Deposit insurance – HubbardOBrienEconomics.com Blog

The State of U.S. Banking One Year after the Failure of Silicon Valley Bank

In March 2023, First Citizens Bank agreed to buy SVB after SVB had been taken over by the FDIC. (Photo courtesy of Lena Buonanno.)

On Wednesday, March 8, 2023, Silicon Valley Bank (SVB), headquartered in Santa Clara in the heart of California’s Silicon Valley surprised its depositors and Wall Street investors by announcing that in order to raise funds it had sold $21 billion in securities at a loss of $1.8 billion. The announcement raised concerns about the bank’s solvency—that is, there were questions as to whether the value of the bank’s assets, including bonds and other securities, was greater than the value of the bank’s liabilities, primarily deposits. The result was a run on the bank as depositors withdrew most of their funds. On Friday, March 10, 2023, the Federal Deposit Insurance Corporation (FDIC) took control of SVB before the bank could open for business that day.

Mandatory Credit: Photo by GEORGE NIKITIN/EPA-EFE/Shutterstock (13817875h)

The run on SVB in 2023 resembled …

bank runs during the 1930s.

In this blog post, we discuss the economics of bank runs and go into detail on what happened to SVB. In response to the failure of SVB, the FDIC declared that selling the bank’s assets and forcing depositors above the $250,000 deposit limit to suffer losses would pose a systemic risk to the financial system. As a result, with concurrence of the FDIC’s Board of Directors, two-thirds of the Fed’s Board of Governors, and Treasury Secretary Janet Yellen, the FDIC announced that all deposits in SVB—including deposits above the normal $250,000 dollar limit—would be insured. The waiving of the deposit insurance limit was also applied to Signature Bank, which failed a few days later. The run on SVB had been set off by the loses the bank had experienced on its long-term Treasury bonds. To reassure depositors in other banks that also held long-term debt, the Fed announced that it was establishing the Bank Term Funding Program (BTFP). Banks and other depository institutions, such as savings and loans and credit unions, can use the BTFP to borrow against their holdings of Treasury and mortgage-backed securities.

Maturity Mismatch and Moral Hazard

The failure of SVB highlighted two problems in commercial banking.

Maturity mismatch. Banks use short-term deposits to fund long-term investments, such as mortgage loans and purchases of Treasury bonds. In other words, banks fund investments in long maturity assets using short maturity liabilities. The resulting maturity mismatch causes two problems: 1) If, as happened at SVB, the bank experiences a run and needs to pay off depositors, it may only be able to do so by selling assets at a loss, which may push the bank to insolvency; and 2) bonds with long maturities are subject to greater interest rate risk than are bonds with shorter maturities: If market interest rates rise, the prices of long-term bonds fall by more than do the prices of short-term bonds. To compensate investors for this greater interest rate risk, long-term bonds typically have higher interest rates than do short-term bonds. (We explain these points in Money, Banking, and the Financial System, Chapter 5, Section 5.2.) The higher interest rates can lead a bank’s managers to invest deposits in long-term bonds in order to earn higher interest rates and boost the bank’s profits, even though they are taking on greater risk by doing so. The decision of SVB’s managers to hold a large number of long-term bonds greatly contributed to the failure of the bank.
Moral hazard. Why might bank managers take on more risk by buying long-term bonds and potentially making other risking investments, such as making commercial real estate loans? For instance, recently, New York Community Bancorp suffered losses on loans made to buyers of office buildings and apartments. A key to the explanation is the extent of moral hazard in banking. In the financial system—including banking—moral hazard is the problem investors experience in verifying that borrowers are using their funds as intended. Although we don’t usually think of bank depositors as being investors who lend their money to banks, in effect, that is the relationship depositors and banks are in. Banks borrow depositors money and use these funds to make a profit. Bank managers are typically rewarded on the basis of how profitable the bank is. As a result, bank managers may make riskier investments than depositors would make if depositors were deciding which investments to make.

In principle, depositors could monitor which investments a bank’s managers are making and withdraw their deposits if the investments are too risky. In practice, depositors rarely monitor bank managers for two key reasons: 1) Depositors often lack the information to accurately gauge the risk of an investment; and 2) Depositors are insured by the FDIC for up to $250,000 per deposit per bank. When a bank fails, the FDIC typically makes insured depositors funds available with no delay, often by establishing a “bridge bank” to continue the failed banks operations, including keeping ATMs open and stocked with cash. Deposit insurance increases the extent of moral hazard in the banking system. If depositors come to believe that in practice even deposits above the $250,000 are insured because of the actions bank regulators took the following the failures of SVB and Signature Bank, moral hazard is further increased. Still, reason 1. above gives reason to believe that, even in the absence of deposit insurance, depositors are unlikely to closely monitor bank managers. If depositors suddenly receive new information on a bank’s health—as happened when SVB suffered a loss on its sale of Treasury bonds—the likely result is a run. Runs potentially can lead other bank managers to become more cautious in their investments, but it will be too late to change the behavior of the managers of a bank that closes because of a run.

Bank Leverage

Because banks are highly leveraged, they are less able to withstand declines in the prices of their assets without becoming insolvent. A business is insolvent if the value of its assets is less than the value of its liabilities. Ordinarily, the FDIC will close an insolvent bank. A bank’s leverage is the ratio of the value of a bank’s assets to the value of its capital. A bank’s capital equals the funds contributed by the bank’s shareholders through their purchases of the bank’s stock plus the bank’s accumulated earnings. Put another way, a bank’s capital represents the value of the bank’s shareholders’ investment in the bank.

Shareholders focus on the return on their investment (ROI). Because banks are highly leveraged, a relatively small return on the banks assets—such as loans and mortgages—can result in a large return on the shareholders’ investment. This relationship holds because the shareholders’ investment (the bank’s capital) is much smaller than the bank’s assets. But just as high leverage increases a bank’s profits if the bank earns a positive return on its assets, it also increases a bank’s losses if the bank suffers a negative return on its assets. Banks would have a greater ability to absorb losses on their investments without becoming insolvent if the banks had more capital. But the more capital banks hold relative to the value of their assets—in other words, the less leveraged a bank is—the smaller the profit banks earn for a given return on their assets. Just as moral hazard can lead bank managers to make riskier investments than their depositors would prefer, it can also lead bank managers to become more leveraged than their depositors would prefer.

Regulatory Responses to the Failure of SVB

As we’ve noted, the problems that led to the failure of SVB were rooted in the problems that all commercial banks are subject to. (The reasons why SVB turned out to be particularly vulnerable to a bank run are discussed in this earlier blog post.) Although there have been extensive discussions among federal regulators, including the Federal Reserve and the FDIC, about steps to increase the stability of the U.S. banking sector, as of now no significant regulatory changes have occurred. However, there have been a number of proposals that regulators have been considering.

Increased capital. As we noted, banks hold relatively little capital relative to their assets. On average, U.S. commercial banks hold capital equal to about 9.5 percent of the value of their assets. Holding more capital would reduce bank leverage, making banks less vulnerable to declines in the value of their assets. More capital would also mean that banks have more funds available to pay out to depositors making withdrawals during a run. In regulating bank capital, the United States has largely followed the Basel accord, which was established by the Bank for International Settlements (BIS). We discuss the Basil accord in Money, Banking, and the Financial System, Chapter 12, Section 12.4. Here we can note that the most recent proposed capital regulations are Basel III, sometimes called the “Basel III Endgame.”

Basel III would require large banks to hold more capital. The proposal has been heavily criticized by the banking industry. Some economists strongly support banks holding more capital to increase the stability of the banking system, but other economists are more skeptical. These economists argue that even if banks held twice as much capital as they currently do, it would likely prove insufficient to meet depositor withdrawals in bank run similar to the one SVB experienced. Holding more capital is also likely to reduce the volume of loans that banks will be able to make. Finally, the problems in the banking system in recent years have typically involved mid-sized regional banks rather than the large banks—those holding more than $100 billion in assets—that are the focus of Basel III. In any event, in testimony before Congress earlier this month, Fed Chair Jerome Powell stated that: “I do expect that there will be broad and material changes to the proposal.” His statement makes it likely that the United States won’t fully adopt the proposed Basel III regulations in their current form.

2. Revising deposit insurance. The establishment of the FDIC in 1934 stopped the bank runs that had seriously damaged the U.S. economy during the early 1930s. Because of deposit insurance, people knew that they didn’t have to quickly withdraw their funds from a bank experiencing losses because even if the bank failed, deposits were insured. But, as we noted earlier, deposit insurance also increases moral hazard in banking by reducing the incentive of depositors to monitor the investments bank managers make. One proposed reform would increase deposit insurance for accounts held by households and small and mid-sized firms because these deposits are less likely to be quickly withdrawn if a banks experiences difficulties and because these depositors are less likely to be able to monitor bank managers. Large firms, investors, and financial firms would not be eligible for the increased deposit insurance. (Under Basel III, banks might be required to hold additional liquid assets so that they would be able to have funds available to meet sudden withdrawals by large firms, investors, and financial firms. It was withdrawals by those types of depositors that led to SVB’s failure.)

3. Increased use of the Fed’s discount window. Congress established the Federal Reserve in 1914 partly in response to the bank panics that plagued the U.S. financial system during the 19th and early 20th centuries. The Federal Reserve Act was intended to allow the Fed to serve as a lender of last resort by making discount loans to banks having temporary liquidity problems as a result of deposit withdrawals. In practice, however, banks were often reluctant to borrow at the Fed’s discount window because they were afraid that discount borrowing came with a stigma indicating that the bank was in trouble. As a result, discount lending has not played a significant role in stopping bank runs. For instance, SVB had not prepared to request discount loans and so weren’t able to use discount loans to provide the funds needed to meet deposit withdrawals. Some economists and policymakers have proposed requiring banks to provide the Fed with enough collateral, primarily in the form of business and consumer loans, to meet their liquidity needs in the event of a run. By identifying sufficien collateral ahead of time, banks would be able to immediately receive discount loans in an emergency. If SVB had provided collateral equal to the value of its uninsured deposits, it might have been able to withstand the run that occurred.

4. Require more securities to be marked to market. Banking regulations allow banks to keep bonds and other securities on their balance sheets at face value even if the market value of the securities has declined, provided the securities are identified as being held to maturity. When a bank experiences liquidity problems it may be forced to sell securities that it previously designated as being held to maturity, which is the situation SVB found itself in. Some economists and policymakers have proposed that more—possibly all—of a bank’s holdings of securities be “marked to market,” which means that the securities’ current market values rather than their face values would be used on the bank’s balance sheet. Economists and policymakers are divided in their opinions on this proposals. Marking more securities to market may give depositors and investors a clearer idea of the true financial health of a bank. But doing so might also be misleading because banks will not take losses on those securities that they actually hold until maturity.

5. Bank examiners become more focused on emerging threats. Some economists and policymakers argue that in practice bank examiners from the FDIC, the Fed, and the Office of the Comptroller of the Currency (which regulates larger banks) are in the best position to determine whether bank managers are taking on too much risk, particularly as economic conditions change. For example, as the Federal Reserve began to increase its target for the federal funds rate in the spring of 2022, other interest rates also rose, causing the prices of long-term bonds to fall. In retrospect, bank examiners overseeing SVB and other banks were slow to question the managers of these banks about the degree of risk involved in their investments in long-term bonds. Similarly, bank examiners were slow to realize the risk that banks like SVB were taking in relying on deposits above the $250,000 insurance limit. These depositors are likely to be the first to withdraw funds in the event of a bank encountering a problem. In principle, if bank examiners were more alert to the effect changing economic condidtions have on the riskiness of bank investments, the examiners might be able to prod bank managers to reduce their risky investments before a crisis occurs.

6. Further consolidation of the banking system. As we discuss in Money, Banking, and the Financial System, Chapter 10, Section 10.4, for many years restrictions on banks operating in more than one state resulted in the United States having many more banks than is true of other high-income countries. In the mid-1990s, after Congress authorized interstate banking, a wave of consolidation in the banking industry resulted in some banks operating nationwide. However, the United States still has many small and mid-size, or regional, banks. The largest banks have typically not encountered liquity problems or experienced runs. Some economists and policymakers have argued that further consolidation could lead to a banking system in which nearly all banks had the financial resources to withstand bank runs. Other economists and policymakers argue, however, that small businesses often rely for credit on smaller community banks. These banks engage in relationship banking, which means that they have long-term relationships with borrowers. These relationships enable the banks to accurately assess the creditworthiness of borrowers because the banks possess private information on the borrowers. Larger banks are more likely to use standard algorithms to assess the creditworthiness of borrowers. In doing so a larger bank may refuse to make loans that a community bank would have made. As a result, further signficant consolidation in the banking system might make it more difficult for small businesses to access the credit they need to operate and to expand.

Finally, as we note in Chapter 12 of Money, Banking, and the Financial System, government regulation of banking has followed a familiar pattern dating back decades. When banks or another part of the financial system, experience a crisis, Congress, the president, and the regulatory agencies respond with new regulations. The regulations, though, can lead financial firms to innovate in ways that undermine the effects of the regulation. If these financial innovations result in a crisis, the government reponds with additional regulations, which lead to new financial innovations. And so on. The nature of banking and the many other channels through which funds flow from savers and investors to borrowers are sufficiently varied and evolve so quickly that it’s unlikely that any particular regulations will be capable of permanently stabilizing the financial system.

Glenn on Bank Regulation

(Photo from the Wall Street Journal.)

This opinion column first appeared on barrons.com. It is also on the web site of the American Enterprise Institute.

Runs at Silicon Valley Bank and others emerged quickly and drove steep losses in regional bank equity values. Regulators shouldn’t have been caught by surprise, but at least they should take lessons from the shock. The subsequent ad hoc fixes to deposit insurance and assurances that the banking system is sufficiently well-capitalized don’t yet suggest a serious policy focus on those lessons. Calls for much higher levels of bank capital and tighter financial regulation notwithstanding, deeper questions about bank regulation merit greater attention.

Runs are a feature of banking. Banks transform short-term, liquid (even demandable) deposits into longer-term, sometimes much less liquid assets. Bank capital offers a partial buffer against the risk of a run, though a large-scale dash for cash can topple almost any institution, as converting blocks of assets to cash quickly to satisfy deposit withdrawals is almost sure to bring losses. The likelihood of a run goes up with bad news or rumors about the bank and correlation among depositors’ on their demand for funds back. That’s what happened at Silicon Valley Bank. Think also George Bailey’s impassioned speech in the classic movie It’s a Wonderful Life, explaining how maturity and liquidity transformations can unravel, with costs to depositors, bankers, and credit reductions to local businesses and households. The bank examiner in the movie, eager to get home, didn’t see it coming.

While bank runs and banking crises can be hard to predict, a simple maxim can guide regulation and supervision: Increase scrutiny in areas and institutions in which significant changes are occurring over a short period. On an aggregate level, the sharp, rapid increase in the federal funds rate since March 2022 should have focused attention on asset values and interest rate risks. So, too, should the fast potential compression in values of office real estate in many locations as a consequence of pandemic-related working shifts and rate hikes. At the bank level, significant inflows of deposits—particularly uninsured deposits—merit closer risk review. This approach isn’t limited to banking. A recent report of the Brookings-Chicago Booth Task Force on Financial Stability, co-chaired by Donald Kohn and me, put forth a similar change-based approach to scrutiny of nonbank financial institutions.

Such an approach would have magnified supervisory attention to Silicon Valley Bank and First Republic Bank . It also suggests the desirability of greater scrutiny and stress testing of midsize banks generally facing interest rate and commercial real estate risk. Those stress tests can give the Fed and the Federal Deposit Insurance Corp. an indication of capital adequacy concerns that could give rise to mergers or bank closures.

Even with this enhanced regulatory and supervisory attention, two major questions remain: For bank liabilities, what role should deposit insurance play in forestalling costly runs? For bank assets, what role should banks play in commercial lending?

Actions taken since Silicon Valley Bank’s collapse have effectively increased deposit-insurance guarantees for troubled institutions. But the absence of a clearer policy framework for dealing with uninsured deposits dragged out the unwinding of First Republic Bank and threatens other institutions experiencing rapid deposit increases and interest rate risk. When regulators asserted in the wake of the runs that the status quo of a $250,000 limit remained unchanged, they lacked both credibility and a means to reduce uncertainty about future policy actions in a run. That makes runs at vulnerable institutions both more likely and more severe. One reform would be to increase deposit insurance limits for transaction accounts of households and small and midsize firms, as recently proposed by the FDIC. Of course, even this reform raises concerns about implementation, how to price the enhanced coverage, and whether supervision will shift toward the “focus on the changes” framework I outlined earlier.

Retaining a more modest role for deposit insurance raises a larger question: What role should banks play in business lending for working capital, investment, and commercial real estate? The FDIC is mandated to resolve bank failures at the least cost to the deposit-insurance fund, but following that path may lead to more mergers of vulnerable institutions into the nations’ largest banks. While consolidation may mitigate risks for depositors with greater diversification of deposits, it leaves open effects on the mix of lending. Knowing local borrowers better, small and midsize banks have a prominent local lending presence in commercial and industrial loans and real estate. Whether such projects would be financed in a similar mix by local branches of megabanks is a question. Congress should consider whether other alternatives might be reasonable. It might permit consolidation among smaller institutions, even if more costly in resolution in the near term to taxpayers. Or nonbank institutions could be permitted to play a role in resolving troubled banks. The latter mechanism should be considered, as nonbank asset managers like Blackstone or BlackRock could fund loans originated by local banks.

Two lessons for regulation loom large. The first is that attention should be paid to policy risk management as well as bank risk management in identifying areas of concern. Think easy money and the reach for yield, inflationary fiscal and monetary policy during the pandemic, and the Fed’s rapid-fire increase in short-term rates to combat stubborn inflation. Second, regulators and Congress need to be wary of both too much deposit insurance (with likely increased risk-taking and pressure on supervision) and too little deposit insurance (with likely jumps in banking concentration and disruption of local credit to businesses).

One can reasonably anticipate additional erosion of capital in non-money-center banks from rising interest rates and lower office real estate collateral values, hopefully motivating a quick grasp of these lessons. While banks don’t have to mark assets to market if current and can survive turbulence until monetary policy eases, potential runs can upset this equilibrium. Declining regional bank stock prices make this risk clear. Only good fortune or a more thoughtful policy stand in the way of additional bank distress and attendant credit supply reductions.

An Old-Fashioned Bank Run: The Collapse of Silicon Valley Bank [This post will be updated as new information becomes available. Updated Monday morning March 13.]

Photo from the Wall Street Journal

Rumors spread about the financial state of a bank. Some depositors begin to withdraw funds from their accounts. Suddenly a wave of withdrawals occurs and regulators step in and close the bank. A description of a run on a bank in New York City in the fall of 1930? No. This happened to Silicon Valley Bank, headquartered in Santa Clara, California and the sixteenth largest bank in the United States, on Friday, March 10, 2023.

Background on Bank Runs

In Macroeconomics, Chapter 14, Section 14.4 (Economics, Chapter 24, Section 24.4) we describe the basic reasons why a run on a bank may occur. We describe bank runs in greater detail in Money, Banking, and the Financial System, Chapter 12. We reproduce here a key paragraph on the underlying fragility of commercial banking from Chapter 12 of the money and banking text:

The basic activities of commercial banks are to accept short-term deposits, such as checking account deposits, and use the funds to make loans—including car loans, mortgages, and business loans—and to buy long-term securities, such as municipal bonds. In other words, banks borrow short term from depositors and lend, often long term, to households, firms, and governments. As a result, banks have a maturity mismatch because the maturity of their liabilities—primarily deposits—is much shorter than the maturity of their assets—primarily loans and securities. Banks are relatively illiquid because depositors can demand their money back at any time, while banks may have difficulty selling the loans in which they have invested depositors’ money. Banks, therefore, face liquidity risk because they can have difficulty meeting their depositors’ demands to withdraw their money. If more depositors ask to withdraw their money than a bank has money on hand, the bank has to borrow money, usually from other banks. If banks are unable to borrow to meet deposit withdrawals, then they have to sell assets to raise the funds. If a bank has made loans and bought securities that have declined in value, the bank may be insolvent, which means that the value of its assets is less than the value of its liabilities, so its net worth, or capital, is negative. An insolvent bank may be unable to meet its obligations to pay off its depositors.

The Founding of the Fed and the Establishment of the FDIC as a Response to Bank Runs

The instability of the banking system led to a number of financial crises during the 1800s and early 1900s, culminating in the Panic of 1907. Congress responded by passing the Federal Reserve Act in 1913, establishing the Federal Reserve System. The Fed was given the role of lender of last resort, making discount loans to banks that were experiencing deposit runs but that remained solvent. The failure of the Fed to stop the bank panics of the early 1930s led Congress to establish the Federal Deposit Insurance Corporation (FDIC) to ensure deposits in commercial banks, originally up to a limit of $2,500 per deposit, per bank. The current limit is $250,000.

Deposit insurance reduced the likelihood of runs but increased moral hazard in the banking system by eliminating the incentive insured depositors had to monitor the actions of bank managers. In principle, bank managers still have an incentive to avoid making risky loans and other investments for fear of withdrawals by households and firms with deposits that exceed the dollar deposit limit.

Contagion, Moral Hazard, and the Too-Big-to-Fail Policy

But if these depositors fail to monitor risk taking by bank managers or if a bank’s loans and investments decline in price even though they weren’t excessively risky at the time they were made, the FDIC and the Fed face a dilemma. Allowing banks to fail and large depositors to be only partially paid back may set off a process of contagion that results in runs spreading to other banks. Problems in the banking system can affect the wider economy by making it more difficult for households and firms that depend on bank loans to finance their spending. (We discuss the process of contagion in this post on the Diamond-Dybvig model.)

The Fed and the FDIC can stop the process of contagion if they are willing to ensure that large depositors don’t suffer losses. One mechanism to achieve this result is facilitating a merger between an insolvent bank and another bank that agrees to assume responsibility for meeting depositors withdrawals from the insolvent bank. But stopping contagion in this manner with no depositors suffering losses can be interpreted as amounting to deposit insurance having no dollar limit. The result is a further increase in moral hazard in the banking system. When the federal government does not allow large financial firms to fail for fear of damaging the financial system, it is said to be following a too-big-to-fail policy.

Silicon Valley Bank and VCs

Runs on commercial banks have been rare in recent decades, which is why the run on Silicon Valley Bank (SVB) took many people by surprise. As its name indicates, SVB is located in the heart of California’s Silicon Valley and the bank played an important role in the financing of many startups in the area. As such, SVB provided banking services to many venture capital (VC) firms. As we note in Chapter 9, Section 9.2 of the money and banking text, venture capital firms play an important role in providing funding to startup firms:

VCs such as Sequoia Capital, Accel, and Andreessen Horowitz raise funds from investors and invest in small startup firms, often in high-technology industries. In recent years, VCs have raised large amounts from institutional investors, such as pension funds and university endowments. A VC frequently takes a large ownership stake in a startup firm, often placing its own employees on the board of directors or even having them serve as managers. These steps can reduce principal–agent problems because the VC has a greater ability to closely monitor the managers of the firm it’s investing in. The firm’s managers are likely to be attentive to the wishes of a large investor because having a large investor sell its stake in the firm may make it difficult to raise funds from new investors. In addition, a VC avoids the free-rider problem when investing in a firm that is not publicly traded because other investors cannot copy the VC’s investment strategy.

An article on bloomberg.com summarized SVB’s role in Silicon Valley. SVB is

the single most critical financial institution for the nascent tech scene, serving half of all venture-backed companies in the US and 44% of the venture-backed technology and health-care companies that went public last year. And its offerings were vast — ranging from standard checking accounts, to VC investment, to loans, to currency risk management.

Note from this description that SVB acted as a VC—that is, it made investments in startup firms—as well as engaging in conventional commercial banking activities, such as making loans and accepting deposits. The CEO of one startup was quoted in an article in the Wall Street Journal as saying, “For startups, all roads lead to Silicon Valley Bank.” (The Wall Street Journal article describing the run on SVB can be found here. A subscription may be required.)

SVB’s Vulnerability to a Run

As with any commercial bank, the bulk of SVB’s liabilities were short-term deposits whereas the bulk of its assets were long-term loans and other investments. We’ve discussed above that this maturity mismatch means that SVB—like other commercial banks—was vulnerable to a run if depositors withdraw their funds. We’ve also seen that in practice bank runs are very rare in the United States. Why then did SVB experience a run? SVB was particularly vulnerable to a run for two related reasons:

1. Its deposits are more concentrated than is true of a typical bank. Many startups and VCs maintain large checking account balances with SVB. According to the Wall Street Journal, at the end of 2022, SVB had $157 billion in deposits, the bulk of which were in just 37,000 accounts. Startups often initially generate little or no revenue and rely on VC funding to meet their expenses. Most Silicon Valley VCs advised the startups they were invested in to establish checking accounts with SVB.

2. Accordingly, the bulk of the value of deposits at SVB was greater than the $250,000 FDIC insurance limit. Apparently 93 percent to 97 percent of deposits were above the deposit limit as opposed to about 50 percent for most commercial banks.

Economics writer Noah Smith notes that SVB required that startups it was lending to keep their deposits with SVB as a condition for receiving a loan. (Smith’s discussion of SVB can be found on his Substack blog here. A subscription may be required.)

The Reasons for the Run on SVB

When the Fed began increasing its target for the federal funds rate in March 2022 in response to a sharp increase in inflation, longer term interest rates, including interest rates on U.S. Treasury securities, also increased. For example the interest rate on the 10-year Treasury note increased from less than 2 percent in March 2022 to more than 4 percent in March 2023. The interest rate on the 2-year Treasury note increased even more, from 1.5 percent in March 2022 to around 5 percent in March 2023.

As we discuss in the appendix to Macroeconomics, Chapter 6 (Economics, Chapter 8) and in greater detail in Money, Banking, and the Financial System, Chapter 3, the price of a bond or other security equals the present value of the payments the owner of the security will receive. When market interest rates rise, as happened during 2022 and early 2023, the value of the payments received on existing securities—and therefore the prices of these securities—fall. Treasury securities are free from default risk, which is the risk that the Treasury won’t make the interest and principal payments on the security, but are subject to interest-rate risk, which is the risk that the price of security will decrease as market interest rates rise.

As interest rates rose, the value of bonds and other long-term assets that SVB owned fell. The price of an asset on the balance sheet of a firm is said to be marked to market if the price is adjusted to reflect fluctuations in the asset’s market price. However, banking law allows a bank to keep constant the prices of bonds on its balance sheets if it intends to hold the bonds until they mature, at which point the bank will receive a payment equal to the principal of the bond. But if a bank needs to sell bonds, perhaps to meet its liquidity needs as depositors make withdrawals, then the losses on the bonds have to be reflected on the bank’s balance sheet.

SVB’s problems began on Wednesday, March 8 when it surprised Wall Street analysts and the bank’s Silicon Valley clients by announcing that to raise funds it had sold $21 billion in securities at a loss of $1.8 billion. It also announced that it was selling stock to raise additional funds. (SVB’s announcement can be found here.) SVB’s CEO also announced that the bank would borrow an additional $15 billion. Although the CEO stated that the bank was solvent, as an article on fortune.com put it, “Investors didn’t buy it.” In addition to the news that SVB had suffered a loss on its bond sales and had to raise funds, some analysts raised the further concern that the downturn in the technology sector meant that some of the firms that SVB had made loans to might default on the loans.

Problems for SVB compounded the next day, Thursday, March 9, when Peter Theil, a co-founder of PayPal and Founders Fund, a leading VC, advised firms Founders Fund was invested in to withdraw their deposits from SVB. Other VCs began to pull their money from SVB and advised their firms to do the same and a classic bank run was on. Because commercial banks lack the funds to pay off a significant fraction of their depositors over a short period of time, in a run, depositors with funds above the $250,000 deposit insurance limit know that they need to withdraw their funds before other depositors do and the bank is forced to close. This fact makes it difficult for a bank to stop a run once it gets started.

According to an article in the Wall Street Journal, by the end of business on Thursday, depositors had attempted to withdraw $42 billion from SVB. The FDIC took control of SVB the next day, Friday, March 10, before the bank could open for business.

The Government Response to the Collapse of SVB

The FDIC generally handles bank failures in one of two ways: (1) It closes the bank and pays off depositors, or (2) it purchases and assumes control of the bank while finding another bank that is willing to purchase the failed bank. If the FDIC closes a bank, it pays off the insured depositors immediately, using the bank’s assets. If those funds are insufficient, the FDIC makes up the difference from its insurance reserves, which come from payments insured banks make to the FDIC. After the FDIC has compensated insured depositors, any remaining funds are paid to uninsured depositors.

As we write this on Sunday, March 12, leaders of the Fed, the FDIC, and the Treasury Department, were considering what steps to take to avoid a process of contagion that would cause the failure of SVB to lead to deposit withdrawals and potential failures of other banks—in other words, a bank panic like the one that crippled the U.S. economy in the early 1930s, worsening the severity of the Great Depression. These agencies hoped to find another bank that would purchase SVB and assume responsibility for meeting further deposit withdrawals.

Another possibility was that the FDIC would declare that closing SVB, selling the bank’s assets, and forcing depositors above the $250,000 deposit limit to suffer losses would pose a systemic risk to the financial system. In that circumstance, the FDIC could provide insurance to all depositors however large their deposits might be. As discussed earlier, this approach would increase moral hazard in the banking system because it would, in effect, waive the limit on deposit insurance. Although the waiver would apply directly only to this particular case, large depositors in other banks might conclude that if their bank failed, the FDIC would waive the deposit limit again. Under current law, the FDIC could only announce they were waiving the deposit limit if two-thirds of the FDIC’s Board of Directors, two-thirds of the Fed’s Board of Governors, and Treasury Secretary Janet Yellen agreed that failure of SVB would pose a systemic risk to the financial system.

According to an article on wsj.com posted at 4 pm on Sunday afternoon, bank regulators were conducting an auction for SVB in the hopes that a buyer could be found that would assume responsibility for the bank’s uninsured deposits. [Update evening of Monday March 13: The Sunday auction failed when no U.S. banks entered a bid. Late Monday, the FDIC was planning on holding another auction, with potentially better terms available for the acquiring bank.]

Update: At 6:15 pm Sunday, the Treasury, the Fed, and the FDIC issued a statement (you can read it here). As we noted might occur above, by invoking a situation of systemic risk, the FDIC was authorized to allow all depositors–including those with funds above the deposit limit of $250,000–to access their funds on Monday morning. Here is an excerpt from the statement:

“After receiving a recommendation from the boards of the FDIC and the Federal Reserve, and consulting with the President, Secretary Yellen approved actions enabling the FDIC to complete its resolution of Silicon Valley Bank, Santa Clara, California, in a manner that fully protects all depositors. Depositors will have access to all of their money starting Monday, March 13. No losses associated with the resolution of Silicon Valley Bank will be borne by the taxpayer.”

[Update Monday morning March 13] As we discussed above, one of the problems SVB faced was a decline in the prices of its bond holdings. As a result, when it sold bonds to help meet deposit outflows, it suffered a $2.1 billion loss. Most commercial banks have invested some of their deposits in Treasury bonds and so potentially face the same problem of having to suffer losses if they need to sell the bonds to meet deposit outflows.

To deal with this issue, Sunday night the Fed announced that it was establishing the Bank Term Funding Program (BTFP). Banks and other depository institutions, such as savings and loans and credit unions, can use the BTFP to borrow against their holdings of Treasury and mortgage-backed securities and agency debt. (Agency debt consists of bonds issued by any federal government agency other than the U.S. Treasury. Most agency debt is bonds issued by the Government Sponsored Agencies (GSEs) involved in the mortgage market: Federal National Mortgage Association (Fannie Mae), Government National Mortgage Association (Ginnie Mae), and the Federal Home Loan Mortgage (Freddie Mac).) The Fed explained its reasons for setting up the BTFP: “The BTFP will be an additional source of liquidity against high-quality securities, eliminating an institution’s need to quickly sell those securities in times of stress.” You can read the Fed’s statement here.

On Sunday, Signature Bank was closed by New York state banking officials and the FDIC. As with SVB, the Fed, FDIC, and Treasury announced that all depositors, including those whose deposits were above the $250,000 deposit limit, would be able to withdraw the full amount of their deposits.

Shareholders in SVB and Signature Bank lost their investments when the FDIC took control of the banks. On Monday morning, investors were selling shares of a number of regional banks who might also face runs, fearing that their investments would be lost if the FDIC were to seize these banks.

President Biden, speaking from the White House, attempted to reassure the public that the banking system was safe. He stated that he would ask Congress to explore changes in banking regulations to reduce the likelihood of future bank failures.