Podcast episode

SVB & Credit Suisse | Bank runs & Moral hazard – Bonus episode

Silicon Valley Bank (SVB) has collapsed and now Credit Suisse is in trouble. Should we be worried about Global Financial Crisis 2.0? Have the policy responses been sensible? Economics Explored host Gene Tunny provides his initial thoughts.

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Links relevant to the conversation

Chris Joye’s article on SVB:

NPR Indicator episode:

Sebastian Merkel’s paper on narrow banking:

World Bank paper on Bank Runs and Moral Hazard:

Bloomberg article on policy response:

Breaking Points video SECRET Fed BAILOUT Pumps BILLIONS Into Banks

Transcript: SVB & Credit Suisse | Bank runs & Moral hazard – Bonus episode

N.B. This is a lightly edited version of a transcript originally created using the AI application It may not be 100 percent accurate, but should be pretty close. If you’d like to quote from it, please check the quoted segment in the recording.

Gene Tunny  00:06

Welcome to the Economics Explored podcast, a frank and fearless exploration of important economic issues. I’m your host Gene Tunny. I’m a professional economist and former Australian Treasury official. The aim of this show is to help you better understand the big economic issues affecting all our lives. We do this by considering the theory evidence and by hearing a wide range of views. I’m delighted that you can join me for this episode, please check out the show notes for relevant information. Now on to the show. Hello, welcome to this bonus episode of economics explored. The failure of Silicon Valley Bank happened after I recorded my last episode on central banks and banking and I didn’t get any time to add any reflections on that collapse in In my last episode. So I thought I’d better do that now. This bonus episode is even more timely given. It now appears Credit Suisse is in trouble. Because things are happening so fast, I’d better clarify that I’m recording this Thursday morning, Australian time on the 16th of March 2023. While I’m not panicking at this point, I do acknowledge that there’s an elevated level of risk in the US and global financial systems. So I’m not going to make any definitive predictions, I think it’s just too hard to tell what’s going to happen. Instead, I want to talk about the underlying economic issue an issue which has been challenging us for centuries. This is the mismatch in maturities between the assets and the liabilities of banks. So colloquially banks, they borrow short, they borrow money from depositors, for example, and those depositors may want to withdraw their money at short notice. And banks lend long, so borrow short lend long, they lend money to homebuyers, for example, to buy houses, and those home buyers repay the bank over many years. If you’ve seen the classic film from the 40s, It’s a Wonderful Life. You’ll recall how Jimmy Stewart’s character, George Bailey, he explains to his worried bank customers how their money was invested in the houses of their neighbours, it’s there, he just can’t get it right away. Banks don’t have the cash on hand to pay out all of their depositors, if all the depositors come in to withdraw their money at any one time. They’ve got some cash on hand, but not enough. This is the concept of fractional reserve banking that Darren Nelson and I discussed last episode. In normal times, there’s nothing wrong with this because most people are happy to leave their money in the bank. And deposits and withdrawals are predictable. It’s something that the bank can manage, they can manage the level of cash, they know what they need to be able to, to satisfy the customers at any one time. But when the financial health of the bank comes into question, a panic or a bank run can happen. And there can be this contagion, there can be a panic across the economy. And it’s not just that bank that there’s a run on there could be a run on all banks as people worry about the stability of the whole system. That’s why central banks and regulators are so concerned when banks get into trouble and and we’ve seen just how quickly they’ve responded to what happened with SPV. And now what’s happening with Credit Suisse. SBB got into trouble because there was concerned about the state of its balance sheet, it had a heavy investment in long term treasury bonds. And if these were not held to maturity, and they were sold in the current market, that would result in the bank losing money. And that’s because of what’s happened with interest rates. So because the interest rate and the price of a bond vary inversely as interest rates have increased, bond prices have fallen. The story is that words spread fast in the venture capitalist community in California that they should encourage all the startups they invested in to pull their money out of sVv. Fast. So once they saw the state of the balance sheet word got around quickly, there was a classic bank run, and SVB collapsed. Incidentally, the concentration of SBBs business in Silicon Valley was a contributing factor to its vulnerability. It’s a well connected community. So the panic spread fast. I’ll link to a great article by Chris joy of Coolibar capital, which explains in detail what happened and also to an excellent episode of NPR as the indicator podcast, which also explains the problems faced by SVB. In his article, I think it’s on Livewire markets, Chris joy, he’s shocked that SVB didn’t hedge against the interest rate risk faced on its holdings of long term bonds. He suggests that this would have been standard practice for banks, meaning SBBs financial risk management was was suspect. According to Chris SVB, had exploited a regulatory change that was made during the Trump administration. It’s a change that SBB had lobbied for several years ago. And it meant that the bank could engage in more risky behaviour, so check out Chris’s article for the full details of that. A note that bank runs have happened periodically throughout history. Fans of the BBC TV show Poldark set in the time of the Napoleonic wars will recall how the scheming George Will Ligon brought about a run on Pascal’s bank in Cornwall. And the show’s hero Ross Poldark had to step in as an investor to help save it by restoring public confidence by making people confident that it had plenty of money after after Ross had invested in it. does this all mean? We shouldn’t have fractional reserve banking? Should we move instead toward full reserve banking or so called narrow banking, whereby banks have to ensure they can access enough money to 100% back all deposits. Historically, this was recommended by eminent us economists, as part of the Chicago Plan in 1933, during the Great Depression. This was in the wake of the collapse of the US financial system earlier that year. To me, narrow banking would not make sense. So rather I can’t see how we could move to this system without being without it being massively disruptive and costly. To pause deposits are one source of funding for banks, they they help reduce the cost of capital and they mean banks can lend more money. This is good for private sector investment and economic growth. I found an intriguing working paper by a former Princeton Postdoctoral Fellow and now University of Exeter lecturer, Sebastian Merkle on the macro economic implications of narrow banking and I’ll link to it in the show notes. He’s developed a macro economic model, which predicts that real productive investment and economic growth would be lower in a case of narrow banking. That said his model predicts the near elimination of banking crises with under narrow banking and in his model, people are better off overall because of that. So, look, there is there are pros and cons of fractional reserve banking versus narrow banking. I’ve got the feeling that narrow banking would be just very difficult practically, and I’m not sure we’d be better off. That said, I think there’s an important debate to be had there, and I’ll try to come back to it in the future. The relevant question to me is whether we can get the right regulations in place to maintain public confidence in the banking system. Can we do this in a cost effective way which doesn’t lead to future problems or unintended consequences. various mechanisms exist to help guarantee confidence in banks and to prevent panics and bank runs. These include regulations regarding the amount of liquid assets that banks should hold the central bank’s lender of last resort function, and deposit insurance regarding the lender of last resort function, the US Federal Reserve has been lending money to the US banking system in the wake of the SVB and Signature Bank collapses I’ll link to a Bloomberg article with some of the details. And now we see Credit Suisse turning to the Swiss central bank for emergency support. I think most people expect Credit Suisse will be supported as it’s probably too big to fail. It’s been plagued by scandals, and it’s lost money in recent years, but I expect it will be saved. Indeed, I’ve just noticed the Financial Times has reported Swiss central bank offers Credit Suisse liquidity backstop after share plunge okay, just as we would expect. I should note here that the lender of last resort function is not meant to save every failing bank. Only those which are facing a temporary cash shortage and whose underlying balance sheets are okay. It’s meant to allow good banks to get ready access to cash so they won’t run out of money in the short term, which is something that could spark a panic and a run on banks across the economy. It’s designed to try and stop that panic as summarised by British bankers or Paul Tucker. Walter Badgett famous dictum is that, to avert panic, central banks should lend early and freely that is without limit to solvent firms against good collateral and at high rates. That is, it shouldn’t be a bailout of badly performing banks, and borrowing rates should be high enough that banks only seek this assistance in genuine emergencies. We need to be careful to avoid moral hazard a concept which is also relevant to deposit insurance which we’ll talk about in a moment. Regrettably, it looks like the US Fed hasn’t been operating strictly according to badgers dictum and its new financing facility for US banks appears concessional. There’s a great story from saga and jetty and crystal ball at breaking points on this, which I’ll link to in the show notes. So please check that out. Alas, the Federal Reserve is arguably contributing to moral hazard in the financial system and to future financial instability. Regarding deposit insurance, given what’s happened with SVB, the US Federal Government has now effectively guaranteed all bank deposits, it’s gone well beyond the defined level of insurance of $250,000. As John Humphries and I discussed on the Australian taxpayers Alliance, econ chat live stream the other night, this could create a big moral hazard. Depositors might not care too much, or they might not look closely enough at the banks that they’re putting their money in. And they might be solely attracted by what interest rate they they earn on those deposits. Banks might figure that their depositors won’t care much, and they’ll take more risks to try and earn higher rates of return. So they can pay their depositors more and they can earn more profits. This could be a recipe for future instability. If the US government is going to do this, it will need to charge higher premiums for deposit insurance to ensure the costs of the insurance are explicit and not burdensome for taxpayers. And banks that have riskier balance sheets should pay higher premiums for deposit insurance. We need to avoid or minimise any moral hazard that comes from deposit insurance. There’s a great 2018 World Bank working paper that I’ll link to in the show notes that’s relevant here. It’s titled bank runs and moral hazard. I’ll read a paragraph from it because I think this paragraph nicely summarises the relevant policy issues. It’s now well established in the empirical literature that overall deposit insurance may ensure depositor confidence and prevent bank runs. But it also comes with an unintended consequence of encouraging banks to take on excessive risk. The empirical evidence points out the importance of design features, and shows that poorly designed schemes can increase the likelihood that a country will experience a banking crisis. It is important for deposit insurance schemes to incorporate features to help internalise risk taking by banks, in addition to specific design features deposit insurance that is complemented by more stringent capital regulations and a system in which supervisors are empowered to take prompt corrective action tend to function more effectively in practice. I think that’s that’s a really good summary. In a future episode, we might have to have a closer look at this deposit insurance scheme in the states and what these latest developments mean for that and what it all means for the the incentives facing banks the potential moral hazard. Honestly, I’m concerned that The US government would bail out all the depositors in SVB. I’m not sure it made sense, particularly given that those depositors or many of them should have known better than to have left so much money sitting in one bank. We’re talking about highly successful companies, such as Canva. I was truly stunned by the revelation regarding just how much money some of these tech firms had in SVB. Citadel hedge fund founder billionaire Ken Gryphon argue that with the government fully bailing out depositors, US capitalism is breaking down before our eyes. As he was quoted by the Financial Times, he would have preferred no bailout. The FT went on to quote him as saying, it would have been a great lesson in moral hazard. losses to deposit depositors would have been immaterial, and it would have driven home the point that risk management is essential. Gryphon highlighted that it appears the relevant regulator, the California Department of Financial Protection and innovation was asleep at the wheel. Apparently there were warning signs that should have been picked up. The Shanter clear columnist in the Australian Financial Review has suggested that the regulator might have been too focused on promoting innovation and startups, rather than focused on what should have been its core mission of promoting financial stability. What lessons should we learn from all of this? Well, bank runs will unfortunately occur from time to time in a capitalist economy. We just hope they’re not when they’re not too frequent. That it seems that we haven’t found a way to prevent them from happening entirely. We get a lot of benefits from the capitalist system in terms of innovation and higher living standards. But there’s no doubt the system can be unstable from time to time. It may be that the US needs to impose tougher regulations tougher capital requirements on banks so that they have better balance sheets, and they’re much less susceptible to bank runs. That is they’ll need to be required to hold a higher amount of quality liquid assets which can be converted into cash quickly. One of the reasons for confidence in Australia’s banking system is apparently stricter bank regulations overseen by the Australian Prudential Regulation Authority APRA, which is currently headed by my old Treasury colleague, John Lonsdale. The financial review has reported that APRA had resisted lobbying by local banks to loosen capital requirements on banks. Given what’s happening in the US at the moment, Apple is looking pretty smart right now. It’s hard to know how to compare what we’re seeing today with the past. SVB is the second largest bank failure in US history. But I don’t think it’s the start of GFC 2.0. Or rather, I hope it’s not the start of that. The GFC the global financial crisis, financial crisis of 2008 that involved financial institutions, which were household names, and much closer to the centre of the financial system. Of course, if Credit Suisse ends up collapsing that the story could be much different. My general inclination is not to worry too much over the latest developments as many things turn out to be unimportant. In hindsight, that said, you never know. Okay, that’s how I see things at the moment. It’s still early days, so my thinking may change over coming weeks. I’ll provide any updates to my thinking in future episodes. What do you think about what’s happening with US banks? And now with Credit Suisse? How concerned are you? Please let me know by emailing me at contact at I’d love to hear from you. Thanks for listening.


Thanks to Obsidian Productions for mixing the episode and to the show’s sponsor, Gene’s consultancy business

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