Recently, Silicon Valley Bank succumbed to what many are calling a bank run. Two days later, Signature Bank in New York was seized by the Federal Reserve and all its uninsured depositors were bailed out. First Republic followed a few days later, receiving a cash infusion from larger banks just to keep its doors open. Then, one of the largest banks in the world, Credit Suisse, essentially closed its doors after being swallowed on the cheap by UBS (who received, of course, government guarantees as a condition of the deal). There have also been rumors of other banks struggling to manage deposit outflows, and credit default swaps (a measure of default risk) on several other major banks (like, ironically, UBS and banking giant Deutsch Bank) are flashing warning signs. Is this the beginning of another banking crisis?
No, of course not. The banking system is fine. Also, I have a bridge I can sell you.
A Bit of History
For centuries, banks largely acted as warehouses for the storage of money (i.e., gold and silver), issuing notes of paper that individuals and businesses could exchange for goods and services in the economy. Banks were distinct from “money changers”, or what some might today call commercial or investment banks. Although these two types of institutions were distinct, the evolution of money (or substitutes for money) blurred the lines between the two. The entire banking system has suffered from a severe case of conflated definitions ever since.
Demand Deposits – vs – Time Deposits
Originally, goldsmiths (i.e., banks) were expected to hold 100% reserves of the gold or silver deposited into their vaults. These were called demand deposits because they were available “on demand.” If Joe Blow wanted his money, he could show up and get it at any time. The bank served as a safe place to hold money, and for this service, Joe Blow usually paid the goldsmith a small fee.
Quite distinctly, “money changers” or investment banks conducted business in a different manner. When individuals deposited funds with these institutions, they recognized that their deposit was essentially a loan. The institutions did not hold most of these deposits but instead lent the funds out for periods of time. An agreed-upon time frame was necessary so that the bank could lend the money out to productive businesses; businesses that could then earn a profit and pay back the loan with interest. A portion of this interest was kept by the bank (which was their primary source of revenue) and a portion was given to the depositors in the form of interest. These were known as time deposits, as they were only available after a period of time. Certificates of Deposit (or “CDs”) are a modern-day equivalent. The banks were still expected to match the duration risk of their assets and liabilities, but as long as they did so prudently, they had no risk of a “bank run”.
While these concepts of banking were commonplace for centuries (being relatively intuitive), they were by no means established law. And therein lies the problem.
An Unfortunate Development
During the 16th century, Spanish bankers in Seville discovered a legal way to increase their profits. They promised their clients they could receive their deposits on demand while lending out (at interest) those same deposits to others. In other words, they destroyed the conceptual distinction between demand deposits and time deposits. This allowed the banksters (ahem, excuse me, bankers) to legally embezzle their client’s money. All they had to do to maintain this charade was to ensure that they had enough deposits on hand at any given time to satisfy the withdrawal requests of their clients. Some banks might have kept 10% in reserves, others less or more depending on their expected needs. But the gig “worked” so long as clients didn’t realize their neighbors all had competing claims on the small amount of real money still in the bank.
Hence, the modern-day bank run is not a flaw in the system. It’s a feature! It is the inevitable consequence of the way banking has evolved over the past millennia. Contrary to the sentiment of many, Mr. Potter isn’t the only villain in It’s A Wonderful Life. George Bailey’s “ol’ savings and loan” did those people wrong, too!
But hold your “crapitalism sucks” memes – it wasn’t merely private bankers that were to blame in this situation. In fact, fractional reserve banking isn’t a feature of capitalism at all. And besides, everything they did was technically “legal” anyway. But the Sevillian bankers also had a very practical reason (besides outsized profits) for doing this. The Spanish government commonly raided bank vaults to fund wars or expeditions to the New World. By lending out their gold and silver reserves, bankers were able to avoid government raiding because they simply didn’t have any money available. In short, the threat of government theft encouraged private bankers to conduct what were assumed to be legal (although unethical) banking practices.
Fateful Court Cases
Western legal standards had not caught up to these increasingly innovative new banking practices in the 17th and 18th centuries. In fact, laws against embezzlement (which is the term used for, among other things, commodity warehouses that act like fractional reserve banks) were not well developed until the 20th century. Early in the 19th century, however, a few cases were brought before British courts that pushed these concepts forward. Arguing that bank deposits ought to be viewed as bailments, critics recognized the inherently fraudulent nature of pledging assets to multiple parties. Other types of commodity warehouses (for agricultural produce, for instance), after all, were not supposed to do the same sorts of things that fractional reserve banks did. Why should an individual’s money be treated any differently than, say, a farmer’s wheat?
Enter a judge by the name of William Grant, who concluded that both time deposits and demand deposits were actually loans to the bank, and therefore the bank was able to do with them as they pleased. A few years later, this was followed up with another judgment, by the same William Grant, that reinforced his original decision. From this point forward, fractional reserve banking was no longer a grey area – having established legal precedent in Western law.
And the rest, as they say, is misery (…sorry again, history!). The rest is history…
Legal Is Not Necessarily Right
Just because an activity is legal doesn’t make it right. This is true for the modern fractional reserve banking system, which is legal but remains an albatross around the global economy’s neck. What is most sinister about fractional reserve banking, though, is that its proponents not only defend it but insist that it’s good for the economy in general. They say that without it, the economy would not grow. They say entrepreneurs wouldn’t take risks, that production wouldn’t increase, and that everyone would still be living in the stone age without the magical powers of modern-day fractional reserve banking.
This article is not the place to address all the fallacies involved in the justifications for fractional reserve banking. The important thing to notice is what this means for diagnosing modern financial problems. Philosophically speaking, if fractional reserve banking is a priori assumed to be a blessing for economic growth, then a posteriori the economic problems we face are always the consequence of something else. This leads to very superficial and often useless economic analysis. Any time there is a banking crisis, the proximate cause must always be the ultimate cause. Put another way, the most immediately apparent problem is always the end of the investigation.
So, What Happened to SVB?
Silicon Valley Bank was the first of several banks in mid-March that succumbed to funding pressures. A fairly plain vanilla description is as follows, from CNN:
“While SVB’s problems can be traced back to its earlier investment decisions, the run on the bank was triggered Wednesday when the lender announced that it had sold a bunch of securities at a loss and would sell $2.25 billion in new shares to plug the hole in its finances.
That set off panic among customers, who withdrew their money in large numbers.
The bank’s stock plummeted 60% Thursday and dragged other bank shares down with it as investors began to fear a repeat of the global financial crisis a decade and a half ago.”
Nothing here is wrong, per se. It’s an accurate description of what happened. But that’s like asking someone “What happened?” when a sports team blew a massive lead late in the game and getting an answer like “Well, the other team outscored them”. Ok, thanks a lot, Sherlock. What we really want to know is why?
Notice a few things in the description above. First, the analysis mentions “earlier investment decisions” as one factor leading to SVB’s demise. This isn’t really fair. Most of SVB’s assets were in government securities (which is what the regulators tell them to do with reserves). But when the Fed decided to hike interest rates last year from 0% to almost 5%, many of those assets lost “market value”. That isn’t necessarily a problem for a bank as long as they don’t have to sell them. The second factor is described as an ill-advised sale of securities at a loss (as a consequence of the “Fed’s hiking spree”). Although SVB didn’t have to sell them, they did. They thought they could make up the realized loss in other ways. But it spooked investors before they had to chance to. Ok, bad decision. Third, this sale led to a “panic among investors” who “began to fear” a repeat of the Great Financial Crisis. All these causes, however, are proximate in nature. They are immediately apparent to anyone who can read press releases or vaguely understands balance sheets.
But what is the ultimate cause? We know the straws that broke the camel’s back, but why was the camel under so much weight to begin with? Was it poor leadership? Bad planning? The Fed? Fundamentally, it was none of the above. The reason all those factors were even relevant is that SVB simply did not possess all of its client’s deposits. Like all banks, it’s been swimming naked and just happened to be too close to shore when the tide went out.
A Feature, Not A Bug
Like SVB, the entire banking system is only partially funded. The accounting gimmicks banks use to match assets and liabilities work until they don’t. And the line between those two results is actually quite thin. For fractional reserve banks, this has always been the case and always will be. The system requires both perpetual consumer confidence and economic growth to avoid SVB-type scenarios. It’s like a two-year-old hopped up on sugar from Easter candy – as long as they keep eating they don’t know how tired they are. Slow down the sugar intake – or remove it altogether – and they crash rather quickly. Put even a little pressure on a frail fractional reserve banking system, and see how quickly cracks appear.
Currently, US Banks (and many more global banks) are sitting on massive bond losses from the rise in rates in 2022. While many banks won’t (unless forced to) sell these securities, and thus won’t succumb to an SBV-type scenario, these conditions are still going to have adverse effects on the system as a whole. Primarily, it is likely to make the demand for dollar funding even more acute, driving the value of the dollar even higher in the future (although, to be certain, not in a straight line).
If even a relatively small portion of clients panicked as those of SVB did, there would likely be many more bank failures across the industry. Even if the recent panic resides (and I wouldn’t be surprised if it did temporarily) there’s a good chance of more bank failures in the months ahead. Having said that, it’s extremely unlikely that the entire system fails (at least for now) because novel accounting gimmicks are plentiful and most large depositors have few other options with which to place their savings than traditional banks. While still problematic, it’s important to understand the inherent frailty of the global banking system as a whole in order to plan accordingly.
There are several implications of the above analysis. First, interest rates must necessarily continue a downward trajectory if the global [dollar] banking system is to avoid complete collapse. Those who say the world is moving away from the dollar are seeing changes in superficial transactions between sovereign nations. However, like an iceberg, they see the surface but miss the fact that governments and financial institutions all over the world still have hundreds of trillions of dollar-denominated debts on their books. That debt not only requires payments made in dollars, but the debt is also unsustainable at now higher interest rates. Foreigners need US interest rates to drop just as much as the US government does (for budgetary reasons). While I sympathize with analysts who think the dollar is imminently doomed (the world might be better off if it were), they often do not understand the size, scope, and importance of the current global banking system. As the global economy moves into recession, the scarcity of dollars among banks and other financial institutions is likely to get worse. As it does, the dollar will strengthen against all other currencies.
Secondly, it is true that most large depositors have few other alternatives for their savings than traditional banks. But one obvious alternative is gold. Gold has always been considered a store of value and for many centuries was the preferred form of money (at least until it was outlawed and replaced with fiat currencies by Western governments). Thus, gold is likely to continue to have healthy demand, especially during the oncoming crisis.
Another alternative is US Treasuries, which serve as a form of savings for large institutions all over the world, including foreign governments and banks. These institutions use treasuries as a way of storing dollars accumulated from massive trade surpluses with the United States. They also use them for financing (i.e., like fractional reserve banks) new investments through global shadow banking activities. When foreign governments and banks sell US treasuries, they are not “abandoning the dollar” as many mainstream financial talking heads believe, they are selling their “savings” to obtain dollars. They sell treasuries because they have to, not because they want to.
The bottom line is this: as the global economy increasingly looks to be heading for a recession, there is every reason to believe that perceived safe assets like the dollar, gold, and US treasuries will be in higher demand.
This analysis is not an approval of the existing system. In fact, the current system is detestable. But investment decisions need to be based on sound economic analysis of real-world conditions, regardless of the ethics of the underlying system. Our global banking system is inherently flawed, it is fundamentally unstable, and it will eventually be replaced. But in the meantime, investors need to be prepared for the recent decades-long trends of lower interest rates and increasing sovereign debt to continue.
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