"Like many tech firms, my company and some of the startups we've created spent the weekend worrying as the fate of Silicon Valley Bank and its depositors hung in the balance. By Sunday the Federal Deposit Insurance Corp. announced that all was OK -- no customers would lose any money. But the same day, regulators in New York shuttered Signature Bank for liquidity issues similar to those that felled SVB. Predictably, recriminations have already begun.
I'm here to warn you that another bank could implode next. Indeed, just about anybody reading this could be at risk of losing everything over the FDIC's $250,000 deposit insurance limit. Which bank am I talking about? Why, all of them, of course.
The fundamental business model of banking is that the bank accepts money from depositors and then invests almost all of it. Banking laws state that a certain amount of depositors' money, called reserve requirements -- typically around 15% of the total -- must be kept for redeeming customer accounts. The remaining 85% gets loaned out, often in long-term illiquid loans. If customers want to withdraw more than the bank has on reserves in a short time period, a death spiral may ensue.
At that point, the bank has essentially two options. Option one is to raise money by selling investments. Selling investments at a loss, however, could push the bank closer to the point where it can't honor customers' withdrawals. Other clients who catch wind of this will understandably start to worry. Option two is to try to raise enough money to bridge its cash needs by selling equity in the bank itself. But doing that requires telling prospective investors details about the bank's situation, which might paint a picture of an institution in trouble.
Silicon Valley Bank did both of these things. It sold $21 billion in long-term bonds, reportedly at a $1.8 billion loss. That sounds like a lot of money, but it was just under 1% of the approximately $209 billion it had in assets. SVB also attempted to raise $2.5 billion in equity investment to help cover that loss -- and its executives appealed to the venture-capital community, representing a huge chunk of its customer base, for support. That turned out about as well as a wounded zebra appealing to the kindness of the local hyena clan. The result was a run on the bank.
Banking relies on probability theory. If you have a large number of account holders and each of them makes independent decisions, then it's unlikely you'll ever have a problem. One account holder might need to pull his money out to meet financial obligations, but while that's happening, another's business is booming. The second keeps money in the bank and might even deposit more. Thousands of depositors' independent decisions average out to leave a relatively smooth and predictable trend in demand for the bank's assets.
But statistical independence rarely exists in the real world. The state of the overall economy tends to affect all the bank's customers in similar ways. Worse, rumors of a bank failure and an elevated risk of losing money can run through the community of customers like wildfire. Instead of a steady, predictable increase in withdrawals, there's a gut-wrenching spike.
Each of these factors occurred last week with Silicon Valley Bank, but they are nothing new. They have occurred in bank runs for as long as the unstable business model has been around.
A bank run in the town of Bedford Falls is central to Frank Capra's 1946 classic "It's a Wonderful Life," clips of which were being emailed around tech companies last week.
In the film, Uncle Billy triggers the run by losing $8,000, which is purloined by the greedy robber baron Henry Potter. The number of zeros has increased over the decades, but the dynamics are the same, including the natural inclination to blame a single bad guy like Mr. Potter. Politicians and the media are already mounting a search for a villain in the Silicon Valley Bank story. They may find one, but it seems more likely that some garden-variety screw-ups compounded unexpectedly.
The FDIC and heavy government regulation of banking were created in part to prevent bank runs by reassuring depositors with government-backed guarantees. But that's a fool's errand in our highly connected world. Any bank could fail if a large enough fraction of its customers panic -- even Signature Bank, whose board includes former Rep. Barney Frank, a primary author of our main banking law.
At best, the FDIC can help clean up the mess after the fact, and where necessary the feds can step in to guarantee all deposits, as they did this weekend for SVB and Signature depositors. That's important, given that the overall banking system -- and with it, the economy -- is a probability game. If bank failures are independent -- say, the Building & Loan goes under because of Uncle Billy -- that's disconcerting but limited in scope. But the economy is interlinked, and bank failures, or even the hint of them, in one area can bring down others. A run on a single bank is tolerable, but a run on the system can suck all the oxygen out of the economy, as happened in the Great Depression.
It almost happened again in 2008, when a crisis in confidence nearly caused a global financial meltdown. Banking is a game of confidence -- it's really the only thing that keeps the model working. But the problem of keeping the faith keeps getting harder. Panic spreads much faster today than in the Bedford Falls of the 1940s. I can speak candidly about every bank being at risk mainly because I'm a relative nobody. If Jamie Dimon or Jerome Powell said the same at the wrong moment, it could spark a financial crisis overnight.
I wish there were an obvious solution to this problem, but there isn't. Tightening reserve requirements, as the Federal Reserve does from time to time, makes it harder for businesses to get loans. That hurts the economy and reduces the interest that deposit holders earn on their money. Increasing regulation more generally will tend to make banks more bureaucratic and less responsive to their customers.
One big reason Silicon Valley Bank had such an outsize hold on the tech industry is that it better understood the needs of young tech companies, and startups in particular. Would a more government-controlled bank do that? Probably not.
Even lacking a solution, it is important to keep the basic instability of banking in mind. Otherwise, we risk well-intentioned interventions being worse than the problem. Banking experts and regulators are like TV meteorologists. For all their skills in predicting what will happen in the short term, they still get surprised. And they don't actually control the weather itself. Sometimes, unexpectedly, a perfect storm comes rolling in.
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Mr. Myhrvold is founder and CEO of Intellectual Ventures, an invention hub in Bellevue, Wash., that has spun out more than 15 startup companies, and a former chief technology officer of Microsoft." [1]
So take your money out of your bank for some time. Do it dancing and smiling, so nobody will understand what you are up to, one more bank run will be avoided today, may be not tomorrow though.
1. Banking Is Always a Risky Business
Myhrvold, Nathan. Wall Street Journal, Eastern edition; New York, N.Y. [New York, N.Y]. 15 Mar 2023: A.17.
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