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Good morning. Markets took a deep breath yesterday, reversing a bit of the Silicon Valley Bank fallout without erasing it. Meanwhile, hot consumer price index numbers gave investors a chance to get back to basics: worrying about inflation.
The CPI report was not filled with good news. The widely expected fall in shelter inflation still hasn’t arrived. Ex-shelter core services inflation, the category keeping Jay Powell up at night, rose 0.5 per cent (6 per cent annualised) in February, despite recent softening in wage growth. Core goods deflation is looking wobbly too; prices there were about flat. These themes will sound familiar from January’s CPI, and that’s the point. More of the same means the Federal Reserve has to keep tightening (unless, of course, the financial system implodes). Email us: email@example.com and firstname.lastname@example.org.
Moral hazard revisited
Having spent the past few days being the guy who tells everyone to calm down, I’m switching sides. While it was a blessed relief to see many regional banks’ stocks rise yesterday, the gains eroded over the course of the day. Some of the banks that have been under the most acute pressure — Zions and Comerica stand out — got barely any relief at all. Shares in First Republic remain 65 per cent lower than a week ago. We are not out of the woods yet, despite an Federal Deposit Insurance Corporation guarantee for uninsured depositors of SVB and a Fed liquidity facility for other banks.
Meanwhile, Ken Griffin of Citadel thinks that the government’s actions are destroying American capitalism. From the Financial Times:
“The US is supposed to be a capitalist economy, and that’s breaking down before our eyes,” he said in an interview on Monday, a day after US regulators pledged to protect all depositors in SVB — even those with balances above the $250,000 federal insurance limit. “There’s been a loss of financial discipline with the government bailing out depositors in full.
“It would have been a great lesson in moral hazard” [to leave the uninsured depositors exposed to risk], he said. “Losses to depositors would have been immaterial, and it would have driven home the point that risk management is essential.”
There are three ideas in there. The first is that had the uninsured depositors been left unprotected, the damage would have been limited. The second is that without financial discipline imposed on banks by depositors, the system loses an important source of capitalist rigour. The third is that this loss is something new, something “happening before our eyes”. The first and last ideas are definitely wrong. The second idea might well be wrong, too.
The third idea is easy to dispense with. Uninsured depositors were protected in the financial crisis, and they were protected in the S&L crisis after the failure of Continental Illinois in 1984. If uninsured depositor bailouts break American capitalism, it has been broken since Mr Griffin was in high school.
The second idea is trickier. As a way to think it through, suppose the government announced universal and permanent deposit insurance tomorrow, paid for by levies on banks by the FDIC’s Deposit Insurance Fund, as small-deposit insurance is funded now. What would happen next?
The worry is that banks would, in effect, be financed by lenders who are not exposed to losses. Those lenders — fully insured depositors — would deploy capital wantonly, giving it to bankers who would lend it in stupid ways, adding risk to the system.
The banks would still face the discipline imposed by the asset side of the balance sheet, however. They would have to earn a sustainable spread. As we argued yesterday, the main source of discipline in any company comes from management’s fear and greed.
Suppose all of SVB’s depositors had been guaranteed. In that case, presumably, there would have been no run on the bank. The wildly incompetent management of SVB would have escaped market discipline! But they would still have the problem imposed by higher interest rates and their own cack-handed mismanagement of the balance sheet: rising deposit costs matched with low, fixed-asset yields, pushing margins towards zero. Indeed, in the world of universal deposit insurance, competition for risk-insensitive depositors might push funding costs up, making the margin problem worse.
Declining profits alone might have cost SVB’s managers their jobs and destroyed the value of their share options. Depositors might not have imposed discipline, but creditors and equity holders would have, eventually.
Another reason to doubt that universal deposit insurance would inject recklessness into the banking system: banks service their depositors in a lot of other ways besides just paying interest. Businesses don’t want nitwits handling their operating accounts, even when there is no risk of loss.
One might think the DIF levies on banks would rise dramatically because of the additional insurance coverage. Not necessarily. There would be fewer bank runs for the fund to cover, for one thing. And there might be much more capital in the banking system. Joseph Wang (aka the Fed Guy) noted to me that corporate treasurers tend to keep excess cash in Treasuries or money markets funds, because of the risk of bank failure. This cash might go to banks instead.
Finally, it is worth noting that there does not seem to be a big problem with insured retail depositors flocking to fly-by-night banks in search of higher interest rates. There is empirical evidence that uninsured depositors flee banks that run into trouble and insured depositors do not (see here and here for evidence from the S&L crisis). But remember the case of SVB, where supposedly hyper-sophisticated depositors failed to discipline the bank’s risk managers until very late in the day, at which point they disciplined it right out of business.
I’m not advocating for universal deposit insurance. Maybe it’s important to keep up the pretence that big deposits are at risk in America. But given that all deposits have been more or less implicitly backed by the US government for 40 years, I’m curious what, exactly, we’re worrying about.
Which brings us to Griffin’s third idea, that SVB’s uninsured depositors could have been cut off without substantial harm. The events of the last week show this claim to be obviously false. SVB was nearly solvent, and might have been able to pay all, or nearly all, of the uninsured depositors’ claims in a resolution. The banking system as a whole is robustly solvent, too. But all the same, the prospect of losses set off a dangerous panic. Here I agree with my colleague Martin Wolf, who wrote this in the FT yesterday:
[B]anks remain as vulnerable to runs as ever and, like it or not, uninsured depositors will not be wiped out in a failure. Confidence that deposits are safe is just too important, economically and politically.
For any self-respecting capitalist, it is infuriating to see the hollow libertarians of Silicon Valley howl for government protection and get it; maddening to listen as bankers, who have grown rich on implicit subsidies and the socialisation of losses, moan about regulation; infuriating that bank crises continue to require government intervention. But these are prices we pay for using the magic of maturity transformation, which turns demand deposits into long-term financing. Unless our banking system is completely restructured, we will continue to pay those prices. And we will probably continue to muddle along OK.
One good read
“No matter how much evidence exists that seers do not exist, suckers will pay for the existence of seers.”