By now you’re almost certainly aware that Silicon Valley Bank (SVB) and Signature Bank (SB), both relatively large, regional US depository institutions, have failed and been taken over by regulators. Apparently both banks had not properly hedged their books against the rather obvious risk that long-term interest rates might rise sharply in response to higher short-term rates and generally tighter liquidity conditions.

Why the banks didn’t hedge their books properly is as yet unclear, but the most obvious explanation is that their respective Treasury operations were being run for profit rather than mere liquidity provision. That is, rather than remaining passively unhedged, they made active, wilful decisions to accept exposure to higher rates in exchange for higher interest-rate margins between the rates paid on deposits and the interest earned on their investments.

Over the weekend, US Treasury Secretary Janet Yellen and Federal Reserve Chairman Jerome Powell jointly announced that not only the banks’ federally-insured deposits but all deposits, however large, would be guaranteed. In the official statement, they make explicit a “systemic risk exception” for their actions:

After receiving a recommendation from the boards of the FDIC and the Federal Reserve, and consulting with the President, Secretary Yellen approved actions enabling the FDIC to complete its resolution of Silicon Valley Bank, Santa Clara, California, in a manner that fully protects all depositors. Depositors will have access to all of their money starting Monday, March 13.  No losses associated with the resolution of Silicon Valley Bank will be borne by the taxpayer.

We are also announcing a similar systemic risk exception for Signature Bank, New York, New York, which was closed today by its state chartering authority. All depositors of this institution will be made whole.  As with the resolution of Silicon Valley Bank, no losses will be borne by the taxpayer.

These “systemic risk exceptions” might also reflect a degree of political cronyism. Numerous large, politically influential tech firms use these banks for their corporate liquidity operations, including their ability to cover regular expenses, including payroll. Moreover, a former senior US Treasury official, Mary Miller, sits on SVB’s board and on Signature’s board sits Barney Frank, former US congressman and head of the powerful Financial Services Committee, which oversees the federal bank regulatory apparatus.

Here is Mr Frank’s bio from the Signature Bank website (emphasis added):

Barney Frank has been a member of the Board since June 2015. Mr. Frank served as a U.S. Congressman representing the 4th District of Massachusetts from 1981-2013 and also was the Chairman of the House Financial Services Committee from 2007-2011. As Chair of the House Financial Services Committee, Mr. Frank was instrumental in crafting the short-term $550 billion rescue plan in response to the nation’s 2008-2009 financial crisis. Later, he cosponsored the Dodd-Frank Wall Street Reform and Consumer Protection Act, which was signed into law in July 2010.

Prior to serving in Congress, Mr. Frank spent eight years as a state Representative in Massachusetts and, earlier, served as Chief of Staff to Congressman Michael Harrington and Chief Assistant to Mayor Kevin White of Boston. Mr. Frank’s extensive experience as a Congressman, and particularly as Chair of the House Financial Services Committee, led the Board to conclude that he should be a member of the Board.

Within the Dodd-Frank Act referenced above are clauses forbidding banks from engaging in any trading activities that put depositors’ funds at risk. This is known as the so-called “Volcker Rule” after former Fed Chairman Paul Volcker. But it was Dodd and Frank who sponsored the legislation that made it into law.

Thus it appears that Frank’s bank broke his own law.

Pandora’s Moral Hazard Box

While it may be unlikely that Frank will accept any responsibility in this matter – he was merely a non-executive director after all – his role at Signature calls into question whether US banks are properly supervised and it also re-opens the Pandora’s Box of moral hazard in bank regulation.

Indeed, the “systemic risk exception” announced by Messrs Powell and Yellen is moral hazard made explicit.

The fact is, central banking, not only as practised today, but by its very nature, is subject to moral hazard. The power to provide emergency liquidity to banks can be seen as an encouragement to take excessive risks with depositor funds. Legendary UK economist William Bagehot, founder and editor of The Economist magazine, was highly critical of the Bank of England and disparaged of the Bank’s bad habit of encouraging bad lending, if only indirectly. Hence his eponymous dictum circumscribing the Bank’s emergency lending powers: “Lend freely, at penalty rates of interest, against good collateral.”

Today, I present you with Powell and Yellen’s updated version thereof: “Lend freely, at artificially low rates of interest, against any collateral whatsoever.”

To claim that the “systemic risk exception” being made for SVB and SB in no way invokes moral hazard doesn’t stand up to scrutiny. Yes, there might be no direct taxpayer assistance involved but referring to taxpayers, in this instance, is just a red herring.

Federal Deposit Insurance Corporation funds are to be utilised. Those are provided by member banks and thus, by extension, by their depositors. In the event of a bailout involving FDIC funds, therefore, it is ultimately the depositors of healthy, better-run banks that are used to make the depositors of unhealthy, poorly run banks whole. Hence whether the taxpayer is directly involved or not, that still qualifies rather clearly as moral hazard.

(As an aside, at time of writing, HSBC has announced that it is taking over SVB’s UK operations for the princely sum of £1. While small compared to the US business, SVB is known to be an important lender to the UK tech sector, including fintech firms, some of which also have US operations. Here, too, a statement has already been made, by the UK Treasury, that no UK taxpayer funds will be used in the acquisition, nor in ensuring that depositors’ funds are not placed at risk.)

The bailout of SVB and SB is really just the most recent yet perennial re-opening of Pandora’s Moral Hazard Box by bank regulators. It may not be on the scale of 2008-9, but the effects, if smaller, are likely to have similar effects over time.

Banks will continue to behave more recklessly than they otherwise would. The financial sector will continue to drain resources from the rest of the economy, depressing investment and productivity growth. Stagflationary economic conditions will become ever more endemic.

And the cancer at the heart of what some still call “capitalism” will continue to grow.

John Butler
Investment Director, Southbank Investment Research