Brian Anderson: Welcome back to the 10 Blocks podcast. This is Brian Anderson, the editor of City Journal. Joining me on the show today is Nicole Gelinas. She's been on the show a number of times. She's a senior fellow at the Manhattan Institute, a contributing editor of City Journal, and as a former business journalist I think she'll be well-placed to discuss today's topic. She's a New York Post columnist, author of the book After the Fall: Saving Capitalism from Wall Street and Washington and a forthcoming book on transportation. Today, though, we're going to discuss her City Journal piece, “Bro-Bank Blues” and the current turmoil in the banking industry. So Nicole, thanks very much as always for joining us.
Nicole Gelinas: Thank you for having me, Brian.
Brian Anderson: So as everybody who follows these things knows by now, Silicon Valley Bank, which was a mid-size bank with clients that included basically I think half of all U.S. venture capitalist-backed technology firms collapsed when it couldn't meet the demands of large depositors who were rushing to withdraw their money. The Federal Deposit Insurance Corporation then stepped in and closed the bank, and then days later, New York City's Signature Bank, another institution that catered a lot to the tech sector failed as well. SVB's collapse was the largest since the 2008 financial crisis. So let's look at that. Why, in as clear way as possible, did this bank fail?
Nicole Gelinas: Well, why did the bank fail is a question that has several answers. The immediate answer is because they didn't manage their risk very well. So what does a bank do? A bank borrows money from its depositors. You deposit money at the bank. As everyone knows from watching, It's a Wonderful Life, the bank doesn't just keep your money in a pile at the bank; it lends your money out to other people and to businesses. So the ideal business model of a bank is you earn more in interest on the loans that you make than you have to pay out in interest to your depositors. And that difference between the interest that you make and the interest that you pay is your profit. So you had the Silicon Valley Bank taking in deposits. The first big risk they took was they relied on depositors who had more than $250,000 in the bank. Why is that a risk? Because those deposits are not insured by the FDIC.
So if you're a large depositor, you have more than a quarter million dollars in the bank, at the first sign of trouble, you're going to take that money out because you could lose some of that money in a bank failure. The second big mistake they did is they took that money and they put it in risky instruments, instruments that had a good chance of not making a higher interest rate than the rate they were making in those deposits. And that's where it gets interesting because these weren't risky instruments that we would normally think of. They weren't making massive speculative loans, but rather they were buying treasury bonds and mortgage bonds. If people remember from the financial crisis, when you buy a treasury bond or you buy a mortgage bond, you're in effect lending to the federal government or you're lending to government-guaranteed mortgage borrowers.
So you think, well, this isn't a very risky business. The government is going to make good on its loans. The people paying their mortgages will make good on their loans. But the problem is the Fed has been raising interest rates. So the value of these existing treasury bonds and mortgage bonds, all of these bonds were issued at very low interest rates, in some cases quite close to zero. So the more that the Fed raises interest rates, the less value those bonds have. It's not because the government and the mortgage borrowers are not going to pay back the debt; it's just because you can get a higher interest rate on newer debt. So that older debt is worth less and less as the days go on. So you had SVB in the position of having to pay depositors a higher interest rate, but effectively the value of these investments it held went down because they were paying a lower interest rate. So that's how it got in trouble. And then the fact that people panicked and pulled their money out obviously didn't help the situation.
Brian Anderson: Just to make this absolutely clear, if these long-term bonds and mortgages were held to maturity, it wouldn't be such a big problem. They had to sell these to cover the losses?
Nicole Gelinas: Right. The panic feeds on itself. So if nobody had known that this problem existed, the bank could have held these securities to maturity—five, 10 as long as 30 years—and taken that small loss, hopefully cut costs in other places and just slog through the loss. But the fact people got wind that it had invested aggressively in these longer term treasury and mortgage securities that were losing value, and people said, well, what if they have to sell these assets? Then the bank confirmed that indeed, it did have to sell some of these assets, and so that just created more depositors taking out their money, and they had to sell more of these assets to meet those deposits. So they were effectively pushing the price down and telling its customers, this is not a very good bet anymore.
Brian Anderson: Now, the FDIC stepped in and said that, in fact, it would retroactively back all the deposits at SVB and Signature Bank, which as you just noted, include a lot of accounts that were well above the $250,000, insurance guarantee. So basically, by making all of the depositors whole, the FDIC was trying to prevent a contagion of financial panic that would spread to other smaller banks. So the idea was to discourage additional bank runs. So what is the prognosis there, and what were the merits and risks of, in effect, backstopping these failed banks?
Nicole Gelinas: As you said, Brian, over the weekend, two weekends ago, it was clear that depositors in other banks, Signature Bank, which the government as you mentioned, seized, and a good dozen or so other mid-size banks were very worried that the same thing would happen to these banks. So they started pulling their money out of these banks. Where did they put it? They put it in the big six institutions, JPMorgan Chase, Citigroup. And that's a problem, because you don't want to end up with just one big bank and everybody putting their money in JPMorgan Chase, because they think the government will never let that bank fail. So you had the government step in that weekend, that Sunday night and say, okay, to the depositors, you don't have to worry. We're going to put an FDIC guarantee on all deposits.
That, first of all, it didn't actually work to stop the short-term panic. Depositors are still pulling money out of these institutions, although at a slower rate. First Republic Bank, another bank that caters to the wealthy is still hanging in there after the government, and the larger banks have tried to shore it up with some money. But the bigger risks are that you're changing the nature of what deposit insurance is supposed to be. Deposit insurance is supposed to be so that people with middle class levels of savings can put some money in the bank and not have to worry that the bank is going to go bankrupt. This comes from the Great Depression. It's not meant to be a guarantee for sophisticated investors—depositors who have hundreds of thousands of dollars or millions of dollars. If you run a business, you're supposed to have a cash manager, someone who manages this risk that yes, the bank could go bankrupt. And how do you do that? You spread the accounts over multiple banks. You have money market investments, you do some treasury management.
So should the deposit guarantee be higher than a quarter million dollars? Probably something the FDIC should look at. If you are a very, very small business, just a few employees, there is a utility function to the bank, and you just have money in the bank to pay your vendors, pay your employees, to take money from your customers. A small business shouldn't have to spend a lot of time and energy thinking, if I put money from my customers in the bank and I pay my payroll over the few days that that money is in the bank, is the bank going to go bankrupt? But somewhere between $250,000 and unlimited, there has to be a cutoff. There are enormous problems in letting companies with hundreds of millions of dollars in bank deposits at one bank keep totally off the hook from any moral hazard that that bank might go under. You're just encouraging these institutions and their large depositors to take undue risks.
Brian Anderson: Well, I see some proposals out there that basically the FDIC should guarantee in an unlimited way depositors, but that would entail a pretty significant change in how it's operating, and as you just suggested, it does raise a moral hazard question. So then you would need to accompany that increase and the guarantee with a lot more regulatory supervision of the banks, right?
Nicole Gelinas: What happens is if you allow unlimited depositors, remember, as we talked about at the beginning, when you deposit your money, you're getting some interest rate. It's been very low up until the past year, but the past year as inflation has gone up and as the Fed has been raising rates, it's a little bit higher. You can get 4 or 5 percent on a long-term bank deposit. So if you have an unlimited guarantee on deposits, what happens is your bond holders to the bank, people and institutions who buy bonds in the bank and effectively put their faith in the bank's credit rating, bond holders are not supposed to be guaranteed at all. They're supposed to take some risk. What happens is there's no incentive to buy a bank's bonds if the bank's bonds are only paying 5 percent and you can get 5 percent on an unlimited deposit, there won't be any bonds in banks anymore. Those will all just be deposits because the bond holders will say, we can just leave a billion dollars at the bank, and that is guaranteed by the government.
So that's a significant problem. You want to have a bond market in the financial industry to take that away and effectively have all lending to banks guaranteed by the government would be a big problem.
Brian Anderson: Yeah, interesting. Now, another aspect of this whole financial scene is that the Fed's balance sheet, the amount of money it has wielded to support the economy has grown from, I guess it was under $1 trillion back at the onset of the financial crisis. Now I think it's up around $9 trillion. Now where does all that money go, and what does the collapse of these banks reveal about the stability of the financial system overall?
Nicole Gelinas: Yeah, I think that gets us to the bigger picture. If SVB took undue risks on its own and went under, the government seized it, I think people would say, okay, it's a rogue bank. In a free-market economy, companies make mistakes. Some of those mistakes send them into bankruptcy. It's not a big deal. You have to have companies that fail to make room for startup companies that may do a better job. But the problem is, this is a systemic risk across the financial system that the Fed and elected officials themselves created. So people have to dust off what they learned during the financial crisis 15 years ago. The financial crisis was caused because of too much lending and borrowing, a lot of complicated issues about mortgage securities and derivatives and credit default swaps. But basically, people borrowed more money than they could afford to repay. That happened on a systemic basis, and when the bills came due, it almost sent the financial industry into mass default until the federal government stepped in.
Why did people borrow more than they could afford to repay? This goes back to everything that we've seen since then with the election of Trump in 2016, all of the discussion around how working class and middle class workers hadn't really seen a real increase in their pay going back to the 1970s. So for 35 or 40 years, middle class pay, particularly male pay in the industrial sector, stayed stagnant. You couldn't support a family on one wage anymore because pay didn't rise. People made up for that in borrowing, including subprime mortgages, and that solved the political problem for a while, at least until 2008. So 2008 comes along, a whole financial system almost collapses. What does the government do? It tries to double down on this strategy, even more lending, even more borrowing with rates at close to 0 percent. The Federal Reserve set its core interest rate at 0 percent, so that banks in turn could lend very, very cheaply. You saw mortgage rates at record lows, credit card rates at record lows, student loan debt explode, and so forth.
So all of that money on the Fed's balance sheet, as you said, going from $1 trillion to $9 trillion. This is just money that the Fed creates, gives to the banks, somewhat simplified, but that's effectively the case, and the banks then turn around and lend that out to people and institutions at low rates. So you see extra trillions of dollars in the economy. This accelerated after Covid, when the economy essentially shut down, millions of people lost their jobs. What happened then? It was twofold. One, the Fed again put interest rates down to zero. It had been trying to raise them a little bit up until then, and also bank deposits soared. So people who didn't lose their jobs, they didn't have any way to spend their money when the economy was shut down. So they kept their money in the bank. They were nervous about the stock market too.
So deposits in banks across the banking system rose from $13 trillion on the eve of the pandemic to more than $18 trillion by the 2022. So you had the deposit base of banks effectively increase by a third. That was a problem for the banks because the banks, they didn't have another multi-trillion dollars worth of good loans to make, especially when the economy was shut down. So what did the banks do? They put this money into long-term treasury bond. So the problem that you mentioned, yes, SVB could muddle through if they didn't have to sell these securities. This problem exists across the entire banking system, including the large banks. And so what the government is trying to do here and what the large banks are trying to do is make sure this panic does not rise to the level of the big banks.
Brian Anderson: The other aspect of this, of course, is the tech involvement with these failed banks. So tech startups are the cutting edge of innovation, generally speaking, they've long been favored by investors until recently. Yet you note in your piece the fact that some of the biggest household-name tech firms, WeWork, DoorDash, Uber, they've not been profitable, and they're not all that inventive when it comes right down to it. So I wonder if the failure of this bank, SVB in particular, along with investors' retreat, as we've seen from cryptocurrency, the recent downfall of the FTX exchange, and higher interest rates, whether that’s going to affect startup funding, and what are the consequences of that? Is it going to hurt American innovation or is this just going to be a salutary check on speculation?
Nicole Gelinas: Hopefully the latter, but it is a concern that it will be the former. So since we always pick on Uber, we can pick on WeWork for a minute. If you think about what WeWork was before the pandemic, this is a startup real estate company renting space from large established real estate companies, and then turning around, cutting up that space, and renting it up to small businesses that don't need multiple floors of an office building, but might want a part of a floor and a co-working space to meet people from other companies and so forth. Nothing wrong with that business model, perfectly good entrepreneurial idea, but it is effectively a real estate middleman. Was it worth the multi, multi, multi-billion dollars that it achieved on the eve of the pandemic? No, clearly not. And so that was a case of easy money propping up speculation.
We've seen that unravel particularly since the pandemic, some aspects of tech—Zoom, Facebook for a while did very, very well, as everyone was online. People have gone back to their normal lives, so some of that has deflated. But we also see the bubble aspects of even big tech where companies like Facebook were just hiring thousands of people. It had really no business plan for how to even put these people to work and are now reversing that and laying off tens of thousands of people. Clearly not very good from an economic perspective, but I think yes, the greater danger is you have real startups, small, small companies in biotech, in other aspects of tech that get hurt too as the venture capital industry just pulls back altogether.
Brian Anderson: All very interesting. Well, thank you very much, Nicole, for enlightening us on these subjects. Don't forget to check out Nicole Gelinas's work. It's on the City Journal website, www.city-journal.org. We'll link to her author page in the description, and you can find her on Twitter @nicolegelinas. You can also find City Journal on Twitter @CityJournal and on Instagram @CityJournal_MI. And as I always say, if you like what you've heard on today's podcast, please give us a nice rating on iTunes. Nicole, thank you very, very much.
Nicole Gelinas: Thank you, Brian.