A Difficult Job Becomes Even More Difficult

Chief Economist Eugenio J. Alemán discusses current economic conditions.

Monetary policy, ever difficult to conduct, became even more difficult over the last week as one of the most difficult processes in banking came to fruition for one bank and brought down another bank in the process: a bank run on deposits.

The lessons the U.S. government and the banking industry learned during the Great Depression helped create the Federal Deposit Insurance Corporation (1933), which instituted insurance on banking sector deposits. Insurance on deposits went from $2,500 back in 1933 to $250,000 today.

It seems that one of the biggest issues for SVB was that a large percentage of depositors were not covered by FDIC deposit insurance. That is, it seems that SVB took deposits mostly from businesses and then invested in longer term, in very safe, but low yielding government securities. As interest started to increase, it seems that customers started to shop around for higher interest rates on their deposits and the bank was unable to stop the bleeding. As customers took their money out, the bank had to sell some of those perfectly secure bonds on fire sale and lost a lot of money in the process, approximately $1.8 billion. When the bank tried to issue debt to re-capitalize for those losses, clients, businesses, and investors, instead of helping recapitalize the bank, went elsewhere, and pushed the bank into insolvency/bankruptcy.

While the FDIC and its deposit insurance facility were created to try to reduce and even try to avoid a banking run, the fact of the matter is that at some level, it is very difficult to completely prevent a run if trust in that bank is lost. The only alternative if this happens is that the central bank acts as “lender of last resort.”

Preventing runs against the banking system does not create moral hazard

Being the “lender of last resort” is the role of the Fed and one of the ultimate reasons for the existence of a central bank. And the Fed fulfilled its role over the last weekend, by taking over SVB and stopping a banking run could have threatened other banks. Hopefully, what the Fed did will be enough.