Capitalism is Collectively Stupid- as the Failure of Silicon Valley Bank Shows
Why was there no private deposit insurance? Answer is collective action failure. Which highlights need for government action.
The schadenfreude is strong - and justified - watching the failure of Silicon Valley Bank as its wealthy depositors plead for a government bailout.
Here you had a bank that serviced crypto startups and every manner of libertarian-minded company that decry government socialism every other day of the week and tout the supposed greater intelligence of private entrepreneurs over lowly government bureaucrats.
The failure of SVB with its $209 billion in assets is larger than the value of all the banks that failed in 2009.
The question is why these brilliant private equity CEOs banking at Silicon Valley Bank didn’t demand private deposit insurance for their holdings?
The answer is that capitalism is and always has been collectively stupid - which is why we get continual crises without government intervention.
In this case, individuals and institutions systematically underestimate and underprice the dangers of crisis itself so they fail to act. And they especially fail to act collectively to provide the institutions to stop the crises that they are underestimating in the first place.
Deposit insurance is the embodiment of that.
First of all, deposit insurance is almost never needed since banks rarely fail, so people don’t generally demand it at the individual level, so institutions without prodding don’t provide it. But when a crisis comes, the lack of deposit insurance increases the depth of the crisis, since those individual depositors then panic, pull their money out of the bank and turn what was a dangerous situation into a fatal one, forcing the bank to close its doors — ie. what happened to Silicon Valley Bank (SVB).
The irony of course is that if deposit insurance is in place, it is almost never needed since its existence means depositors don’t panic so financial institutions are far more likely to weather any crisis. Silicon Valley Bank is actually not involved in risky investments itself, so while it was in some financial trouble because of locking itself into low-interest securities as interest rates rose radically this last year, it would have survived that temporary crisis if its depositors hadn’t collectively panicked - which in turn doomed the bank and the depositors collectively.
Deposit insurance is the collective protection against the effects of financial crisis that in turn also prevents the financial crisis itself.
So if this is so obvious and history shows its importance, why hadn’t the brilliant entrepreneurs put a private version in place at Silicon Valley Bank?
That is the conundrum of capitalism that the market continually fails to deliver products that would stop capitalists from slitting their own throats.
Notably, this crisis would likely not have happened in Massachusetts, another historic hotbed of high-tech innovation.
Why? Because it has a privately-financed system called the Deposit Insurance Fund that protects non-FDIC accounts:
DIF protects all Massachusetts-chartered savings bank deposits that aren’t protected by FDIC insurance, which is any amount deposited in excess of the FDIC’s $250,000 per account limit. According to DIF, “The combination of FDIC and DIF insurance provides customers of Massachusetts-chartered savings banks with full deposit insurance on all their deposit accounts. No depositor has ever lost a penny in a bank insured by both the FDIC and the DIF.”
With DIF, there’s no maximum insured amount per account – depositors’ funds theoretically enjoy unlimited protections.
A recent academic study examined the performance of banks protected by the Massachusetts-based DIF fund during the 2008-2009 financial crisis and found striking results:
We obtain the following three novel results. First, deposits of DIF member banks increase relative to non-DIF banks during the financial crisis….DIF member banks significantly increase lending during the financial crisis. The increase in lending is primarily driven by residential mortgage lending, and loans with longer maturities. This result indicates that the unlimited insurance coverage of private deposit insurance might provide banks with a more stable deposit funding during the crisis, which eventually leads to more long-term lending.
Here is the kicker, though. Despite this clear advantage of having deposit insurance for all deposits and clear lessons of this advantage from as recently as a decade ago, Silicon Valley Bank didn’t provide it.
It is telling that the only state with consistent insurance for accounts not protected by the FDIC is Massachussetts. And the only reason Massachusetts has it is because the state government passed legislation in 1932 to jumpstart its creation - notably before the FDIC was even created. The Massachusetts system is now completely private and managed by its member banks, but it’s notable that this collective system of mutual insurance came about only because of government action.
Whatever is done to revive, sell and/or liquidate Silicon Valley Bank, the lesson from its failure and the success of the Massachusetts DIF- where no depositor has ever lost a dime of their deposits since its creation eighty years ago - should be to create a national version of the Massachusetts system.
The failure of Silicon Valley Bank is probably not a domino leading to imminent collapse of the rest of the banking system, but it should serve as a warning of what could happen.
It doesn’t have to happen if the government pushes banks around the country to put in place a collective system of deposit insurance for accounts larger than currently insured by the FDIC.
And no, the market won’t fix the problem on its own. Banks outside Massachusetts have had eighty years to replicate some version of the system there and haven’t.
The lowly government bureaucrats in Massachusetts solved a problem back in 1932 that the Silicon Valley libertarians have yet to solve without government intervention.
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Nathan, in banking lingo, assets are debts, not capital. They are not a reserve from which to pay those debts all at once because they are lent out leveraged either in the form of loans, which may be very illiquid, or investments carrying some mix of credit, market, interest or basis risk. It was market risk that blew up MBS for the bonds that had mainly effective credit risk protection through subordination and other credit support structures.
Oops. ... likewise that an institution like SVB offering higher rates on fixed term deposits only does so because rates in the capital markets are even higher.
Ah, but the yields. In the world of this century Before, the only assets with lower perceived returns were investment in plant and equipment and R&D. VC, like Big Pharma, are exceptional only because they have a strategy of high risk seeking the one big payoff.
Besides, the geniuses whose job it is to make the operating decisions on specific investments are creatures of moral hazard playing with other people’s money and taking compensation from the upside only or even from mere volume. It’s all a game, in the game theoretic sense.
I speak as the former lawyer who was, variously, the principal advisor to WMB’s mortgage backed securities and treasury operations.