Bank closures are a signal of tighter lending, a disinflationary trend

AUTHOR: Michael R. Malone

Newswise — David Andolfato, a professor and chair of the Department of Economics at the University of Miami Patty and Allen Herbert School of Business, blamed the March 10 collapse of Silicon Valley Bank, a popular lender to Silicon Valley tech startups, and two days later Signature Bank in New York, regarding poor risk management and imprudent decisions related to raising federal interest rates.

Federal regulators bailed out both banks and issued a joint statement to explain that their action to close the two banks was intended to “protect the U.S. economy by strengthening public confidence in our banking system.” They promised that taxpayers would not suffer losses and that all depositors of the two banks would be “made whole”.

The collapse and subsequent federal intervention shook the financial system and sent stock markets crashing. As a result of the federal action, President Joe Biden said that “every American should feel confident that their deposits will be there if and when they need them.”

Andolfato, who previously served as senior vice president of the Federal Reserve Bank of St. Louis and special adviser to Christopher Waller, the board’s governor, answered the following questions about the government’s bailout program.

The Federal Deposit Insurance Corporation (FDIC) was created 90 years ago during the Depression and the worst banking crisis in the nation’s history. What is its role and how and when does it function?

The FDIC’s primary role is to assure small depositors that their money is safe. When a bank fails, the FDIC makes sure that the bankruptcy is resolved in an orderly manner and without disruption to the payment system.

What kind of reserves does the FDIC have and how is it funded?

The FDIC is an independent government agency. It does not receive funding from congressional appropriations. The agency generates its reserves through the premiums it charges its member banks.

What caused Silicon Valley Bank (SVB) in Santa Clara, California, and Signature Bank in New York to close?

In essence, these banks have not properly managed the risks on their balance sheets. They were betting that interest rates would not rise, or at least not so dramatically. When interest rates rose sharply, the value of their long-term (and unhedged) assets declined. Large (uninsured) depositors withdrew their funding from these banks.

How does the closing of these middle-class banks relate to the Fed’s rate hikes to control inflation, which as of March 2022 are at the fastest clip since the 1980s?

It is strongly related to the Fed’s interest rate policy. They imprudently bet that rates would not rise or rise as fast as they did. The SVB also failed to comply with Basel III requirements (an internationally agreed set of measures) recommending a sufficient liquidity coverage ratio and net stable funding ratio. The former ensures that the bank has sufficient high-quality liquid assets, and the latter ensures that a significant portion of deposit funding is stable.

Could the closing of banks, not necessarily these two, but others, be foreseen because of the rise in interest rates?

Regulators probably should have seen the risks, but it is difficult to predict the behavior of depositors. In the case of SVB, the depositors proved very worrisome.

Is this the start of a trend of bank closings? To what extent should we be concerned?

I doubt most banks have managed their risk as badly as SVB. But what we should expect is that all banks will now try to repair their balance sheets to avoid a similar fate. This will mean tighter lending standards and a contraction in bank lending. The effect will be disinflationary, the downward trend in inflation.

Are there other components of the financial system that are vulnerable or will become vulnerable as a result of the Federal Reserve’s aggressive actions to control inflation?

Probably in the shadow banking sector, as in 2008-09. But that sector is now better regulated after Dodd-Frank, the 2010 legislation that created the Consumer Financial Protection Bureau, the agency tasked with protecting consumers from fraudulent and predatory financial practices by ensuring that banks, mortgage and student loan lenders, and credit card companies play by the rules.

President Franklin Delano Roosevelt in the 1930s initially resisted signing the Glass-Steagall Federal Insurance Act of 1933 because he believed it encouraged bad behavior. Do Bancassurance Programs Encourage ‘Bad Behavior’?

Economists call this “moral hazard.” The phenomenon is not necessarily “bad” or “immoral.” What it refers to is the supposed propensity of insurance to encourage risk-taking. If a person has fire insurance for their home, they may be less likely to take precautions that would prevent a fire, for example. Although such behavior probably exists, there is much debate about how quantitatively significant it is. The same applies to deposit insurance in banking.

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