Tag: equity

Econ 101: SVB and bank runs

What is a bank run and how can we prevent them? A bank run, as I am sure you all know, is a rush by depositors to withdraw their deposits for fear that the bank will not have the money to give them. But there is a lot to unpack there in order to understand what is going on and how runs might be prevented.

It is important to understand the difference between debt and equity—between lending a specific amount of money with specific terms and investing an amount of money in exchange for a share of the earnings (or losses) of the recipient. When you buy shares in a company, it has no obligation to return your money. If you no longer want to invest in that company, you can sell your shares to someone else or the company might, at its discretion, buy them back. Its failure to “return” your money cannot be the cause of a company’s bankruptcy (take over by creditors to collect what the company is no longer able to return).

The deposits that we make in our banks are a special case of debt finance of whatever the banks do with our money. As we know, they lend much of it to people and companies for one thing or another and invest some in hopefully safe assets like Treasury bills and keep a tiny bit on hand for when you need cash. But the deposit contract says that you have the right to withdraw (or pay to someone else) any or all of it whenever you want to. Thus, banks must keep sufficient liquid assets in order to satisfy such withdrawals by selling them in the market when you demand your money back. The Federal Reserve, our lender of last resort, also has facilities for lending to banks needing cash against the collateral of bank assets.

The difference between illiquidity and insolvency is critical as well. A bank is solvent when the value of its assets match or exceed the value of its liabilities (such as your deposits). But having sufficient good assets doesn’t mean that that bank can always honor your deposit withdrawal demand. That is a question of liquidity. Does the bank have enough of its assets backing your deposit in forms that it can pay out immediately (cash in its vault, deposits at the Federal Reserve that it can transfer to another bank or use to buy cash, or assets it can quickly sell such as t-bills, or credit lines with other banks or the Fed, etc.)?  “The difference between bank liquidity and capital” Thus, even a solvent bank (positive capital) might fail to honor your withdrawal demand if it doesn’t have sufficient liquid assets. “The big bailout-what next?”

Usually, a bank becomes insolvent when more of its loan assets default than the bank has capital to cover such losses. But as we will see in the case of Silicon Valley Bank, insolvency can also result from a decline in the current market value of a “good” asset.  When depositors suspect that their bank might be insolvent, they will withdraw their money while they still can. This tends to use up the bank’s liquid assets compounding the risk of default. As the word spreads the classical bank run takes off (electronically these days rather than long lines outside the bank as in the old days).

The SVB, which specialized in financial services to start-ups and technology companies, enjoyed a huge increase in its deposits over the last four years, increasing from $49 billion in 2018 to $189.2 billion in 2021 dropping back to $175.4 billion at the end of 2022. It invested most of those deposits in “safe” long term government and similar debt. While the default risk for these assets was negligible, the risk of a loss in current market value if market interest rates increased was high. No one will pay the face value of a 3% ten-year bond while current market rates for the same maturity are 4%. The rapid increase in interest rates as the Federal Reserve reversed money growth to fight inflation tanked the current market value of a large share of SVB’s assets making it impossible for it to come up with the cash depositors might demand if they “ran”. That is how runs work. On March 10 SVB was put into receivership.

The original sin of modern banking is financing long term loans/investments with money (demand and savings deposits). Islamic banking, what uses equity investing, is wiser in this regard. During the Savings and Loan crisis in the U.S. in the 1980s and early 90s (financing mortgages with deposits) more than 1000 S&Ls failed when interest rates increased. But in fact, the U.S. bank regulation regime has some good features. While bank risk taking is subject to many, often costly, regulations, the ultimate check on risk taking comes from the knowledge of bank owners that they will lose their entire stake if their bank becomes insolvent. The Federal Deposit Insurance Corporation (FDIC), which oversees America’s deposit insurance scheme, has developed effective bank bankruptcy and resolution procedures that allow it to take over and resolve insolvent banks with barely a ripple. A favorite tool is the so-called purchase and assumption transaction by which a healthy bank buys the assess of the insolvent one and assumes its liabilities (deposits), usually over a weekend. Thousands of insolvent banks have been resolved by the FDIC in the last fifty years.  See “Institutional and Legal Impediments to Efficient Insolvent Bank Resolution and Ways to Overcome Them” by Warren Coats and Arno Liuksilo “Warren Coats-17”

Most bank depositors pay no attention to the financial condition of their bank because their deposits are insured against losses, which until last week had been raised to $250,000. But the government has now implicitly extended such insurance to all deposits via accounting and other tricks, thus removing any remaining check on bank risk taking from all depositors. On Monday, President Biden announced that no depositors in SVB (and Signature Bank of New York) would lose any of their deposits.  Following the banking crisis of 2008, the Dodd-Frank law further strengthened financial sector regulations. The most important and helpful provisions of this 2,300 page law provided for significant increases and strengthening of bank capital requirements.  

The overuse of debt rather than equity financing is a more general weakness in our economy. The IRS should stop subsidizing it. Interest on borrowing is deductible from taxable income while dividends on equity financing are not. While increasing bank capital makes them less run prone, a simpler and easer to regulate approach is to remove the cause of runs all together by eliminating any risk that your bank can’t honor its obligation to return your money on demand. Another few thousand pages of laws and regulations might catch the last mistakes (though it is hard to see why regulators didn’t address the obvious duration risks taken by SVB), but there is an easier, less costly solution. Bank failures result from the mistakes of banks (their owners and managers) and the failure of depositors to more carefully evaluate the soundness of the bank in which they deposit their money. But depositors have little competence to evaluate bank soundness, and why should they be expected to?

Money (bank deposits) should be fully separated from credit. Deposits should not finance loans. Those financing investments should share in its risks (and rewards) via equity financing. “More than decade ago Professor Kotlikoff and [John Goodman] proposed “limited purpose banking” in The New Republic and in Investment News. The idea is that credit market institutions should be intermediaries between savers and investors and should not themselves use depositors’ money to make risky investments.”

When we deposit money in banks for safekeeping and making payments there should never be any doubt about the bank’s ability to return it on demand and thus no reason to “run” on the bank to protect our deposits. This is the essence of the Chicago Plan which would replace so call fractional reserve banking with 100% reserves (deposits at the central bank). When my bank deposit is backed totally by my bank’s deposits at the Fed, I would know with certainty that they were 100% safe and instantly available.  The “Chicago Plan” and New Deal Banking Reform | Levy Economics Institute (levyinstitute.org) Narrow banking schemes have a similar motivation. “A proposal for the feds balance sheet”

Shifting Gears: The Way Forward

The Trump administration accomplished many good things and many bad things (especially in the trade and foreign policy areas). Trump himself belongs in jail in my opinion. Hopefully, with the new Biden administration we can turn our attention to policy issues and stop calling our policy opponents nasty names. We must state the positive case for why our policy views are more appropriate–why they are better for our country. These are the sorts of public debates that we have been missing for a while and to which we should return.

One of our most fundamental principles is America’s commitment to equal treatment under the law for everyone regardless of race, religion, sexual orientation, or preferred hair style. Equal treatment is extended to everyone whether they or their ancestors came from Asia, Europe, Africa or Ireland (yes, even Ireland). We have never fully measured up to this principle, but it remains, and should remain, the objective to which we continually strive. It means that our accomplishments and “place” in society largely reflect our own talents and efforts. We are a nation of individual liberty. We are free (to a large extent) to make our own decisions. Our policy disputes often concern where to draw the line between what we decide for ourselves and what the government decides for us. My blog last week on our response to Covid-19 provides an example: https://wcoats.blog/2021/03/06/the-unnecessary-fight-over-covid-19/

Equity (equal outcomes) was the fundamental principle of the Soviet Union, though its outcomes fell far short of the principle. Between these extremes of equity (communism/socialism) and equality (equal treatment under the law) is our actual world of governments with more intrusive or less intrusive rules and dictates on our behalf, with broader or narrower social safety nets, etc.  America continues to debate where and how to set these boundary’s, but one of our great strengths, and a source of our broadly shared affluence, is undertaking the debate from the side of (and with the presumption of) self-reliance (with family and friends) and equality under the law.

The distinction between equity and equality is sharply contrasted in the following WSJ oped.

THE  WALL  STREET  JOURNAL.

Friday,  March  5,  2021.

Section A, Page 17, Column 1

‘Equity’ Is a Mandate to Discriminate

The new buzzword tries to hide the aim of throwing out the American principle of equality under the law.

By Charles Lipson


On his first day as president, Joe Biden issued an “Executive Order on Advancing Racial Equity and Support for Underserved Communities.” Mr. Biden’s cabinet nominees must now explain whether this commitment to “equity” means they intend to abolish “equal treatment under law.” Their answers are a confused mess.

Arkansas Sen. Tom Cotton raised the question explicitly in confirmation hearings. Attorney General-designate Merrick Garland responded: “I think discrimination is morally wrong. Absolutely.” Marcia Fudge, slated to run Housing and Urban Development, gave a much different answer. “Just to be clear,” Mr. Cotton asked, “it sounds like racial equity means treating people differently based on their race. Is that correct?”

Ms. Fudge’s responded: “Not based on race, but it could be based on economics, it could be based on the history of discrimination that has existed for a long time.” Ms. Fudge’s candid response tracks that of Kamala Harris’s tweet and video, posted before the election and viewed 6.4 million times: “There’s a big difference between equality and equity.”

Ms. Harris and Ms. Fudge are right. There is a big difference. It’s the difference between equal treatment and equal outcomes. Equality means equal treatment, unbiased competition and impartially judged outcomes. Equity means equal outcomes, achieved if necessary by unequal treatment, biased competition and preferential judging.

Those who push for equity have hidden these crucial differences for a reason. They aren’t merely unpopular; they challenge America’s bedrock principle that people should be treated equally and judged as individuals, not as members of groups.

The demand for equal outcomes contradicts a millennium of Anglo-Saxon law and political evolution. It undermines the Enlightenment principle of equal treatment for individuals of different social rank and religion. America’s Founders drew on those roots when they declared independence, saying it was “self-evident” that “all men are created equal.”

That heritage, along with the lack of a hereditary aristocracy, is why claims for equal treatment are so deeply rooted in U.S. history. It is why radical claims for unequal treatment must be carefully buried in word salads praising equity and social justice.

Hidden, too, are the extensive measures that would be needed to achieve equal outcomes. Only a powerful central government could impose the intensive—and expensive—programs of social intervention, ideological re-education and economic redistribution. Only an intrusive bureaucracy could specify the rules for every business, public institution and civic organization. Those unhappy implications are why advocates of equity are so determined to hide what the term really means.

Americans have demanded that all levels of government stop giving special treatment to the rich and powerful. That is simply a demand for equality. Likewise, they recognize that equal treatment should begin early, such as with adequate funding for K-12 students.

Since the New Deal, most Americans have supported some form of social safety net for the poor and disadvantaged. But this safety net doesn’t demand that out-of-work coal miners receive the same income as those who are working. The debate has always been about how extensive the safety net should be and how long it should last for each recipient. There is broad agreement that no worker should be laid off because of his race, gender or religion. Again, that is a demand for equal treatment.

What we are seeing now is different. It is the claim that the unfair treatment of previous generations or perhaps a disadvantaged childhood entitles one to special consideration today as an adult or young adult. Most Americans, who are both generous and pragmatic, have been willing to extend some of these benefits, at the margins and for limited periods. They don’t want to turn these concessions into large, permanent entitlement programs, giving substantially different treatment to different groups, even if those groups have suffered historical wrongs.

One measure of how unpopular these unequal programs are is how often their proponents need to rename them. “Quotas” were restyled as “affirmative action.” The goal was still to give special benefits to some groups to achieve desired outcomes. Now “affirmative action” has also become toxic, rejected most recently by voters in deep-blue California. Hence, the new name, “equity.”

Instead of making their case openly and honestly, advocates of equity twist and turn to avoid revealing their radical goal of re-engineering society through coercion. If the results fall short, as they inevitably would, the remedy is obvious: more money, more rules and more indoctrination. Why not tell us who will receive these special benefits and for how long? At whose expense? Who will administer these programs? Who will judge whether the outcomes are fair enough? When will it all end?

Since the ultimate goal is achieving equal outcomes, these evasions raise the hardest question of all. Isn’t equity just a new brand name for the oldest program of achieving equal outcomes? Its name is socialism.

Mr. Lipson is a professor emeritus of political science at the University of Chicago, where he founded the Program on International Politics, Economics, and Security.