Do the Feds Know What They Are Doing?
Headlines have been portending in recent weeks that First Republic Bank could be the next potential failure in a banking crisis that started in March—and that is exactly what has happened. This news comes in the wake of reports published by the Federal Reserve and the Federal Deposit Insurance Corporation (FDIC) that clearly identify the cause of recent bank failures: the regulators themselves.
Just as they did with the financial crisis of 2008, many critics of regulators are laser-focused on blaming a light-touch approach by the Federal Reserve and government agencies. And once again, they are overlooking an alternative reason: the actions of the Fed and others leading up to the crisis. Specifically, the Fed’s management of interest rates during the last year, combined with regulators’ overzealous response to recent banking uncertainty, proved to be more destructive than helpful.
The Nature of the Crisis
When Silicon Valley Bank (SVB) collapsed seemingly out of nowhere in March, calls came from many quarters for the federal government to step in. Those demands only increased when Signature Bank in New York also went under just two days later. Tweets from venture capitalists and former hedge funders warned that failing to act would jeopardize the banking system—and potentially the entire economy.
After a long weekend, the feds finally gave in to these pleas, choosing to ignore existing FDIC insurance limits in order to make bank depositors whole again. While SVB and Signature were viewed largely as regional banks, the breadth of their customers—the logic went—was too far-reaching not to step in. In the days and weeks after their collapse, regulators worked to arrange sales of the banks’ assets to prospective buyers.
Many have critiqued the federal response to the SVB and Signature failures as just another bailout for Wall Street. Setting aside whether the government’s rescue of depositors is properly understood as a bailout—and, to be clear, it’s not—those Twitter commentators were right to be concerned. The possibility of contagion and a domino effect of bank failures echoed the 2007-08 financial crisis and motivated a robust government response.
Of course, neither SVB nor Signature Bank were as large as the banks that failed during the Great Recession. Bear Stearns was estimated to have had $400 billion in assets at the time of its collapse, while Lehman Brothers had more than $600 billion and was then the fourth-largest investment bank in the world. In contrast, SVB had ranked just 16th-largest with about $210 billion in assets, while Signature added another $110 billion.
Interest Rates Are Key to the Story
The size of the banks at play isn’t the only difference between today and 2008. The story of the last year and a half, of course, is that inflation has returned with a vengeance, spiking at the highest level in more than 40 years before persistently lingering. While most economic indicators, particularly job growth and wages, remain strong, the Fed must now prioritize inflation in a way that it did not have to during the run-up to the Great Recession. To respond to inflation, the Fed raised interest rates seven times in 2022, to a level not seen in more than 15 years. Those rate hikes continued into this year, when the fed funds rate hit 5% for the first time since the height of the housing boom.
One result of the Fed’s actions is that economic growth has begun to slow considerably: The latest estimate shows the economy growing at just 1.1% annually so far this year, and The New York Times affirmed that “higher interest rates drove the slowdown.”
But slower growth and moderated inflation are just the first observable impacts of the Fed’s increase in rates. Raising interest rates ultimately slows growth by making certain consumption and less productive forms of investment less attractive. Speculative startups and even established tech firms tend to struggle when rates rise, as recent layoffs illustrate. After all, enterprises have to produce a high rate of return to beat what can be earned “risk free.”
For everyday consumers, the opportunity cost of spending frivolously goes up when more interest can be earned by keeping money in a savings account. Likewise, the threshold for investing in new business ventures also increases because the rate of return provided by such projects must also clear the same hurdle.
Rising Rates and SVB
But rising interest rates also had an impact on SVB, which was largely profiting thanks to the so-called carry trade, whereby investors borrow on the short end of the yield curve and sell assets on the higher end. In essence, SVB’s balance sheet was prone to problems as the Fed increased interest rates, because they squeezed this arbitrage opportunity and made the banks’ investments no longer profitable.
For this reason, raising interest rates can imperil businesses that were just skating by thanks to low rates. When those rates rise, borrowing becomes more expensive, and previously profitable ventures may no longer be so. In other words, we can expect that when the Fed raises interest rates, some businesses will become less profitable, while others will fail.
Of course, this situation can be particularly perilous for depositors at banks with already questionable balance sheets. And indeed, this risk is a big part of the story with SVB, Signature and now First Republic. As in the run-up to the Great Recession, the Fed’s actions changed the investment calculus for the banking system, making the recent failures a predictable outcome in an overheated, inflationary environment.
And don’t just think of SVB and Signature—big box stores like Bed Bath & Beyond have also declared their bankruptcy in recent weeks, but of course, they don’t have depositors in need of rescue and therefore receive less attention.
As many commentators have noted, SVB had a substantially larger bond portfolio than other banks, and while bonds are often perceived as less risky than other investment vehicles, they are more vulnerable to rising interest rates. That exposure inflated perceived profitability when rates were low, but ultimately blew up as rates rose and the bank was slow to adjust.
The Fed Shouldn’t Be Surprised
To be clear, the Fed’s increases in interest rates since the start of 2022 are completely reasonable. With inflation on the march, the United States’ experiences in the 1970s and ’80s show that price stability must be the central bank’s top priority—even if it means slower growth and the risk of recession.
And the evidence is now clear that the Fed was probably too late to move, whether because of complacency or a general belief that inflation was a phenomenon of the past. Had the Fed taken on inflation earlier, it could have potentially raised rates more slowly and given banks like SVB more time to reassess their balance sheets.
But the federal actions since mid-March have been nothing short of baffling. In its first meeting after the rescue of SVB and Signature depositors, the Fed raised interest rates another 25 basis points. While they signaled that “the end is near,” the Fed was still expected to raise rates again regardless of the turmoil in the banking system.
Either of the Fed’s actions—raising interest rates to slow growth or rescuing depositors from failing banks—would have been justifiable when taken in isolation. Indeed, manipulating interest rates in response to inflation has been the stated purpose of the Fed since its founding in 1913. But taken together with the response to SVB, Signature and now First Republic, the combination of actions represents a nonsensical monetary policy.
And let’s also not forget about the incoherence of the Biden administration’s fiscal policy during this entire mess. Despite the Fed’s tightening of interest rates, the president has largely continued to pursue expansionary fiscal policy, further exacerbating already existing inflationary pressures.
The Federal Reserve is an independent and still largely respected body, but its response to the banking failures is contradictory at best and detrimental at worst. If the Fed and FDIC can’t get out of each other’s way, we may be in for even more economic hardship during the next few years.