Is This How the Next Financial Crisis Begins?

To say that events of the past few days have been shocking and unnerving is a bit of an understatement. Even those of us who expect a major recession or financial crisis to occur have been startled by what happened and how suddenly it occurred. And the obvious question that’s being raised now is, is this how the next financial crisis is going to begin?

What Happened

Last Friday state regulators shut down Silicon Valley Bank, a bank that lent heavily to the tech sector. The move came on the heels of the bank’s facing financial difficulties and failing to come up with fresh capital.

While Silicon Valley Bank may not have been a household name before last week, the bank had been in existence for 40 years and was the 16th-largest bank in the country at the time of its failure. At the time of its failure, the bank had $175.4 billion in deposits, $151.6 billion of which were uninsured.

Now, you may be asking yourself, why were there so many uninsured deposits? It’s because the bank catered largely to the tech sector and to venture capital firms. These firms often had large sums of cash sitting in their accounts, millions or hundreds of millions of dollars, well in excess of the $250,000 limit for FDIC deposit insurance.

One of the bank’s strategies appeared to be taking deposits and then using them to purchase bonds that were considered “safe,” such as Treasury bonds and agency mortgage-backed securities. In normal times this might be considered a relatively safe and conservative approach to take. But we’re not living in normal times.

At the time of SVB’s failure, the bank’s bond portfolio had an average maturity of 6.2 years and an average yield of 1.8%. Of course, with 3-month Treasury bills now earning over 5% interest, this means that the value of SVB’s bond holdings had plummeted over the past year.

Remember that as bond yields rise, bond prices fall. That wouldn’t be a problem if you hold those bonds to maturity. But banks don’t have the luxury of doing that.

There’s a maturity mismatch inherent in fractional reserve banking in that banks borrow short and lend long. That is, they borrow money from depositors (who are essentially creditors to the bank) that they pledge to redeem instantly or within 30 days or whatever the terms of the account read. But they lend that money (by buying bonds or issuing loans) for terms that are far longer than 30 days, and potentially many years in length.

What happens when depositors go to the bank to withdraw their funds and all that money is tied up in loans? Well, the bank has to try to call in those loans. Or in the case of bonds that it owns, it has to sell those bonds. And with its bond holdings having lost value, every redemption causes the bank to lose more money. In SVB’s case, that was about an 8.5% loss on a $21 billion bond sale.

Remember that since 2020, banks in the US have not been required to hold any bank reserves against deposits. That allows for nearly unlimited amounts of lending, but it also results in severe problems if the bank has insufficient reserves on hand to pay out depositors wishing to withdraw their money.

In the case of SVB, its bond holdings would have had insufficient value for all depositors to be able to redeem their deposits. And as word began to circulate about the bank’s difficulties, a bank run began to occur. With the risk that the bank might eventually become insolvent, regulators made the decision to shut the bank down to stem an even more severe bank run or a systemic banking crisis.

Of course, SVB wasn’t the only bank to face difficulties. Regulators made the decision to shut down New York-based Signature Bank on Sunday. SVD and Signature are the 2nd- and 3rd-largest bank failures in US history, only surpassed by Washington Mutual in 2008.

Like SVB, Signature also had large amounts of non-insured deposits. The federal government also made the decision to ensure that all depositors at both institutions would be made whole, not just insured depositors. But why?

What It Means

Consider what would have happened if non-insured depositors had not been made whole. What likely would have happened is that regulators would have sold off the banks’ devalued assets to raise money to reimburse uninsured deposits.

Those assets weren’t worthless, but they weren’t worth as much as they had been. Uninsured depositors would have likely taken a haircut of some sort, maybe on the order of 10-20%. That’s better than losing everything, but for startup companies that need every dollar to fund payroll, that could mean the difference between staying in business or going bankrupt. To forestall that, companies began to withdraw their money, precipitating a bank run.

Had regulators not decided to make uninsured depositors whole, it would have signaled to depositors elsewhere in the country that their uninsured deposits could be lost, something they should have already known. But that realization might have caused them to start pulling their funds out, threatening even more banks with insolvency.

By protecting uninsured deposits as well, regulators are hoping to keep other banks in similar situations from facing bank runs. But that also risks creating even greater moral hazard.

Moral hazard already exists in the banking sector because of deposit insurance. Because bank deposits are already insured up to $250,000, depositors don’t do their due diligence when choosing a bank.

When you chose to open your bank account or credit union account, did you look at the bank’s financial statements before doing so? Do you know how much debt your bank has issued, what its loan to deposit ratio is, or how much exposure it has to auto loans, home mortgages, or subprime loans?

Odds are that 99.9% of Americans don’t do that. They look for free checking, convenient bank and ATM locations, or other similar criteria. So banks aren’t reined in by market discipline. Depositors figure that if the bank fails, they’ll still have their money since they’ve deposited less than $250,000. So even badly-run and risky banks continue to get funded with customer deposits, keeping them in business longer than they should be.

Now there’s an implicit backing even of uninsured deposits. Uninsured depositors are going to expect the federal government to back even uninsured deposits going forward thanks to the cases of SVB and Signature. And you can imagine the moral hazard that will ensue.

According to the latest FDIC statistics, there are $17.725 trillion in bank deposits in the US, only $10.068 trillion of which are insured. So there are $7.657 trillion in uninsured bank deposits, or 43% of all total deposits. And the Deposit Insurance Fund is currently at $128.2 billion. That’s equivalent 56% of the amount of the uninsured deposits at SVB and Signature combined, 1.27% of all insured deposits in the country, and 0.7% of all total bank deposits in the country. That seems a little worrisome, doesn’t it?

What the Future Holds

What everyone wants to know is, what is going to happen going forward. What happened the past few days looks eerily similar to what happened with Bear Stearns in 2007. Bear Stearns began to experience difficulty with respect to the housing sector and federal regulators swooped in to contain the problem, eventually facilitating a purchase of Bear Stearns by JPMorgan Chase. We were told that everything was just fine, and most people didn’t look into things any further.

But then along came Lehman Brothers in September 2008 and all of Wall Street thought Lehman would get the same treatment as Bear. When the feds let Lehman fail, it was a major shock. Markets were completely taken aback, and within a few weeks it seemed as though the financial system was on the verge of collapse.

The question we have to ask ourselves is, will federal regulators continue to treat failing banks the way they have treated SVB and Signature? Or will they let them fail and allow uninsured depositors to take a haircut?

What happens if everything is fine for the next few months and then another major bank fails, and FDIC doesn’t backstop uninsured depositors? All hell would break loose on Wall Street, and we could see ourselves repeating 2008 all over again.

As much as we would like to think this time is different, we can’t be too certain about that. No one knows what’s in the mind of regulators, and they are certainly fallible human beings capable of making mistakes.

Certainly there’s a lot of fear in markets today, with safe havens like gold and silver seeing major price increases as people begin their flight to safety. We’ll have to see what happens in the coming days and weeks, as more and more Americans are becoming aware once again of the frailty of our banking system.

Goldco is ready to work with you if you’re looking to protect your assets with gold and silver. With the likelihood of a recession or financial crisis seeming to rise along with the increasing instability in the banking system, we could be on the cusp of another 2008-style crisis. And demand for gold and silver could continue to rise if more weakness in the financial system becomes apparent.

Don’t let your hard-earned wealth fall victim to the vicissitudes of financial markets. Call Goldco today and start protecting your financial future with gold and silver.