112 Comments
Mar 15, 2023Liked by Noah Smith

The problem for these smaller banks isn't just that interest rates went up. It's that they had a flood of deposits when interest rates were extremely low, mainly due to the various stimulus programs. The smaller banks couldn't grow their loan portfolio at a comparable rate to the increase in deposits so they had to buy more bonds. Then with swollen bond portfolios, rates went up causing large unrealized losses and at the same time, deposits were shrinking as the excess cash was disappearing. SVB is an extreme version of this story but I've been hearing about community banks feeling this funding stress since last fall.

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I can't see how the FDIC can make a credible commitment not to bail out depositors in future (they didn't bail out Indymac, but that brief period of bravery ended with the GFC). So, it would be better to make the guarantee explicit, and regulate accordingly (roughly, turn them into public utilities).

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“Without borrowing short and lending long, there really isn’t much of a reason for a bank to exist!”

The job of a bank is to manage the RISK of borrowing short to lend long. SVB appear to have done the thing that is the obvious banking option, but with:

- much longer dated long lending than is in any way sensible for an institution with 100% demand deposits - 1 year treasuries are still “lending longer” than overnight deposits but are much less exposed to rate moves; and

- zero risk management of the risk by swapping those longer rates to floating.

By lending long and swapping to floating could still have achieved additional margin due to the longer-term commitment, but would have had a gain on the derivative to offset the losses on the bond portfolio.

It really is banking risk management 101 and to have done none of it seems utter madness.

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Now that the government has shown that it will save the banks from risk doesn’t that make it more likely that the banks will just keep taking more risks?

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Nice article. Whatever anyone thinks of the yuan or BRICS et cetera, it's clear that the dollar is in for tough times ahead. The Fed is caught between Scylla and Charybdis.

A strong dollar, boosted by higher interest rates, is beneficial to the middle class and the poor who retain substantial amounts of their capital in cash. A strong dollar also, of course, makes imports cheaper. Of course, the most important benefit is it helps counter inflation.

But the era of zero interest rates went on for too long( the pandemic clearly didn't help matters). It meant that regional banks all over the country were sitting on massive piles of unrealized losses. Tech, the industry which benefits most from zero interest rates, was given a full decade of it. What did they do with it? Well, the honest truth is other than Elon Musk( who I have to concede built actual useful stuff), hardly anything that matters.

Captured by venture capitalists, The tech industry has spent all of that time and resources promoting the gig economy to disrupt traditional labour, crypto in the absurd hope that institutional gambling and Ponzi schemes constituted some kind of financial alternative, and the metaverse to do precisely what exactly?

They have squandered a golden opportunity to actually build the next era of technology on American shores ( perhaps LLMs make a difference: the jury is still out there).

The decision to freeze Russia's reserves, go after Oligarchs' assets regardless of due process, and weaponize the financial system will come in time to be remembered as one of the greatest geopolitical own goals of all time. It means that the elite all over the world are more reluctant now to purchase western assets which of course drives dollar demand down, it means China can and is entrenching itself in the middle east and I can't draw out all of the massive implications there, and it means America has unwittingly made itself the midwife of an alternative financial system, albeit one with very different goals and strengths.

So, the Fed can't afford to keep raising interest rates: it will break several of American industries( banking and tech most clearly). It can't afford to not keep raising interest rates ( if inflation is not countered properly, the consequences for the median American are steep)

As it is, Biden by endorsing the right decision to make depositors whole( ironic that 'independent risk taking libertarians' panicked and clamoured for federal intervention so easily), may have damaged his own chances of reelection. The collateral damage of this decision will be vast. But, in keeping with the grand old rules of capitalism, the venture capitalists will escape much of it.

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“But I think Summers’ argument just doesn’t make sense here.”

Small wonder, because Summers has been wrong on important policy for decades. He’s arguably the worst applied economist of his generation. It baffles me as to why people can’t find a better economist to quote. Summers’ thinking should not be the Good Housekeeping Seal of approval for economic columns.

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Seems like the obvious answer is some help fighting inflation from the fiscal side.

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Mar 15, 2023·edited Mar 15, 2023

To say Treasuries are subject to interest rate risk from the fed ignores their inherent risk. They are subject, like all dollar denominated bonds, to INFLATION risk. And as the largest institution, the government is also ironically the largest DRIVER of said inflation, whenever they make a poor investment decision with the funds they are loaned - investments that don't return good economic growth.

When that government spending investment returns poorly, resources have been wasted and supply shortages occur. This causes the price inflation that devalues bonds before the fed even tries to raise rates to stop it.

When you invest in Treasuries, you are investing in the government spending that investment wisely.

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Ahhh, another economic event, another cycle, and there will be more acts to the American financial play until democratic economics eventually replaces autocratic economics. The only clarification is that there are multiple autocrats, not just one on top. It’s a whole class on top who work to perfect the sly skills of wealth while appearing to play by the rules. The drastic income gap in this country is not an accident — the SVB boys collected theirs while walking out the door. This sly winning is helped by the inscrutability of economics; Larry Summers just isn’t very good at it. But the human supply chain is wearing down, so maybe more fundamental change is in store? Hopefully soon . . . .

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The Fed is trying to break the economy to reduce inflation. Mind you, it won't break these formerly

Libertarian turned Socialist VCs, no it'll save them--its waiting to break the middle and poor classes to quell inflation. A good portion of the crap in the system was just bailed out like 2008. We are a top heavy country now--is it any coincidence that our deficit has skyrocketed and productivity plummeted along with the pigs learning to walk on two legs?

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"And if you’re not going to borrow short and lend long, why are you a bank in the first place?"

Banks do provide another important service (the service that SVB's and other banks depositors are likely most interested in): they allow individuals and businesses to store and transmit money electronically without having to manage piles of cash. The banks could even charge a fee for this service with no lending required.

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Mar 15, 2023·edited Mar 15, 2023

Thanks Noah for this. Reading all the hot takes on this over the last several days was driving me nuts. Seemed like everybody wanted to use this as an excuse to ride their favorite hobby horse (woke capitalism, annoying tech bros., etc). Even the usually reliable Derek Thompson seemed to be getting in on the action. I look forward to your follow-up articles

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I was similarly baffled when I read that tweet from Larry Summers.

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I'm more in the Larry Summers camp here. Managing the risk of borrowing short to lend long is the primary value add of a bank. Lots of other things intermixed along the way but that is the foundation. That we have a generation of bank managers who haven't experienced a rising interest rate environment does not excuse them from failing. In the SVB case this is exaggerated by their specific, intentionally sought (and created), market niche of focusing on start-ups. Startups have an unusual relationship with cash in the best of times and when times are stressful that gets even worse. SVB's role in risk management was to anticipate and manage that risk or alterntaively, participate in the broader market instead. So we have naive bank managers and naive startup founders (and startup CFOs) mishandling the risk surrounding tens, hundreds of millions of dollars and the bank fails when the very favorable risk environment rapidly changes. Not too much of a surprise.

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Fabulous.

There is a slope change in the depositories curve around 7/2018. Why?

I'm still thinking that a core tenet of macro theory is based on elastic response instead of many different time based viscous responses. I think this makes the Inflation fighting = k(interest rate), inaccurate and not as effective.

Our national and global economy is 10x more complicated than 1970s - 80s

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Noah, how can you not mention duration matching even once in this article? I believe this is the norm in banking, to reduce interest rate risk and essentially lock in a low risk spread on deposits. SVB deliberately chose not to do this. They were gambling that rates wouldn't go up as fast as they did in order to earn a higher spread. I think future regulations should force this type of gamble to be disclosed to depositors, more like surgeon's general warning on a cigarette carton, rather than a couple bullet points and a small table buried deep in a 10k.

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