firstly, the FDIC protection does not extend to shareholders and certain unsecured creditors. Secondly, none of the rescue package is to be funded by taxpayers, instead, the money used to reimburse depositors would come from a fund paid into by U.S. banks.  

Lastly, the regulatory classification of Systemically Important Banks (SIBs), a title reserved for a select few very large banks in the world whose failure is deemed to potentially endanger the global economy may need to be revisited. SIBs attract a much stricter suite of bank regulations given their risk to global financial stability. SVB, a mid-sized US bank has shown us that size doesn’t necessarily matter when it comes to a global threat to the world economy – at least that’s the verdict as shown by US regulators’ recent actions.