By now everyone should be aware of the drama in the US surrounding Silicon Valley Bank (SVB), Signature Bank, and many other unnamed banks that a “senior Treasury official” said might have similar issues.
Essentially these banks attracted a lot of deposits by offering favourable conditions and then used the cash to buy long-dated government bonds, making a silly, unhedged bet that rates would stay low and they could profit on the interest differential. Bonds are, after all, super safe – the Basel regulatory framework assigns them a zero risk weighting – and held to maturity, they are redeemable at full value (assuming the government doesn’t default).
But because enough people came asking for their deposits well before those bonds were due to mature, SVB was stuck between a rock and a hard place: its bonds were trading at a significant discount (bond prices move inversely to yields), so even if it flogged all of them, it wouldn’t come close to covering its customers' deposits – it was insolvent.
Enter the US government, which decided to guarantee all deposits above the $250,000 that it already insured; and not just for SVB and Signature, but for all US banks. While it’s true that doing so comes at “no cost to the taxpayer” in a literal, short-term sense (the guarantee will be paid by charging all other banks higher fees, i.e. a tax), it opens the sector up to long-term costs in the form of moral hazard and additional regulation (with potential side effects including a reduction in competition/innovation, increased financial sector concentration, or a rise in dodgy non-bank lending (shadow banking)).
Guaranteeing all deposits is also a secret bailout for the owners and managers of other banks that took similar risks but haven’t yet failed, and now probably won’t (in the near term) – rather than forcing those banks to face the music, many depositors will sit tight knowing their money is safe. Those banks will continue taking risks with deposits, which will either save them or eventually cause them to fail with even greater losses that the taxpayer will have to eat.
That problem is what’s known as moral hazard (privatised gains; socialised losses – in this case, the incentive to take risks with deposits without facing the consequences), and the US government has just opened its financial sector up to a whole lot more of it in the future. Sure, many owners and managers of banks that eventually fail will be punished. But not always, and not before paying themselves fat bonuses for many years, all while attracting deposits away from more responsible banks that don’t take large risks.
In bailing out the banks, President Biden wanted to “stabilise everything”. But as Nassim Taleb would say:
“Seeking to restrict variability seems to be good policy (who does not prefer stability to chaos?), so it is with very good intentions that policymakers unwittingly increase the risk of major blowups.”
There’s always a trade-off: the short-term stability Biden just bought will come at the cost of long-term instability.