Banking crisis of 2023 and monetary policy

• Published date: 01 June 2023
• Author: John McCormack
• Date: 01 June 2023
• DOI: http://doi.org/10.1111/jacf.12572

DOI: 10.1111/jacf.12572

MESSAGE FROM THE EDITOR

Banking crisis of 2023 and monetary policy

John McCormack

Correspondence

John McCormack

Email: johnlmccormack@gmail.com

Roughly a decade after the Global Financial Crisis of 2008, both senior bank executivesand bank regulators had regained confidence in their ability to manage individual banks and the banking

system.

Over the period 2009–2022, the Fed imposed not only more

extensive stress tests of bank capital adequacy but also new cli-

mate change stress test requirements for the largest banks, all with

the goal of containing systemic risks. The Fed’s 2022 stresssce-

nario for the next banking crisis involved a steep recession and

declining interest rates. By this time, internal bank risk manage-

ment and regulatory supervision seemed robust and sophisticated

to bank executives and regulators alike.

In the Roundtable discussion published in this issue, Paul

Kupiec, Senior Fellow at the American Enterprise Institute noted

that,

In June of 2017, then Fed Chair Janet Yellen said

that, thanks to enhanced Dodd Frank regulation,

she did not believe there would be a new financial

crisis in her lifetime. And on several recent occasions,

Fed Chair Powell and Vice Chair Barr echoed Sec-

retary Yellen’s assurance that the banking system is

sound and well capitalized.

This confident assessment proved premature, however.

By the middle of March 2023, massive bank runs by unin-

sured depositors caused the failure of the Silicon Valley Bank and

Signature Bank, while billions more in deposits fled several large

regional banks in the following weeks, ultimately causing First

Republic Bank to fail as well. Since these three banks had min-

imal insured deposit balances, the Fed and the FDIC guaranteed

all deposits at these three banks to prevent systemic bank failures.

By itself, this move cost the deposit insurance fund more than $22

billion, losses that had never been anticipated.

As participants in the Roundtable discussion agree, the main

culprit has been Silicon Valley Bank’s failure to manage what

turned out to be enormous interest rate and funding risks. For

nearly a year leading up to its failure, SVB did not even have a

Chief Risk Officer. Consideration of the possibility of interest rate

increases, and their likely effects on bank profits and depositors

did not seem to come into its management’s purview. The bank

had tripled in size over the prior 3 years, with that growth tak-

ing the form of large deposits by venture capitalists and tech firms

connected to those venture capitalists. And 95% of the deposits

turned out to be uninsured.

Had SVB followed the standard maturity matching principles

banks are expected to follow, they would have invested those

funds in highly liquid, very low-risk, and very short-term assets.

Instead, half of SVB’s assets were longer-term Treasury securi-

ties and agency mortgage-backed securities. This asset mismatch

proved disastrous in the rising interest rate environment of the last

quarter of 2022 and the first quarter of 2023. By the first week of

March, the mark-to-market losses on these securities were approxi-

mately equal to SVB’scapital. Far from being concealed by opaque

or inadequate reporting, SVB’s losses were disclosed in its annual

10K report and had been discussed publicly by (non-banker) ven-

ture capitalists such as Peter Thiel. The bank sold virtually all its

“available for sale” portfolio of securities on March 8 at a signifi-

cant loss. Failing to raise additional capital, it found its depositors

heading for the exits. SVB lost $42 billion in deposits on March 9

and another $100 billion in deposits the next day, at which point

regulators closed the bank.

While acknowledging the spectacular failures of bank manage-

ment, Paul Kupiec observes that “the truth is that these failures

are as much a consequence of a gross miscarriage of bank supervi-

sion. Bank supervisors failed in their duty to preemptively impose

prompt corrective action, remedial measures to correct the obvi-

ous safety and soundness issues that caused these banks to fail.”

He points out that federal banking regulators have ample pow-

ers under prompt corrective action rules and legislation to remedy

any serious bank safety and soundness issues they identify. Signif-

icantly, none of the three failed banks was listed as a “problem

bank” by their regulators and all were rated “well capitalized”

when they failed.

In the past, banks have tended to be reasonably well informed

about the financial condition of their correspondent banks; and as

a result, their willingness or unwillingness to loan funds to other

banks was a critical indication of problem banks. But, as Paul

Kupiec explains in our lead article, “Depositor Discipline and the

Banking Panic of 2023,” one of the unanticipated consequences of

the Fed’s actions in 2008 was the reduction in the ability and role

of the inter-bank federal funds market in imposing risk discipline

2© 2023 Cantillon & Mann.J. Appl. Corp. Finance. 2023;35:2–3.wileyonlinelibrary.com/journal/jacf