Economic Commentary – How Fragile Are The Banks

How Fragile Are The Banks

The failure of Silicon Valley Bank and the simultaneous troubles afflicting First Republic Bank and now Credit Suisse can’t help but call into question the strength of our banking system. The speed with which this all happened means there are more rumors than truth floating around. While it will take some time to learn all the details, the key causes and risks are now known.

The question on everyone’s mind is, “will my bank be next, and should I withdraw my money now?” Answer: right now, and for the foreseeable future, the banking system is sound, and you do not need to withdraw all your money from your bank.

A Bank’s Key Role

Now, let’s get into the details. All banks are intermediaries; they take money from depositors, paying something for the depositors’ money. They may actually pay interest, but sometimes, it’s just offering services like access to ATMs, generating monthly statements, etc. Paying interest and/or providing these services is how they pay us for depositing our money with them. These are the key cost factors.

On the revenue side, the bank’s primary goal is to lend that money to borrowers, charging the borrower higher interest than it pays the depositor. This is the profit spread. Banks cannot lend 100% of the depositors’ money because depositors also write checks and make withdrawals, usually on a fairly predictable pattern.

Banks hold back a certain amount of deposits to ensure they can meet withdrawals. These are known as reserves, and the government regulates them. At any point in time, it is possible that too many depositors would want to withdraw their money and exhaust the reserves. If this happens, and the bank can’t honor a withdrawal request, word tends to spread fast, and a “run on the bank” begins. Every depositor tries to withdraw their money, which no bank can sustain. Even the most financially sound bank would have troubles.

The Federal Deposit Insurance Corporation (FDIC) is a U.S. government corporation that was created to examine and supervise banks and guarantee deposits up to a limit. The FDIC provides security to depositors that they don’t have to withdraw all their money – even if a bank is in trouble – because the federal guarantee is there; if we all believe our money is safe, the primary cause of a run on a bank is eliminated.

Thousands Of Bank Failures

The system has worked so well that most people do not know how many bank failures (as judged by the FDIC seizing the bank) have occurred. They are reported in the news but usually don’t get much attention. In fact, there have been 563 bank failures from 2001 through 2022 (chart below). That number jumps to 4,104 if we go back to the great depression, according to the FDIC.

These are so often non-events because the overwhelming number of depositors have less than the guaranteed maximum (currently $250K) in the bank, and none of them lost any money. The process is fairly seamless. Typically, the FDIC sieves the bank after normal hours one day and opens up the next day – right on time – with FDIC employees instead of the bank’s employees. Depositors come in, transact business as normal, and nobody worries. In most instances, the FDIC works in the background to arrange a merger or takeover by another bank.

Depositors with larger balances than the guaranteed maximum usually suffered losses of 10% to 20% of their balances. Even in these situations, total losses are avoided, and many companies consider this risk just a cost of doing business; it’s usually less expensive to bear this risk than to constantly have to move vast sums of money around to multiple banks in order to stay under the guaranteed maximum at each bank.

Why Banks Fail Today

As we’ve explained, any bank could fail if it suffered a run on the bank. But the FDIC has largely eliminated this as the cause of bank failures. Most bank failures – prompting an FDIC takeover – occur when the bank stops making a profit.

Banks have to earn a profit from the money they have. This is called the “net interest rate spread.” For instance, if a bank pays depositors 1.25% while issuing mortgages to borrowers at 4.75%, then the bank’s spread is 3.5%, minus any other costs of operating the bank. The spreads tend to be very small, and the spreads can be the smallest when interest rates are low.

If that spreads reverses, and the bank is paying more than it earns on its money, losses start accumulating, capital is decreased, and bank reserves can be jeopardized – once again, prompting the FDIC to step in.

The concepts here are really pretty simple. At the heart of the matter, it all boils down to management. As in any industry, there are good managers and poor managers. It bears repeating that there have been 563 failures in the last 22 years. Bad management, but it barely makes the news and rarely prompts panic.

Why Was Silicon Valley Bank So Unique

SVB was unique because of the customer base it chose and the decisions management made in a low-interest rate environment. These combined to form a perfect storm for SVB.

SVB was the fabled bank of Silicon Valley. The vast majority of its customers were technology companies. The bank was so well connected in this micro-environment that most venture capital firms told their technology companies to deposit venture capital or IPO money in SVB. So when a start-up received a venture capital investment or went public (usually multiple millions of dollars), the start-up deposited all that money in SVB.

The problem for SVB was that it couldn’t loan out all that money; it became swamped with deposits it couldn’t lend. The net interest rate spread was essentially negative. At some point, every dollar deposited cost the bank more than it could earn on that dollar. As one example, Roku had a $487 million balance with SVB.

To reverse this situation, SVB used the extra money to make bond investments; this is perfectly legal and was encouraged as a result of the 2010 Dodd-Frank legislation. SVB’s primary investment was long-term treasury bonds because they paid the highest interest rate. As long as interest rates remained stable, SVB was actually making a very attractive profit on its depositors’ money.

Interest Rates Killed SVB

When the Fed began raising interest rates to combat inflation, the speed of these increases caused two things to happen.

First, new funding for technology firms decreased significantly, prompting tech firms to withdraw money from SVB to meet payroll and other costs.

Second, the value of the long-term treasury bonds owned by SVB decreased significantly in value. If SVB had let the bonds mature, they would not have lost money on these investments. Bonds held to maturity would have been redeemed 100%.

Unfortunately, the number of withdrawals needed by tech firms was so large that SVB was forced to sell some of the long-term bonds at significant losses. What was only a paper loss (the temporary decrease in value of bonds) became real losses (the bank had to sell them at depressed prices). As reported in The Wall Street Journal, SVB had to sell $21 billion in underwater bonds, and it lost $1.8 billion on the sale.

When word of that loss hit the street, several major venture capital firms told the CEOs of their technology companies to move their money from SVB to other banks as quickly as they could. A run on the bank began.

Here’s the bottom line on SVB. Its customer base was so concentrated in one industry that was dependent on low-interest rates for funding, and bank management bought so many long-term bonds that when rates rose, everything was squeezed.

If SVB had diversified its customer base into other industries, and/or if SVB had diversified its revenue-generating assets better, it most likely would have survived.

Other Banks In The News

As SVB went under, people noticed that Silvergate Bank, Signature Bank, and Credit Suisse were also in trouble. This created the impression of some sort of systemic contagion in the banking system. That’s not true. The connection here is only unfortunate timing. These other banks failed or got into trouble in different ways; in that sense, they are no different than the 563 banks which failed in the last 21 years or the 4,104 which failed since 1934.

Let’s face it, technology and Silicon Valley are sexy media topics, and this story was perfect for prime time. But there is nothing about SVB, or the others, which threatened the overall banking system.

Long-term Affects And Investment Ramifications

One unique aspect of the SVB collapse does have profound consequences. Whether an act of panic or wisdom (the jury of respected economists is divided on this one), the FDIC decided to cover all deposits at SVB, not just up to the $250K maximum. Given the size of some of SVB’s depositors – remember Roku’s $487 million – this represents an astounding de facto increase in the guaranteed maximum.

As of this writing, for all intents and purposes, there is no maximum guarantee. It’s infinite. Whether you maintain $250K in a bank or $250 million, the FDIC is poised to cover 100% if your bank fails.

There are profound advantages and disadvantages to this. As Niall Ferguson and Moritz Schularick pointed out in a Wall Street Journal article based on their research paper, there will be more short-term confidence in the banking system along with more long-term danger in that system.

The FDIC 100% deposit coverage makes it safe to keep almost any balance in any bank that falls under the FDIC plan. But this 100% coverage removes one of the safeguards against bad bank management.

SVB took too much risk, and risk-taking sometimes ends badly, as SVB’s collapse shows. There is a cost to taking on too much risk. But if the FDIC removes that risk (which it does with 100% deposit coverage), there are fewer safeguards preventing bank management from taking more risk in the future to potentially earn more profits. If the risk pays off, they keep the profits; if the risk causes failure, all other U.S. bank depositors bear the cost, and in an extreme failure, arguably, U.S. taxpayers would pick up the tab. Management now has a greater incentive to take risks, creating a moral hazard.

For the immediate future, your cash in FDIC insured banks is safe. But 10, 15, 20 years from now? Is it possible that a bank failure and 100% coverage would be too big for even the U.S. government? It’s conceivable but not probable. As a nation, we still have time to solve this problem.

Cash Is Not King

There is an expression among stockbrokers, “cash is king,” meaning that when stock prices crash, and you have lots of cash on hand, you can buy great stocks at reduced prices. While there is some truth to this, you cannot take the concept to an extreme. The government’s recent actions have increased the probability that cash will lose value over the long term. Sitting on too much cash waiting for “the right opportunity” may actually hurt you.

This isn’t an argument for abandoning cash and buying gold or silver or anything like that. There are way too many stupid ads for those programs already. This is an argument for the wisdom of broad and detailed diversification.

Diversify Wisely

Broadly, it is prudent to diversify your net worth between some combination of 1) cash, 2) publicly traded stocks/bonds, 3) real estate, and 4) privately owned businesses. Within this context, it is also prudent to diversify between domestic and international options. While one or a couple of these could get hammered, the odds of all of them suffering at the same time is much smaller.

At the detail level, the stocks and bonds you hold need to be professionally diversified with goals clearly established and performance regularly measured.

Your financial future is determined by how you accumulate wealth over time and how you protect wealth. We wish there was a magic formula we could publish, but the truth is that each person has different goals and different tolerances for risk. The common thread for all investors has always been balancing accumulation and preservation.

Executive Summary

The failure of Silicon Valley Bank and the troubles facing others, including Credit Suisse, call into question the strength of our banking system. Many are asking if they should withdraw their funds in fear that their bank is next. Fortunately, SVB is truly a unique situation. While the banking system today is still safe, and deposits arguably more secure than anyone thought, there are long-term ramifications for how you should build and protect your wealth.

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