Since the beginning of March, US regulators have closed and sold three banks: Silicon Valley Bank, Signature Bank and First Republic. The failures are the biggest to hit the US since the 2008 financial crisis. The turbulence in the market quickly contaminated Europe, where large-scale share sell-offs put numerous banks under heavy pressure caused by.
In response to the crisis, governments and central banks wasted no time and offered a variety of rescue packages to prevent panic. Although the White House purposely avoided the term “bailout”, many contended that the administration did perform a bailout by ensuring that depositors would be paid in full. For example, Paul Krugman stated that “Yes, it was a bailout … the source of the funds does not change the reality that the government came in to rescue depositors who had no legal right to demand such a rescue.”
The True Factors Behind the Banking Crisis
Many blamed the Fed for raising interest rates and triggering the economic downturn that led to bank failures. While the Fed was far from innocent, the high interest rates were not the root cause. The real problems were low-interest rates, loose monetary policies, and bank regulations. The Fed and other central bankers were behind all these phenomena.
Over the last decade, central banks maintained low interest rates to stimulate demand in times of crisis. During the pandemic, the Federal Reserve’s balance sheet experienced substantial expansion, and at the beginning of 2022 rose to around $9 trillion. It was about $4 trillion before COVID. Over that period, American banks experienced soaring cash reserves as a result of the rise in the money supply (more than 40% in just two years). Hence, they used a large share of that cash to buy large amounts of bonds in hopes to sell them later for a profit. For example, approximately $117 billion of SVB’s total assets ($212 billion) were invested in Treasuries and mortgage-backed securities. When inflation forced the Fed to raise interest rates, however, bond prices collapsed and commercial banks got into trouble.
To make things worse, since 2008, banks have encountered a plethora of new constraints and requisites in regard to reporting, capital requirements and liquidity. Excessive regulation has thus created an environment where banks and regulators work side by side and give rise to “regulatory capture”: banks exert undue influence over regulators, potentially leading to lax enforcement or inadequate oversight. Not surprisingly, when banks believe that regulators turn a blind eye and eventually bail them out in times of trouble, they tend to engage in excessive risk-taking and imprudent lending practices, ultimately leading to a crisis.
The Rationale for Allowing Troubled Banks to Fail
When regulators seized and closed Silicon Valley Bank (SVB) and Signature Bank, depositors of these banks feared for their money. The Federal Deposit Insurance Corporation (FDIC) insures depositors’ money up to $250,000. Thus, individuals with more than that deposited in either of these banks could face losses. However, the Treasury Department, the Federal Reserve, and the FDIC promptly extended the FDIC’s guarantee beyond the $250,000 limit.
The US leaders say these rescues won’t cost citizens anything and will be funded by a special levy on the FDIC, along with $25 billion in newly created money, but that is not true. Worse, the Fed is extending bailouts even to healthy banks by lending against their failed financial investments. Not only does this reward recklessness, but it also increases the losses to Americans, who are indirectly affected by inflation, higher tax pressure and heavier public indebtedness.
To conclude, bank bailouts interfere with the natural process of creative destruction, following which unsuccessful businesses go belly up and resources are reallocated to more productive uses. Allowing bad banks to fail has several benefits in the long term. It ensures that financial institutions remain accountable for their actions, and encourages better risk management practices that enhance the stability of the financial system. Last, but not least, the failure of a bank can create opportunities for other banks as well as for new, innovative actors. In other words, increased competition leads to better services for consumers.
By letting bad banks fail, taxpayers are spared the expense of bank rescues and bailouts. Of course, this can have short-term negative consequences, such as job losses and economic disruption. However, the long-term benefits of promoting market discipline, protecting taxpayers, encouraging innovation, reducing moral hazard, and increasing transparency outweigh the short-term costs.
Photo by Christopher Windus