Monday, March 13, 2023

Thoughts on Silicon Valley Bank: Why the FDIC plan isn’t (but also is) a bailout; and why systemic risk remains


 - by New Deal democrat

There’s no big economic data being released today. Which I guess is fortunate, since we had a little kerfluffle over the weekend. Which may or may not be over. Herewith hopefully some commentary to put this in terms non-finance people can understand.

The really important issue for most people outside of the industry is whether or not this amounts to a taxpayer-funded bailout of wealthy VC’s and their clients. Answer: it doesn’t, but it kind of does.

First, let’s talk about why this was not a bailout. In 2008, when Wall Street investment banks were in crisis, neither shareholders nor bondholders nor senior management were cleaned out, in whole or in part. The USG stepped in and made them all whole. Had the USG not stepped in, they all would have been wiped out. That’s a bailout.

By contrast, in your typical FDIC takeover of a failed bank, senior management is out. Shareholders are wiped out. Bondholders, depending on how solvent or not the bank was, may take a haircut in whole or in part. And that is also exactly what has happened with SVB. No special exceptions were made. Nor does any part of the backstop announced by Yellen on Sunday offer any exception for future banks in similar trouble.

In short, a typical FDIC action. Not a bailout. In that regard, the only major wrinkle is that the FDIC was not able (at least so far) to find a buyer or a consortium of buyers for SVB, so it is having to operate the corpse of SVB directly.

Secondly, for the most part it was not a bailout of SVB depositors as well. That’s because it appears to be conceded by all parties that SVB had a *liquidity* problem (i.e., it couldn’t pay off all its depositors all at once) rather than a *solvency* problem (the value of its assets was insufficient to pay its debts). So, had the normal process played out, presumably all of the depositors would ultimately have received 100% of their money back. So, backstopping the depositors did not bail them out; it merely gave them access to all of their money now rather than later.

Now, let’s talk about why this *was* a bailout. The law is, bank depositors have FDIC insurance up to $250,000. Everyone knew this going in. Had this been The Bank of Depositors With No Political Clout, you can bet that the limit would have been enforced, and depositors would have to wait for their money. An exception was made because the depositors at SVB had enough political clout that they could have exacted major damage on the financial system. As the old saying goes (accounting for inflation), “If you owe the bank $1 million, the bank owns you. If you owe the bank $100 million, you own the bank.”

In short, the depositors at SVB had the risk that by law they assumed when they put their money in the bank in excess of $250k, removed. That’s a bailout.

Beyond whether SVB depositors received a bailout, the actions taken Sunday by regulators essentially assure that all future depositors for the duration of the plan will receive similar treatment.

But wait! It’s not taxpayer money, so it’s not a bailout! Well, it isn’t and it is. The Deposit Insurance Fund that will be tapped to make depositors whole is pre-funded by banks under the Dodd-Frank law. So, not taxpayer money? Well, the Deposit Insurance Fund is created by a tax. It is not the property of the banks, but property of the US Government. So it *is* taxpayer money, and to the extent banks are successful in passing on the costs of the assessment on to their depositors, it is depositors in “good” banks who are funding depositors in “bad” banks.

Beyond the issue of whether the rescue plan announced Sunday is or is not a “bailout“ of SVB (and Signature Bank of NY, and probably other banks in the near future), there is a much more important problem.

That problem is, the $250,000 FDIC limit on deposit insurance has effectively been removed, in total. 

Why is that a problem? Remember, SVB had a liquidity problem, not a solvency problem. Over the weekend, there was sufficient panic (that customers with large deposits at any bank deemed not “too big to fail” would withdraw their money today and put it in one of the banks subject to systemic stress tests under Dodd-Frank, causing those banks in turn to fail) that Treasury and the FDIC felt it necessary to step in and protect the deposits.

The precedent has been set. If Wall Street can put a gun to the head of the US financial system due to depositors’ foolish acts, and has successfully just done so, then every banker and large customer knows that the same thing will happen in the future.

And the next bank that does under may indeed be insolvent, not just illiquid. Is there anyone who seriously doubts that when that insolvent bank goes under, the same extortion won’t play out? The talking heads on CNBC last night were talking about massive bank runs today and recession by the end of this week had the FDIC not stepped in with a rescue. Those exact same arguments will be made when the next insolvent Bank of Depositors With Political Clout fails as when an illiquid bank fails. 

(And, by the way, we shouldn’t assume the crisis has been entirely averted. There are a number of other banks, and apparently at least one large brokerage, who might still be victims of bank runs, and need to tap the FDIC’s emergency fund, as early as this week).

In other words, we now have a banking system vulnerable to systemic risk where bankers and large clients know they can take reckless risks, but the FDIC will be forced to make their customers whole if the risks blow up, well beyond the $250,000 official limits of FDIC insurance.

Obviously the partial repeal of Dodd-Frank that was done in 2018 needs to be undone, at least mainly if not fully. That isn’t going to happen unless and until the next time the Democrats have a governing trifecta.

In the meantime, the threat needs to be minimized. That means ensuring that banks don’t have 95% uninsured deposits, like SVB did. It’s possible that large depositors might be forced to diversify, but I’m not sure if the FDIC, or Treasury, or the Fed has the legal authority to do so. That leaves enforcing such rules against banks themselves. In the future, bank covenants forcing loan clients to do all of their banking with the bank providing a start-up or similar loan must be subject to strict limits. In other words, a business like Roku can’t be forced by a bank to hold $500 Million in uninsured deposits with them. 

One way or another, if the $250,000 FDIC limit has gone away - and effectively it has - then the systemic risk to the system, and the risk to taxpayers to have to bail out those bank depositors with uninsured deposits, must be minimized. Until then, we’re in trouble.

Also, in the meantime, it seems *very* likely that banks will tighten lending standards further. This increases the odds that there will be a recession in the very near future.