With all the discussion about the recent failure of Silicon Valley Bank (SVB), Signature Bank, and FTX, it is easy to get confused about markets and where they are headed. In addition, we have foreign banks like Credit Suisse who have or have had similar problems. Then there are all the pundits on television who want to give advice and proclaim their knowledge of the FED, markets, banks, rates, and stocks. For most of us this is a flood of conflicting information that is difficult to sort out.
The easy answer from 100,000 feet is there are too many variables in the discussion to proclaim any overarching answers. You can only look at pieces, figure out how they are performing, and how their performance affects your accounts or investments. Trying to understand the current world financial mess is just beyond all of us, even if we own a supercomputer.
There are three certainties at this time, and you can “take them to the bank” as the phrase goes:
- The current financial mess was caused by Congress and the massive outpouring of money during and after the pandemic which triggered inflation, but also by the FED when they dropped all reserve requirements and declared the inflation “transitory.”
- The FED must continue to raise rates or inflation will continue to rise, silently robbing us of all our savings.
- The mess at SVB was caused in part by the FED when they dropped all reserve requirements, but also by the San Francisco FED when they did not act on known issues with SVB’s bond portfolio.
So, let us examine each of these since they are the core issues, and why the FED must raise rates.
The Current Financial Situation
When Congress approved the first stimulus payment at the beginning of the pandemic it was needed by many Americans and was therefore the right thing to do. It would have been preferable to pass those dollars out based on need, but that was not possible given the speed of the spread of the virus. However, all money passed out after the first stimulus was unnecessary and in the long term injurious to the economy and the nation. The second and third round of checks did nothing more than buy votes, discourage people from going back to work, drive up our national debt, and fuel the fires of inflation. And then the FED was and is left to try and clean up the mess, but unfortunately contributing to the mess at the same time.
During 2021 Chairman Powell was approaching the end of his term and wanted to be sure he was reappointed as the FED chairman. So, for all the year of 2021 he went along with the narrative that inflation was temporary (transitory became the word of the day) even though a first-year economics student would have known better. It appeared that his sole mission was to delay action on the inflation issue until after his reappointment. We always hope this is not the case with our politicians, but history tells us otherwise.
Not noticed by the public just because this would be a banking nuisance, was the dropping of all reserve requirements by the FED. After March 26, 2020, banks no longer had to set aside part of each deposit as a buffer against unusual amounts of withdrawals. This removal was to help bank earnings during the pandemic but should have been reinstated in 2022 or early 2023. To some reserve requirements might seem antiquated and now replaced by capital requirements, liquidity requirements, and stress tests. But the banking system lost a valuable set of guide rails. Reserve requirements were a brake, a slowing of the lending side of banking on each individual bank and were imposed before the bank had liquidity problems.
The inflation “transitory” lie was reinforced by Janet Yellen who had some credibility as a former FED chairman, but Yellen can or will only repeat what she is told to say. It is obvious watching her this past week talk about the SVB mess that she often contradicts herself and administration positions within hours of making statements. Like others of her generation still in Washington, she is well past her prime and needs to retire. She is now contributing to the confusion, not the solution. Any student with just one economics class under his or her belt could do better.
The FED Must Raise Rates to Control Inflation
The issue not discussed on television with any frequency or clarity is the “fractional reserve system” and how it affects the economy. But the multiplication factor of this fractional reserve system can have a big compounding effect in times of inflation. Quite simply fractional reserves limit the number of times a bank is allowed by regulation to re-lend money deposited in customers’ accounts. This is not illegal; it is how a bank makes money through lending deposits and the process has existed in the United States for more than a century.
Let’s assume a simple example with only a few customers and just a single bank in a time with a 10% reserve requirement.
Customer A deposits $1,000 in their account. By regulation, the bank must hold 10% of that deposit in cash so that it can meet the short-term needs of customers. But the other 90% can be loaned out by the bank to other customers to make money. From an academic perspective the way to calculate the total impact of just a $1,000 deposit is through the formula m=1/R where m becomes the money multiplier and R is the reserve requirement. In our example above, the money multiplier is 10 (1/.10), meaning that a $1,000 deposit can be loaned out enough times to create a total of $10,000 in circulation.
But what happens if there is no reserve requirement? The easy answer is that customer deposits can be recycled into more loans infinitely, expanding the money supply in unintended and unpredictable ways. Using the m=1/R formula above to examine this change. If the reserve requirement went to 1% then a $1,000 deposit could be multiplied in its reuse by 100, so that $1,000 deposit can become $100,000 in the real economy. Then at 1/0.1% it becomes $1 million. Obviously, we can continue this progression to a point of infinity where the reserve requirement is so small that it does not exist. In that world deposits can be reused infinitely with only the original deposit as “real money.”
But surely the FED would never end the requirement for reserves in the banks! That is exactly what happened on March 26, 2020, when the FED lowered the reserve requirements for banks to zero. This one move took the ill-advised spending in Washington and put it on steroids. It created an environment where not just the FED could add money to the economy, all banks everywhere could multiply the money in circulation infinitely. At that point, the pandemic created fear of deflation. The FED forecasted wrong, 100% wrong. Congress flooded the system with money and the FED allowed it to be multiplied infinitely.
But this change also weakened the banks so that when they had a problem, like SVB had recently, they had fewer resources to draw on in a crisis. It is not possible to know if the SVB problem could have been completely avoided with reserves. But we do know it would have been less of a problem because their lending power would have been restricted with each deposit. The new method of holding “reserves” seems to be to entice banks to hold their excess cash at the FED through interest incentives. But this assumes equal holdings, equal management skill, and equal asset/liability management skills. None of these are ever present. To make matters worse lowering the reserve requirement to zero is an expansive move at a time that the FED is trying to contract the money supply. They are fighting against themselves to solve the problems.
Now to the crux of the issue. With no reserve requirements and the system flooded with money, the FED is forced to raise rates and raise them dramatically. They must crush consumer demand for credit because the normal controls are gone. Each bank failure is now met with more bailouts, only compounding the problems with more money going in the system at a time it should come out. Bank reserves have many benefits and for some reason the FED seems to be on a path to overlook those factors other than macro analysis. There are other benefits outside of monetary policy.
- First, reserve requirements slow down lending and avoid excesses through normal daily operations.
- Second, the safety and soundness of banks has confidence benefits that resonate with the public just as a bank failure has panic written all over it.
- Third, the inability or willingness to maintain statutory reserves sends early warning signals to regulators and provides a reason to investigate when a bank cannot meet its required reserves.
The mess at SVB was caused in part by the FED
The failure of SVB this past week is partly to do with FED policy on relaxed reserves and their rapid rise in interest rates, but more so with just failing in their oversight duties. It had been obvious for years that SVB had poor to no oversight on their investment activities. They made the classic banking mistake of letting interest they paid for money exceed the interest they received for investing money. In the 1980’s this became obvious when S&L’s were making long-term fixed-rate loans and funding them with variable rate short-term deposits.
SVB did this same thing with securities. They were taking in deposits and then investing the money in long-term treasury securities. This looks safe on the surface because the treasury securities are backed by the federal government. But the short-term value of the bonds does fluctuate with interest rates, and as the FED continued to raise rates, they took their eye off the ball and did not see what it was doing to banks. SVB held large quantities of treasury bills that in the long-term were probably all right, but in the short-term were worth less than their purchase price.
The one thing that SVB and other smaller banks cannot do is be forced to sell those bonds at a loss to meet customer needs for cash. And that is just what happened. SVB was poorly managed and losing money. When word spread about problems with the bank customers suddenly started demanding their money in quantities that could only be met by selling bonds. And with many tech savvy customers, social media became the way to do a run on the bank. This is nothing more than a flash mob meeting at the mall to dance, but this time the dance was fatal.
Then the FED made an even worse error and bailed them out as a political favor. Many of the customers of SVB were climate darlings running companies with little hope of success. The customer list also included Governor Gavin Newsome. It has been reported that he stood to lose a significant amount of money if the FDIC did not act. The problems with SVB and their investment practices had been reported as far back as 2021, so the FED had plenty of time to correct the errors. Washington riding in to save SVB was as much of a political favor as a help to all depositors, and it was not sound banking practice.
Then the FED and the FDIC did an even dumber thing. Rather than let them fail as they should, they guaranteed all deposits in all banks nationwide. This essentially nationalizes the banking system so long as banks know they cannot fail. Bank management now has no incentive to run a safe and sound business. By protecting customers and not shareholders it will now be more difficult to create smaller banks by attracting investment capital.
And to compound the stupidity, the FED failed to do for SVB what it had already done for the Bank of Japan and take their treasury securities in exchange for cash until the crisis passed and the bank could be sold. This piece of mismanagement defies all logic. (See Yen Collapse)
All is not lost
Now that we have a split Congress the House of Representatives can investigate and hold the feet of the FED and Treasury to the fire for mismanagement.
- For sure Yellen and Powell need to be retired and fresh blood who believe in sound banking and accountability brought in to replace them.
- The decision on reserves needs to be revisited and reinstated at some level to dramatically pull money out of the system and help end inflation.
- The FED needs to shock the system much as Paul Volker did in the 1980’s by doing fewer, more dramatic interest rate hikes to completely kill demand for loans.
But do we have anyone left in Washington with this much courage is the key question?
This article was completed with the collaboration of freeman and a big thanks for fact checking.
Resources Used in This Article
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