SVB: We saved the banks – was it worth it?

When your living room is on fire is not the time to worry whether foam from the extinguisher might damage the carpets. You just need to make sure the whole house doesn’t burn down.

There will be plenty of time in the weeks ahead to assess the moral hazard created by guaranteeing uninsured deposits of companies that parked all their cash at Silicon Valley Bank. We can also ponder the merits of extending funding at par against securities worth far less than that posted as collateral under the new Bank Term Funding Program (BTFP).

The US financial system was in a blaze over the weekend that almost spread out of control. So, let’s not rush to pick holes in the blanket the Fed, Treasury and FDIC threw over it, especially not while it is still smoldering.

But let’s take a close look at how a run on one medium-sized bank linked to the tech sector and a couple of minnows exposed to crypto suddenly threatened the entire US banking system.

It does not protect the soundness of the whole system if a few very large banks are closely supervised and regularly stress tested but smaller ones are not.

That was a key lesson of the global financial crisis. In aggregate, those small banks quickly become a systemic risk. In the UK, it was never going to stop at Northern Rock until chancellor Alasdair Darling went on the radio to announce the government was guaranteeing every last customer deposit.

Rapid growth should always be a warning signal for bank regulators.

Taking funding from a small group of similar companies, many of them burning through cash as part of their business plans and now struggling to raise any more from venture capitalists, presents a glaring funding risk on the liability side.

Taking those short-term and potentially flighty deposits and ploughing them into long-dated government and mortgage bond assets is a highly concentrated bet on interest rates going down.

So, one year ago, when rates started to go up instead, the most cursory stress test would surely have demanded speedy remedial action.

It’s all very well to argue that a higher liquidity coverage ratio might have seen Silicon Valley Bank pour even more into government bonds, but credible banks managing liquidity risk with high-quality liquid assets tend to hedge interest rate risk; they don’t outright bet on it.

So, the poverty of supervision here needs to be addressed, and quickly, or confidence in smaller banks will not be restored.

Even then questions will remain over the sustainability of the business model. Banks have got away with paying next to nothing for deposits at a time when one-year US Treasury bills have been yielding 5%. That makes no sense when duration risk of a mark to market loss in T-bills is minimal and the credit risk is so much better than any bank.

What incentives were used to trap deposits at a bank acting more like a poorly run hedge fund? It’s hard to believe this sprang from a fundamental failure to learn the most basic rules of risk diversification all CFOs and treasurers take on as summer interns.

What happens now to bank funding, as depositors seek to diversify? Does the short-term emergency response last and become business as usual?

Sharing the cost of universal deposit insurance will drive up banks’ non-interest costs and they will then pass that on to customers. Smaller banks may also now need to offer much higher rates to attract deposits and that will impair their net interest margins and reduce capital generation for new lending.

And that raises one more big question. Large private credit funds are now the lenders extending floating rate loans to US companies. The increase in capacity of these funds has been around $1 trillion in the last few years. That’s the equivalent of maybe five new European national champion size banks opening up in the US.

We have been told time and again that the non-bank financial sector is where the problems will break out, as the private credit business works economically only because those funds don’t have bank-like capital requirements.

But many of them do have closed committed liquidity pools to invest. And it turns out that the biggest risks were building inside the supposedly regulated system.

Let’s not pretend this was anything other than an ultimately state-backed bailout, even if banks posting sub-par collateral for one-year funding do remain on the hook for any eventual realised loss.

Between them, US taxpayers, through the $25 billion backing the BTFP, and every American with a bank account have just saved the US banks.

But if all they do is rip off depositors and originate mortgages ultimately sold through the government sponsored entities, and don’t do much lending to the real economy, are they worth saving?