Run on the Bank

In this episode:

• How Banks Work
• What Causes Banks to Fail
• How the Government is Responding 
• How Bank and Brokerage Accounts May Be Protected
• Dilemma for the Federal Reserve

Find out more and reach out to us on our blog.

Transcript

[00:00:00] Lisa James: Welcome to the Nest Egg Podcast. This is Lisa James, and I'm here with my partner Lori Zager. We're a team at Ingalls and Snyder, L L C, an independent registered investment advisor. Today we're diving into the ramifications of a run on the bank.

[00:00:25] Lori Zager: So I like to say that there's nothing certain in life other than death. And that we try to explain complex financial concepts. In layman's terms, today we're gonna talk about how banks work, what causes banks to fail, how the US government is responding, how banks and brokerage accounts can be protected, and the dilemma that this recent banking problem has caused for the Federal Reserve.

So basically the way that a bank works is it takes deposits from its customer. You know, for people that [00:01:00] want to, you know, put their money somewhere and keep it safe, keep it in cash, and they lend those funds out to someone that wants to use that money for things like buying a house or building a business and.

If the bank takes in more in the way of deposits than it makes in loans, it takes the rest of that money and makes investments in things like government bonds. 

[00:01:25] Lisa James: Right? So one thing to know right now is there are a lot more restrictions on what kinds of investments and bonds or securities that banks can make with the deposits that they.

Lend out, uh, to other customers. So in the past, banks had bought really risky securities. For those of you who remember the SNL crisis, the savings and loans went out and bought junk bonds that, that were very low credit, uh, quality, and they lost a ton of money on it. And it [00:02:00] costs SNLs to fail. Um, in, in the more recent financial crisis in 2008, Banks made a lot of riskier mortgage loans and lost money on that.

So regulations have been put into place to try and force banks into buying very safe securities. So right now that is primarily government bonds and government guaranteed mortgage backed securities. And these securities are expensive because they have very. Little credit risk, so they train at relatively low yields.

[00:02:39] Lori Zager: As you guys know, we blog all the time and we. Did a blog on this subject and used a picture from the New York Times, which, um, I think kind of explains things pretty easily. And it shows that the bank is getting two mil billion dollars in deposits from customers. And again, as we said, they have to pay something for those [00:03:00]deposits.

It then takes that money, a billion dollars, it puts in loans in this example, and a billion dollars it puts in bonds. Interest rates rise, which is what happened. And when interest rates rise, newer bonds pay out more so the older bonds are less attractive to buyers and become worth less. In the picture that we have on our website, the bonds that the bank owns that were worth a billion dollars are now only worth 500 million.

So now, instead of having the original 2 billion that the depositors put into the bank, they only have a billion. 500 million. So the depositors, some of them decide that they want their money back, and as they start to one, if enough of them asks for their money back, the bank's not gonna be able to fund all of that.

So the bank has got to do something in order to come up with the cash for the depositors that want that money. And when depositors see this, they. Create a [00:04:00] run on the bank, and that's essentially what happened with Silicon Valley Bank. Although some things that were unique to Silicon Valley Bank made the situation a lot worse.

[00:04:12] Lisa James: That's right. So if you look at Silicon Valley Bank, which is the bank that really started the whole level of concern about the security of deposits and the shape that US banks are in Silicon Valley Bank. A special situation. So they actually had a very concentrated depositor based because Silicon Valley Bank decided that they were gonna be the bank to the tech industry when the tech industry was booming.

So in 2020, uh, when technologies. Stocks were really going crazy, and there were a lot of IPOs and companies were raking in lots of money. They went to Silicon Valley Bank and deposited the money there, and Silicon Valley Bank [00:05:00] tripled in size very, very rapidly. And so, They didn't look like a traditional bank because first of all, they couldn't come close to lending out the money that people had deposited.

So they actually bought a very high percentage of government and mortgage backed bonds. And not only did they do that, the bonds that they were buying yielded a very low interest rate because interest rates were low at that time. 

[00:05:28] Lori Zager: So just like Lisa said that the government has regulated. What kind of bonds you could buy or the banks can buy.

They didn't regulate the duration. They didn't say you had to buy only short-term bonds. They just said you had to buy certain types of bonds. And because credit rates, credit quality, right? Certain credit quality, and because. Interest rates were so low, a lot of these banks trying to make some money on the bonds that they bought went out at longer timeframes.

And [00:06:00] when interest rates rise, the longer you have to wait to get your money, the more that affects the price of the bond that you currently own. 

[00:06:08] Lisa James: Now the interesting thing about banks and the way that banks account for the bonds that they own is that they have a. Of saying that their bonds are held for sale, which means they might sell it at any time.

You know, if depositors need money and those bonds that can be sold at any time are actually marked to market, which means as the price of the bond moves up and down, the bank has to show that price as the value of their holding. But banks also, Can classify their bonds as held to maturity. 

[00:06:46] Lori Zager: And there's an advantage to that in that as if interest rates go up and the price of the bond goes down, it doesn't look like they've lost any money because they're saying they're gonna hold it until the [00:07:00] thing comes due.

And so as a result, you know, if they have a thousand dollars bond at the end, Term, it'll be worth a thousand dollars. Even if the, even though if they had to sell it today, it might be worth far less than that. 

[00:07:14] Lisa James: It wasn't really a problem when interest rates were low and stable because Silicon Valley Bank paid very little for their deposits.

They made a little bit of money on the interest rate difference between their. Which might have been a quarter of a percent, and the bonds that they own, that maybe yielded a percent and a half. But things changed. And when inflation became a problem for the economy, the Federal Reserves started to raise short-term rates.

And not only did short-term rates go up, but longer term rates went up as well. 

[00:07:52] Lori Zager: And just to make a point, this is the fastest rise in interest rates. Ever. [00:08:00] So not only did they raise them, they raised them very, very quickly. 

[00:08:05] Lisa James: Yes. And there were multiple consequences to the, the increase in rates. Uh, one thing that was very important for Silicon Valley Bank is that technology stocks reacted very negatively to higher interest rates.

So all of their clients, Faced falling equity values and instead of issuing new stock at these low prices,

[00:08:31] Lori Zager: if they wanted to fund their business in some way, 

[00:08:33] Lisa James: yeah. All of these companies were not actually making a lot of money, so they needed to either raise money in the form of equity or they needed to take.

Deposits out of the bank to pay their employees and their other costs. 

[00:08:47] Lori Zager: They could have sold bonds too, but that would've cost them more money because interest rates were higher. 

[00:08:51] Lisa James: Right? So they had all these deposits at Silicon Valley Bank, so they started withdrawing them. So now Silicon Valley Bank, [00:09:00] instead of growing, which it did dramatically, During 2020 and 2021, as interest rates rose, the deposits started to shrink.

So where does Silicon Valley get the money to pay a depositor when they wanna take money out of the bank? Well, they have a certain amount of cash around just because they have to. That's how banks work. But as the depositors wanna take more and more money out, they then have to sell they're securities.

[00:09:31] Lori Zager: Because Lisa is the bond guru, I'm gonna talk about bonds and layman terms. Those of you that know me know that I have equities to the moon. But anyway, so basically what happened is, as the depositors wanted their money, The bank had to come up with cash, and they only had a certain amount of cash on hand, so they had to sell the bonds that they had invested in.

And because they had bought those bonds at very low [00:10:00] rates and interest rates had gone up. Those bonds were now worth less than what they paid for them. 

[00:10:05] Lisa James: And the biggest problem was that it became apparent to some of the venture capital firms that worked with all of the, the tech depositors at Silicon Valley Bank.

They realized that Silicon Valley was losing money when they sold their bonds. And that worried them in terms of whether they were actually going to have enough money to. Give all of the depositors their money back. And so they, that created a run on the bank. And actually it was also a social media run on the bank because everybody was tweeting and, you know, talking about all of this, uh, activity.

And it flashed around the market so quickly that in one day on Thursday, March 9th, customers withdrew 42 billion. And on Friday there was. 100 billion [00:11:00] on deck to be withdrawn from the bank. That's what you call a run on the bank. 

[00:11:05] Lori Zager: Well, on Friday, March 10th, the F D I C closed the bank, and on Monday they transferred all deposits to a full service bridge bank that's gonna be operated by the F D I C as it markets, uh, Silicon Valley Bank to potential buyers.

Many people asked, where are the regulators? Where were the regulators? Well, interestingly, Gregory Becker, who was c e o of Silicon Valley Bank until it failed, was quietly removed as a director of the Federal Reserve of San Francisco on March 10th. So he. Basically policing his own shop until the very end.

And now there's a bunch of different inquiries about whether or not people on that serve as members of the board or as management of a [00:12:00] bank should be. On the Federal Reserve, I think, uh, Bernie Sanders, I believe has introduced regulation to, uh, say that uh, someone who is on the, in the management of, uh, a bank should not also be.

Board of director of the Federal Reserve. There's just all kinds of stuff that just make me sick about this. Not only Gregory Becker that uh, people are up in arms about, but you know, really a lot of the bank regulation that happened was because of a bill called DOD Frank, and the frank part of that was a congressman by the name of Barney Frank.

He was a lawyer by training, or is a lawyer by training. His intentions, I think were all the best in terms of trying to make the banking system safe. And he was particularly concerned because he was interested in housing and creating housing for people that, [00:13:00] um, hadn't been able to afford it. Something that really bothers me is that Barney Frank was on the board of another.

That was taken over by the F D A C, the second bank in this crisis called Signature Bank. He was a director of Signature Bank. It has been speculated that he was asked to be a director of Signature Bank because Signature Bank was, uh, a smaller bank. But when the regulation was originally put into place, they talked about banks, I believe, of being of 60 billion in assets or above, had to adhere to more onerous types of regulation.

And Signature Bank was just bumping up against that threshold. And so they reached out to Barney Frank and asked him to come on board as a director and Barney Frank in. Lobbied. He didn't, not as an [00:14:00] official lobbyist, but he did suggest to other former colleagues and members of Congress that the regulation had gone too far and it was too onerous on some banks that really weren't that big.

I think Lisa, they changed the regulation from 60 billion to 250 billion. So only banks over 250 billion were called strategically. Important banks, sibs, you'll hear that term. And those banks then had to deal with more onerous regulations. But someone like Signature Bank did not, and Barney Frank was the director, o o of Signature Bank until it failed or was taken over by the F D I C.

It saddens me that that happened because I think, you know, his original intention was, was good. It is what it is. So it's not just Gregory Becker who, uh, was, uh, doing things that, uh, don't pass my [00:15:00] sniff test, so to speak, but I, I would put Barney Frank in there as well. So what did Treasury Secretary Janet Yellen do and response and, and why did she do it?

[00:15:10] Lisa James: Well, It became apparent that Silicon Valley Bank was about to fail. There were a lot of meetings over that weekend between the F D I C that ensures deposits. The Federal Reserve, which basically oversees the banking system, president Biden, and then Janet Yellen, who's the Secretary of the Treasury. They all got together and tried to figure out what the best course of action would be, and they decided to take a very big step, which was to protect all the depositors of Silicon Valley Bank.

The reason this is a big step is the F D I C. Amounts at Silicon Valley Bank [00:16:00] were only 7% of all of the deposits. So Silicon Valley Bank had these really big accounts with a lot of uninsured deposits. So why did they just 

[00:16:12] Lori Zager: normal, normal circumstances? The government, the F D I C would only ensure anybody that had 200 and.

Thousand dollars or less per account, per account or type of account. The government was a little bit worried there was gonna be a lot of pushback. And where was the money coming from? 

[00:16:28] Lisa James: Well, it is more than that. I mean, the, the rationale for going above the F D I C insurance amount is, uh, something called systemic risk.

So the issue with Silicon Valley Bank is if all of these companies. Couldn't get their deposits back. And actually if the bank had failed, they weren't gonna be able to pay their employees. They weren't gonna be able to pay, uh, their vendors or, you know, anybody else that they needed to help [00:17:00] run their business.

So it no longer was an issue of, well, will these people at Silicon Valley Bank get their depositors? It became an issue of all these people going on from the companies not being paid or potentially losing their jobs. So, uh, at that point it became, Big issue that the, you know, basically our government decided it was much more important to guarantee the deposits than to allow the bank to fail.

And this brings up a lot of questions in people's minds on the topic of moral hazard. And Lori will talk about that a little. 

[00:17:39] Lori Zager: Well, I was reminded of it, I'd forgotten about this. But basically, The theory is that if you ensure, uh, or make it very easy for people to take risks, that they'll take 'em, um, because they don't really have anything to lose.

So if you're gonna ensure a hundred percent of people's deposits, they can, banks will do whatever they want. Banks will do [00:18:00] whatever they want with it. They make the most money. And, um, so, but, but there is a problem when the banking system, uh, is potentially at risk.

[00:18:19] Lisa James: So is the banking system at risk?

[00:18:22] Lori Zager: Well, You know, I don't think I've been asked this a couple of times that this is an oh 8, 0 9 kind of situation. The government did act very quickly. Uh, 43% of US deposits are uninsured now, and the Federal Reserve has really been involved. Uh, they did close, as I said, uh, signature Bank of New York in addition to Silicon Valley Bank.

Uh, there's been worries about First Republic, which is another bank out here. And I think the problem with First Republic is that people are looking at their, um, [00:19:00] unrealized losses and looking at their uninsured deposits. And although they love the bank for the banking relationships, I understand that.

There's negative equity. The stock is really not worth anything when you look at all of their liabilities. Um, it's not one that, uh, we've sidestep that issue. 

[00:19:18] Lisa James: Because people became concerned about other regional banks, particularly running into some of the same problems that Silicon Valley Bank and Signature Bank ran into.

The Federal Reserve took another. In order to give confidence to the banking system, and they created a new bank term funding program called B T F P. And um, this program's actually pretty important because it means that the Fed will offer loans to banks, um, up to one year in. To banks, not just banks, but also savings associations and credit unions.

Um, [00:20:00] and they will allow them to pledge their government and mortgage backed securities to the Fed and get a hundred percent of the value of those securities as a loan. So the securities might be worth 80. But the Fed will let the bank pledge the security and give them a hundred cents on the dollar.

That gets rid of a lot of potential issues. In terms of these unrealized losses the banks might have on these securities, because now they don't have to sell them. They can just go to the Fed and say, here, I'm posting this as collateral. You give me a hundred per a hundred cents on the dollar. And it gives them time to work through their balance sheet issues.

[00:20:45] Lori Zager: And not every bank is considered to cause systemic risk in the system, and it's really done on a case by case basis. And that's what creates even more concern to some degree in some of these, uh, other [00:21:00] banks that are considered at risk because it's not clear whether or not, you know, this is a Bear Stearns or whether it's a Lehman.

You know, bear Stearns was ultimately taken over. Lehman Brothers ran, ran outta time. Ran outta time. So it's unclear what's gonna happen if another bank has a problem, and as we said, it's on a case by case basis. So what should you do? If you've got money in a bank? How can you protect yourself given that it's only 250,000?

Um, and we're really talking about individuals here when we, when we speak about this. 

[00:21:37] Lisa James: Right? And so obviously it's a quality problem that you have so much money that you put in banks where $250,000 bits of, of F D I C insurance aren't gonna do it for you. But, um, one of the things that's interesting about, uh, the F D I C insurance is it's.

Per person. It's basically per [00:22:00] type of account. So like if you have a joint account, an individual account, an ira, a Roth ira, a trust account, those accounts are all different types of accounts and all have separate F D I C insurance. And there's one very interesting, uh, type of account, which is called A P O D or payable on death bank account that has beneficiaries.

And if you have a P O D account, you can have up to four beneficiaries on that account. In between you and your four beneficiaries. The F D I C will pay five times the 250,000 deposit insurance, which makes it 1,000,002 50. And that's something a lot of people aren't aware of. Um, but it really helps if you're trying to make sure that all your deposits are, are protected by the F D I C.

And there are some other things that you [00:23:00] can do, like, you know, put your deposits in different. Or one thing we've suggested and is actually one of the reasons that banks are seeing outflows of deposits is right now you can make a lot more money in a money market mutual fund than you can in a bank deposit, uh, in a checking account or a savings account.

And so that's another alternative for your cash. 

[00:23:24] Lori Zager: You know, and, and you're actually seeing money come out of the smaller regional banks go into these strategically important banks. And that makes sense because they have had to, again, have a little bit. Uh, more onerous in terms of their regulations. We should mention that there is some place that you can go and look, um, to find out more about it.

It's, uh, it's fdic.gov/regulations/resources. And, um, you can get information about F D I C insurance, but let's go to brokerage accounts for, for a bit. [00:24:00] We at two X Wealth Group use Charles Schwab. So some of this, uh, we might refer specifically to Schwab, but, but in general, um, there is a. Agency that protects brokerage accounts.

It's called the Securities Investor Protection Corporation. If you own stocks or bonds in a brokerage account, those are segregated by the broker dealer, whether it be Schwab or anyone else. And unless the broker is fraudulent, or for some reason, those securities are missing, those are your. And even if the broker were to go out of business, you should have what you own again, unless there was some sort of fraud or missing.

Since the S sip C'S inception about 50 years ago, 99% of eligible investors got their investments back in brokerage firms cases that had handled. So why do you even need S I P C coverage? So [00:25:00] S I P C insurance is really used to make investors whole. If there's a shortfall, as I said, because the brokerage firm was involved in fraud or there were things that was, were missing any cash that is held.

For instance, at Schwab's bank is got F D I C insurance, just like. Would be held at another bank. And then there's something that Schwab has, and I don't know about other brokerage firms because I said we use Schwab and they have an excess S I P C insurance coverage for securities and cash. And you might want to check with your broker dealer to see if, if they also have excess S I P C. 

[00:25:38] Lisa James: What kind of dilemma does this cause for the Federal Reserve? So the Federal Reserve is, is responsible for a functioning banking system. So if there are problems within the banking system, the Fed, as they just did, tends to leap to the rescue so that people have confidence. [00:26:00] And the process of leaping to the rescue actually puts a little bit more money into the system to the extent.

A bank can take their securities that are worth 80 cents on the dollar and get a hundred cents and the dollar back from the Fed as a loan. That's essentially adding liquidity at a time when the, when the Fed is trying to remove liquidity from the financial system because they are basically allowing bonds that the Fed owns on its own balance sheet to mature and not.

Buy more, which means that that's essentially taking money out of the financial system and they're also raising rates in order to basically cut liquidity in the system. So it's sort of like demand. 

[00:26:49] Lori Zager: Yeah. You wanna create, you know, if, if, if a loan costs you a lot more, you may think twice about taking out that loan or buying that car or buying that house.

[00:26:59] Lisa James: So the [00:27:00] interesting thing that's happening now is, On the one hand, the Fed is providing some liquidity. On the other hand, they're taking some liquidity away. What's the upshot of this? Well, one of the things that people say is because of the trouble that we've had with banks, that banks are gonna be more conservative about lending.

And in fact, if banks are more conservative about lending. That slows the economy down too, almost as effectively or even more effectively than the Fed raising rates or, or, uh, allowing bonds to mature. So there are a lot of moving pieces here that are all sort of counterbalancing each other.

[00:27:37] Lori Zager: So the problem is that if the bank is forced to ch choose between his two children, it's gonna choose the.

Where the banking system fails, it's gonna fix that. And as we've argued in a number of blogs, they really can't fix inflation anyway. They can help try to make inflation calm down, but [00:28:00] we think that there are structural problems. Shortages of certain types of commodities, including energy, copper being a couple that, uh, we've, uh, particularly are concerned about.

And we think that there's also a shortage of people and that's we're seeing in the labor numbers and war is also quite inflationary. So, um, we think that, uh, Is gonna happen is you're gonna have the Fed saving this, the banking system bought inflation. If it was a problem before, it's more likely to to be a problem.

And also a recession, which we've talked about in a podcast, is, uh, also more likely. 

[00:28:43] Lisa James: Right. So, uh, this is why the market goes up, goes down, goes up, goes down, because a lot of people are really uncertain about, you know, what the future holds in the. Six to nine months, you know, will we, will we have a recession?[00:29:00]

Will, you know, the economy chug along? Cuz everybody's working cuz we don't have enough people. So everybody remains employed. We don't really know. 

[00:29:09] Lori Zager: Yeah. And if we are gonna have a recession, markets don't bottom, at least haven't in the past until you're in the recession. Yeah. When Lisa and I were preparing to do this, uh, podcast and we're looking at the blog that we had written, I noticed something that was a mistake, which will be corrected on our website.

It says that the F D I C. closed the bank on Friday, March 13th, 2023 after a run on the bank. Actually, that was March 10th. My mother died on March 13th, so I think it was just a Freudian slip, uh, that uh, I put the wrong date for when the f d I seeks. Was the bank. My mother was 91 years old. She had a good run and it coincided with a run on a bank.

But anyway, we're [00:30:00] here to help. And that's all for now.