The kidnappers’ demands were familiar. “All right Janet baby, just stay calm and nobody gets hurt. Forget your ‘We’re not going to do that again’ tripe. Make all of our depositors whole, give us a Learjet to our Caribbean resort, and everything will be just fine.”
That ostensibly was March 12. Within a few days, U.S. Treasury Secretary Janet Yellen had reversed course. Not only were all the uninsured depositors in Silicon Valley Bank to be “made whole,” but so were all the high-level depositors in other banks in similar straits.
Whether the execs flew off on a Learjet remains to be seen.
Look around! It clearly is not March 1930, nor November 2007. No stock market collapse, no bank doors locked, no bread lines, no mass foreclosures or layoffs. Whew, just a close call.
Being held hostage to circumstances needn’t be unpleasant if you can stay in your own home, keep your job, your captors don’t rub your face in your vulnerability and history shows that hostages in your plight seldom get hurt. So we U.S. citizens pay little attention when financial institutions hold the gun of a Great Depression II to our collective temples. That is, until we do start paying attention, and perhaps a whole lot more.
So if no harm, no foul, to bailouts of big depositors, why do both Trump Republicans and Elizabeth Warren Democrats find rare unity to keep yammering about it? Why do economists generally condemn the idea that some banks are “too big to fail?” Why did the Minneapolis Fed even sponsor an essay contest for students in six states on it in 1993? Why did Minneapolis President Gary Stern and Ron Feldman, a key researcher, write “Too Big to Fail: The Hazards of Bank Bailouts,” a 230-page book on this 20 years ago? Why should anyone care?
The answer is that two opposite assertions are true at the same time.
The first is that the failure of a large bank or other financial institution, well ingrained in ordinary citizens’ lives, can trigger a population-wide loss of confidence in the financial system. That triggers a chain-reaction “contagion” of bank failures as the collective action of millions of households trying to protect themselves from economic harm exacerbates the problem exponentially.
Second, if government steps in to prevent large banks from going bust so as to minimize the chance of such contagion, it inevitably creates incentives for bank managers to incur risks they would not otherwise take, since the penalty for being unsuccessful is decreased. Moreover, depositors lose incentives to monitor how banks are managed, because they no longer risk personal loss if bad lending and investing practices are covered.
The upshot of this all is that bank failures inevitably still occur. Perhaps they are less frequent under a regime of government protection, but they also are larger and more destructive than if such a too-big-to-fail policy had not been followed. The greater the risk, the greater the reward — and the greater the damage.
The conundrum is to balance policies that protect individual depositors from losses without creating incentives for recklessness. These inherently must be carried out in large part by an apolitical central bank that must function in a politicized nation. Depositors and investors across the political spectrum want their money to be safe but also want it to earn high returns. They hate inflation, but don’t want recessions. They want low-cost car and home loans and high returns on IRAs and in 401(k)s. Moreover, there must be no bailouts where ordinary people’s taxes protect “malefactors of great wealth.”
There is no way this all can be done.
Awareness of the problem is not new.
The Bank of Sweden and Bank of England were established in the 1600s precisely to deal with contagion, and both incorporated practices to reduce perverse incentives. In Adam Smith’s 1776 book “The Wealth of Nations,” he discusses what we now know as “moral hazard,” the inadvertent creation of perverse incentives, in the banking system.
In 1873, Walter Bagehot, an English businessman, journalist and scholar wrote “Lombard Street,” still the seminal work on central banking that contains “Bagehot’s dictum” on how central banks should respond to panicked financial crises.
Bagehot asserted that in a crisis a central bank should “lend freely” to solvent banks, but only against “sound collateral” and at a “penalty interest rate” that deterred borrowing by institutions not actually in peril. This is a remedy to avoid contagion in which illiquidity might become insolvency.
The 2007-09 “bailout” of Wall Street investment firms and insurance companies, in addition to consumer banks, involved tremendous levels of “lending freely,” but to institutions that were insolvent, did not all have “good collateral” and at interest rates so low as to carry no “penalty.” It was done by Fed Chair Ben Bernanke and Treasury Secretary Hank Paulson, who were well aware of the dangers of TBTF, but who were terrified of it anyway.
Carter Glass, a Virginia Democrat who served both in the House and Senate, wrote the Federal Reserve Act in 1913 and helped establish federal deposit insurance in 1933 to give government tools to fight contagion. He understood the dangers of perverse incentives. So did Marriner Eccles, a Utah businessperson who played a major role in the 1930s banking and Federal Reserve reforms.
The knotty problem is that in a sudden situation, the fear of contagion sparking a historical economic crisis overpowers prudent avoidance of moral hazard.
So when Yellen said uninsured depositors were not going to be bailed out, she was sincere. Her about face very likely was motivated by the discovery that SVB was not alone. There were other banks in the same situation — illiquid assets and a high fraction of deposits above the FDIC’s $250,000 limit. Imposing tough love on SVB’s large depositors threatened to engender runs on these other banks. To paraphrase the late Illinois Sen. Everett Dirksen, “$20 billion here and $50 billion there and pretty soon you are talking about real money.”
So once again, we avoided an immediate problem now at the possible, even probable, cost of a larger problem later. But the nation is more politically divided than at any time since 1865. Congress is at a level of dysfunction approaching paralysis.
The economy is more complex and its internet base allows a bank run to take place in minutes online rather than hours or days standing in line. Stern and Feldman understood the complexity of the problem, and did come up with practical measures that would ameliorate if not solve it. These were lauded by reviewers but have been ignored by policy makers for two decades. Perhaps current events will spur Congress to convene bipartisan hearings to query these two economists and others on their suggestions.
Yes, and I am going to get a pony on my birthday too!
St. Paul economist and writer Edward Lotterman can be reached at email@example.com.