Tag: bank failure

The Problem with Fractional Reserve Banking and an Interesting Irony

          Last week, I discussed the failure of Silicon Valley Bank and the harsh realities of the fractional reserve banking system.

          Since I wrote that piece last week, there have been more bank failures and bank rescue packages.

          Signature Bank followed Silicon Valley Bank.  Credit Suisse was propped up with a $54 billion loan from the central bank of Switzerland.  First Republic Bank is being bailed out by bigger banks.

          As I have been stating here for a VERY long time, when there is too much debt to be paid, it won’t be paid.  And, since banks have debt as assets, when debt goes unpaid, banks fail.

          In the case of Signature Bank, there is an interesting ancillary story.

          First, the facts around the Signature Bank failure.  While I am no longer a fan of the editorial content of “Forbes”, the magazine did report on the Signature Bank failure (Source:  https://www.forbes.com/sites/brianbushard/2023/03/13/what-happened-to-signature-bank-the-latest-bank-failure-marks-third-largest-in-history/?sh=b4456b890ff6):

Signature Bank, a New York-based regional bank that became a leader in cryptocurrency lending, shuttered suddenly on Sunday, marking the third-biggest bank failure in U.S. history just two days after the country’s second biggest failure, Silicon Valley Bank, rocked the stock market and reignited fears of “challenging and turbulent” economic times.

New York’s Department of Financial Services announced Sunday it had taken possession of the bank, which had more than $110 billion in assets and more than $88 billion in deposits as of the end of last year.

Signature Bank became the third regional bank to collapse in a matter of weeks, following the high-profile collapse of California-based crypto-friendly banks Silvergate Bank and Silicon Valley Bank, whose failure spooked investors wary of widespread financial vulnerability.

          Interestingly, one of the Signature Bank board members is former US Congressman and co-sponsor of the Dodd-Frank Act, Mr. Barney Frank.

          If you’re not familiar with the Dodd-Frank Act, it was passed in 2010 in response to the banking failures at the time of the Great Financial Crisis.  Dodd-Frank (among other things) created the Financial Stability Oversight Council.  According to the Dodd-Frank Act, the FSOC has three primary purposes (Source:  https://www.investopedia.com/terms/f/financial-stability-oversight-council.asp):

  1. “To identify risks to the financial stability of the United States that could arise from the material financial distress or failure, or ongoing activities, of large, interconnected bank holding companies or nonbank financial companies, or that could arise outside the financial services marketplace.
  2. To promote market discipline by eliminating expectations on the part of shareholders, creditors, and counterparties of such companies that the U.S. government will shield them from losses in the event of failure.
  3. To respond to emerging threats to the stability of the U.S. financial system.”

I find number 2 above especially interesting.  Reading it, one would logically conclude that bailouts would be a thing of the past.  But, as we all know, bailouts are once again being used to make depositors, even uninsured depositors, whole.  This from “CBS News” (Source:  https://www.cbsnews.com/news/silicon-valley-bank-signature-bank-collapse-joe-biden-cbs-news-explains/)

The startling collapse of Silicon Valley Bank and Signature Bank continued to ripple across the American economy even as the U.S. raced to stabilize the banking system.

In a bid to contain the risk of contagion, financial regulators announced Sunday that they will guarantee all deposits at the banks, while President Biden said Monday that “Americans can have confidence that the banking system is safe.”

          In the case of the Signature Bank failure, there is an interesting, ironic side story.  Seems that the co-sponsor of the Dodd-Frank Act, former congressman Barney Frank, is on the Board of Directors of Signature Bank.  This from “The Wall Street Journal” (Source: https://www.wsj.com/articles/barney-frank-signature-bank-failure-silicon-valley-bank-dodd-frank-congress-elizabeth-warren-d1588178?mod=djemalertNEWS):

Life is full of irony, but it’s hard to think of a richer one than Barney Frank sitting on the board of the failed Signature Bank. The former Congressman who was the scourge of Wall Street, the co-author of the Dodd-Frank Act that was supposed to keep the banking system safe, wasn’t able to prevent his bank from becoming one of the first casualties of the latest bank panic. 

It’s amusing to think of Mr. Frank cashing a check as a bank director, but then even left-wing former Congressmen have to make a living. And in Mr. Frank’s case, it has been a nice one, with cash compensation of $121,750 and stock awards of $180,182 in 2022 alone. He’s been on the board since 2015. Perhaps out of office and late in life, Mr. Frank developed a strange new respect for capitalism.

Mr. Frank once famously said he wanted to “roll the dice” to ramp up lending on Fannie Mae and Freddie Mac before they failed. Signature seems to have done the same as it dove into crypto during the Federal Reserve-fueled financial mania.

In recent interviews, Mr. Frank is blaming crypto for the bank’s demise in the wake of the Silicon Valley Bank (SVB) closure on Friday. He told Politico that Signature was in good shape as recently as Friday, but was then hit by “the nervousness and beyond nervousness from SVB and crypto.” He said the bank is the “unfortunate victim of the panic that really goes back to FTX,” the failed crypto exchange.

Mr. Frank seems to blame regulators for taking a needlessly hard line against Signature because of crypto. “I think that if we’d been allowed to open tomorrow, that we could’ve continued,” Mr. Frank told Bloomberg. “We have a solid loan book, we’re the biggest lender in New York City under the low-income housing tax credit.”

We sympathize with Mr. Frank because the Biden Administration really does want to purge the U.S. banking system of any dealings with crypto companies. It may be that the regulators decided to roll up Signature Bank because of its crypto association. It wouldn’t be the first time regulators saw an opening in a crisis to achieve a political goal by other means.

If Mr. Frank is right, he now knows how hundreds of thousands of other people in business feel when regulators panic for political reasons and look for businesses to shut or blame.

As for the failure of Dodd-Frank’s regulatory machinery to prevent the latest bank failures, Mr. Frank is taking no blame. He says the reforms made the system sturdier, and he also dismisses claims by Sen. Elizabeth Warren that some modest Trump-era changes in bank rules for mid-sized banks made a difference.

“I don’t think that had any effect,” Mr. Frank told Bloomberg. “I don’t think there was any laxity on the part of regulators in regulating the banks in that category, from $50 billion to $250 billion.” He ought to know from where he sat on the Signature board.

Mr. Frank is getting a painful education in the difficulty of running a company when politicians don’t like the business you’re in.

          The reality is, as I noted last week, that under the fractional reserve banking system, even banks that would be considered healthy by current standards can be taken out by a bank run by depositors.  This is a reality that was reiterated in a recent MSNBC interview by former FDIC Chair Sheila Bair.  (Source:  https://www.msn.com/en-us/money/companies/banking-system-on-the-verge-of-a-bear-stearns-moment-former-fdic-chair/ar-AA18LP2A)

Bair added that the “immediate problem” posed by the situation in the banking system is “if people start to panic and take deposits out of a perfectly healthy bank, they’re going to force that bank to close.”

“It’s the classic Jimmy Stewart problem,” she told host Neil Cavuto. “We deposit money into a bank, they lend it out, they invest it in securities, it’s not all sitting in a vault. If you try to get all the money out at once, you’re going to force the bank to unnecessarily fail.” 

According to Bair, actions taken by the government have created “mass confusion” that could cause efforts to support the banking system to backfire. Acknowledging there are some banks with problems, she also emphasized that only a small percentage of the overall banking system has issues. 

“[The government is] trying to imply that all uninsured are protected, which they don’t have legal authority to do, frankly, and this is putting pressure on community banks,” she said. “It’s really troubling.”

            If you or someone you know could benefit from our educational materials, please have them visit our website at www.RetirementLifestyleAdvocates.com.  Our webinars, podcasts, and newsletters can be found there.

“First Bank Failure of Many?”

As I discuss in my New Retirement Rules Class, ever since 1971, the US Dollar has been debt rather than an asset.

          On August 15, 1971, President Richard Nixon eliminated the link between the US Dollar and gold, making the US Dollar a fiat currency.

          Since that date, US Dollars have been loaned into existence.  The lower a bank’s reserve requirement and the more borrowing that occurs, the more US Dollars are created.  Of course, as longer-term readers of this weekly publication know, after the financial crisis, when interest rates were reduced to zero, lending did not accelerate.  It was at that point that the Federal Reserve began a ‘temporary’ program of quantitative easing or currency creation.

          Since that time, worldwide debt has increased from about $100 trillion to about $300 trillion.

          Since banks have debt as assets, I have been talking about the strong likelihood of banks failing as excessive debt goes unpaid.

          This pattern of bank failures as asset price bubbles caused by currency creation has existed for much of history.

          It happened during the financial crisis.

          Many of you probably remember Henry Paulsen, the Treasury Secretary at the time, getting on television and stating that unless he got $700 billion from congress immediately, the financial system as we knew it would fail.

          Congress complied and the banks got their bail out.

          From a historical perspective, a bailout is not normal or typical.  For most of history, when banks fail, there is a ‘bail-in.’  Banks are bailed out by the bank’s depositors, who lose some or all of the money they have in the bank.

          A bail-in was the solution for failed banks in 1933 when President Roosevelt declared a bank holiday, relieving banks of any responsibility to repay depositors.

          While it is too early to tell, the most recent bank failure involving Silicon Valley Bank will likely see many depositors lose their deposits.  Looks like at least a partial bail-in might be happening.

          In case you haven’t yet heard, Silicon Valley Bank, the 18th largest in the country, failed last week.  This from “Zero Hedge”. (Source:  https://www.zerohedge.com/markets/record-bank-run-drained-quarter-or-42-billion-svbs-deposits-hours-leaving-it-negative-1bn):

For those who slept through yesterday, here is what you missed and why the US banking system is suffering its worst crisis since 2020. Silicon Valley Bank, aka SIVB, the 18th largest bank in the US with $212 billion in assets of which $120 billion are securities (of which most or $57.7BN are Held to Maturity (HTM) Mortgage Backed Securities and another $10.5BN are CMO, while $26BN are Available for Sale, more on that later )…

… funded by over $173 billion in deposits (of which $151.5 billion are uninsured), has long been viewed as the bank at the heart of the US startup industry due to its singular focus on venture-capital firms. In many ways it echoes the issues we saw at Silvergate, which banked crypto firms almost exclusively.

The big question, of course, is what happened in the past 24 hours to not only snuff the bank’s proposed equity offering, but to push the bank into insolvency.

We got the answer just a few moments after that tweet, when the California Department of Financial Protection and Innovation reported that shortly after the Bank announced a loss of approximately $1.8 billion from a sale of investments and was conducting a capital raise (which we now know failed), and despite the bank being in sound financial condition prior to March 9, 2023, “investors and depositors reacted by initiating withdrawals of $42 billion in deposits from the Bank on March 9, 2023, causing a run on the Bank.“

As a result of this furious drain, as of the close of business on Thursday, March 9, “the bank had a negative cash balance of approximately $958 million.”

At this point, despite attempts from the Bank, with the assistance of regulators, “to transfer collateral from various sources, the Bank did not meet its cash letter with the Federal Reserve. The precipitous deposit withdrawal has caused the Bank to be incapable of paying its obligations as they come due, and the bank is now insolvent.”

Some context: as a reminder, SIVB had $173 billion in deposits as of Dec 31., which means that in just a few hours a historic bank run drained a quarter of the bank’s funding!

But not everyone got out in time obviously, there is a long line of depositors who are over the $250,000 FDIC insured limit (in fact only somewhere between 3 and 7% of total deposits are insured).

          The article goes on, listing MANY companies and organizations that had uninsured deposits in the bank.

          Here’s the reality of the fractionalized banking system.  Banks are required to maintain minimum reserves that are a percentage of deposits.  That minimum reserve requirement currently stands at 10%.

          As the article excerpt above points out, the run on Silicon Valley Bank had depositors demanding withdrawals of $42 billion on total approximate assets (as of December 31, 2022) of $173 billion.

          That’s a little more than 24% of deposits.

          This bank had a relatively high amount of liquidity given the minimum required level of reserves.  Yet, despite that relatively high level of liquidity, the bank run consumed all the liquidity and then some, making the bank insolvent.

          “Business Insider” tells of the predicament of a winery owner who is dealing with the bank failure.  (Source:  https://www.businessinsider.com/silicon-valley-bank-collapse-wine-industry-napa-valley-cade-surprise-2023-3?utm_campaign=tech-sf&utm_medium=social&utm_source=facebook):

Conover said CADE has a “large loan” and mortgage with SVB on four wineries and five vineyards. And as of Saturday, the company’s checking account “is locked up.”

“I’ve never been through this before,” Conover said. The only similar crisis he could recall was during the 2008 recession.

          Here is a business owner with debt outstanding to the bank with a checking account that is locked up and not accessible.

          While it will take some time to see how this is sorted out, for the time being, this business owner has a problem – outstanding loans requiring payments and a once liquid checking account that is now illiquid.

          There are a few lessons here.

          One, as noted at the beginning of this piece, if there is too much debt to be paid, it won’t be paid.  Since banks have debt as assets, when debt goes unpaid, banks become insolvent.

          Two, under the fractionalized banking system, because reserves are only a portion of deposits, nearly any bank that experiences a bank run of large enough magnitude can become insolvent.

          Three, it’s probably prudent to know the safety ratings of your bank, keep deposits under the $250,000 insurance threshold (if possible), and diversify holdings among multiple banks.

            If you or someone you know could benefit from our educational materials, please have them visit our website at www.RetirementLifestyleAdvocates.com.  Our webinars, podcasts, and newsletters can be found there.