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Why the banking crisis may be a good thing

The FT hosted a panel discussion Thursday on the current banking problems. One participant argued that the Fed’s announcement that it would guarantee all SVB deposits last weekend was not in any way shocking because all deposits have been effectively guaranteed since the 1980’s. Another participant pointed out that clearly many people didn’t know that or there wouldn’t have been a run on SVB in the first place!

What we actually have is a deliberately ambiguous system. When things are calm, deposit insurance is only guaranteed for limited amounts - $250,000 in the US and £85,000 in the UK (per account). Larger deposits, quite common for wealthy retirees and especially for businesses, are not assured of safety. The absence of a guarantee is supposed to provide a check on risky behaviour.

But once a crisis emerges, central banks typically do have to explicitly guarantee all deposits, or else there would be a series of runs on the weaker banks which would create a systemic crisis. (And possibly a political crisis too). That’s what the Bank of England did in 2007 when it guaranteed all deposits in failing Northern Rock, what the Fed did in 2008 and what the Fed did again last week with SVB. The Fed has not (yet) guaranteed all deposits of all banks. That could come if the crisis becomes sufficiently intense, but this is very unlikely in my view since banks generally are much better capitalised today and SVB’s balance sheet was uniquely weak.

Does this ambiguity work to temper risk-taking? I think it does. Consider the alternative. Suppose all deposits of all approved banks were guaranteed to any amount. None of us would be inclined to stick with large established banks or conservatively managed institutions. We would simply place our deposits with the bank paying the highest rate. More than likely that will be a new, small, racy bank with weak governance and an unproven business model. Retail depositors often do that already, knowing they are protected up to the limits, but wealthier people and companies are usually much more cautious.

If everybody did it there would be enormous pressure on banks to take more risks. Not a good thing. There are already mis-matched incentives between bank management and their owners (shareholders and unsecured bond-holders) with the former keen to maximise profits, bonuses and share appreciation in the short term, and the latter at risk of wipe-out if things go wrong (as is happening to SVB owners).

But, you might object, surely this ambiguity leads periodically to the kind of crisis we are seeing now, with damaging effects on the economy. Well, yes. But I would say, first, this is exactly what central banks are trying to do with the current tightening cycle. They are trying to dent confidence and slow the economy. Financial stress is part of the process of tightening monetary policy. If nobody is stressed why would they cut back on spending?

Secondly, these periodic crises, provided they are reasonably contained, (unlike 2008), help to limit risk-taking over the cycle. Banks are going to be more cautious for the rest of this year and likely for a few more years until memories fade, and this is a good thing.

So, how did it get out of control in 2008? Millions of trees have given their lives for opinions on this, but I would point to two things. First, the financial sector had been repeatedly ‘saved’ with aggressive Fed rate cuts for the prior 20 years, starting in 1987, so nobody had any memory of prolonged financial crises (unless they paid attention to what happened in Asia, but few did). As a result risk-taking ratcheted up and up, cheered on by the government which wanted mortgages to be provided to low-income borrowers, and accepted by the regulators who were asleep on the job.

Secondly, the US government made an appalling mistake by letting Lehman go. That should never have happened.

So, what are the implications for today? First, we can expect the authorities to ‘do whatever it takes’ to prevent a meltdown. They know the playbook much better now than in 2007-8. Secondly, the underlying health of the financial system is anyway far better than in 2007. Thirdly, despite the fall in market interest rates over the last week, financial conditions have tightened. You can see that in credit spreads (see chart) and it is likely to show up in lending and balance sheet decisions in coming weeks too. Credit spreads are not through the roof – which I think reflects the limited scale of the current ‘crisis’ – but they are well up on a week ago.

These financial ructions are presumably why the ECB withdrew its promise of further rate hikes at later meetings, even though it moved the full 50bps this week. The Fed is likely to go 25bps next week. Whether we see the Fed raising rates further through the spring will depend not just on economic data (as they have said for months) but also on financial conditions. I suspect the latter will stabilise (or be stabilised) before long, leaving inflation and growth as the main considerations once again, but time will tell.

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