by eatOr last year, the Federal Reserve raised short-term interest rates at the fastest pace since the early 1980s in an effort to contain the highest inflation since the early 1980s. But in its zeal to tame inflation , the Fed is seemingly oblivious to all the ways in which sudden sharp changes in the economic tailwind can have unintended and potentially serious side effects.
This simple truth, which should have been obvious, became more apparent last week when one of the largest financial institutions in the United States suddenly collapsed. Silicon Valley Bank as of March 1 was valued at nearly $17 billion and had nearly $200 billion in customer deposits. Its clients were often venture capital firms and the companies they financed, making the bank a strong player in a profitable position. Then, almost without preamble or warning, these venture firms panicked when the bank announced it was selling some of its Treasury bonds at a loss and advised the firms it backed to pull their money. Within two days, $40 billion was blown, the stock plummeted, and federal and state regulators stepped in and took over. Two days later, regulators seized New York-based Signature Bank, which had more than $100 billion in deposits.
These two were the largest bank failures since the 2008-2009 financial crisis and the second and third largest bank failures in US history. And they happened almost overnight, with little build-up and little warning signs. Even the 2008 crisis, severe as it was, was heralded by abundant signs that something was amiss in the financial sector. These two bank runs, followed by a general panic among depositors and investors that all medium-sized banks were in serious trouble, looked more like a sudden car crash: everything seemed relatively smooth until it wasn’t. And the culprit in this case was the very institution whose mission it is to prevent bank failures and systemic collapse: the Federal Reserve.
The collapse of the two banks caused immediate panic in financial markets, with shares of nearly a dozen regional banks plunging on fears that customers would flee to the safer havens of big money center banks like JP Morgan Chase and Bank of America. Recognizing that bank failures and panics tend to grow rapidly and uncontrollably, the Treasury Department and the Fed moved quickly to guarantee that even when the banks themselves could fail and shareholders disappear, genuine depositors would have full access to the funds and they will not lose anything.
All this happened so quickly that it was difficult even for informed participants to follow the developments, let alone get a clear sense of what went wrong. There is and will be considerable (and rather arcane) debate about whether the Treasury bonds held by Silicon Valley were sufficient to meet their short-term capital needs during a multi-month period where many of the longer-dated bonds (above from 10 years) were losing value ahead of the Fed’s rate hike.
Read more: How the SVB collapse sparked a truth run
What is clear is that in the wake of the last major financial crisis, banks needed to hold more capital and reduce risk. Silicon Valley Bank did just that by holding on to what is considered a near-riskless asset, US Treasuries. The arcane part, though critical, is that there is a significant difference in holding 2-year bonds versus 30-year bonds when interest rates are rising rapidly. The longer a bond’s duration, the more its price falls when interest rates rise. Because Silicon Valley Bank had more of its holdings in these long-term bonds, it began to suffer paper losses as the value of these bonds declined. And because it wasn’t so big as to be classified as systemically risky like banks with more than $250 billion in assets, it didn’t face as stringent capital and regulatory requirements as, say, Chase. When it sold a tranche of those bonds at a loss to cover customer withdrawals, the entire VC industry in California and elsewhere freaked out, told its customers to pull their money, and voila, a bank.
It may be true that Silicon Valley and Signature’s management failed their risk controls. It is undeniably true that the assets they held, US Treasuries, were about as vanilla as it gets. In fact, the Federal Reserve and other bank regulators had pointed out since the 2008-2009 financial crisis that banks that held a significant reserve of US Treasuries should be viewed more favorably and better inoculated against potential problems. That’s exactly what Silicon Valley Bank did, and that’s exactly why it collapsed.
Which brings us to the real cause of what happened: a Fed that has been so focused on containing inflation that it has virtually ignored the dangers of its policy of raising interest rates faster than at any other time in history. He acted as if inflation were such a threat to financial stability that he lost sight of the fact that the fight against inflation can, if pursued too draconianly, be itself a threat to financial stability.
The Fed is a technocratic agency. It takes seriously its mandates of price stability and safeguarding the health of the financial system, and its mandarins have been extremely critical in times of crisis, especially in 2008-2009 and March 2020. But the flip side is a tendency to become detached from the real effects of their decisions, and the past year of aggressive rate hikes has gone from a legitimate (if debatable) response to higher-than-expected inflation to a zealous crusade to tame higher wages, a tight labor market and strong consumer spending with the belief that sometimes you have to hurt the economy to help it. Short term pain for long term gain.
This includes an apparent indifference to the secondary effects of fighting inflation. Fed officials spoke of a labor market that is too tight “to an unhealthy level.” In the abstract, a tight labor market can be negative for inflation since it leads employers to pay higher wages to attract scarce workers, but in the real world, a tight market means more people are employed and paid more. Treating this as a negative will likely anger a significant portion of the real people who make up the economy, and that in turn will ultimately undermine the credibility the Fed needs to do its job.
Even more worrying is the failure to respect the structural risks of raising interest rates so aggressively. Yes, the relentless inflation in places of the past, such as Weimar Germany in the 1920s and many countries in Latin America and Africa in the last decade of the 20th century, can be dangerous to social stability. But is 6% inflation for a year after a global pandemic a sufficient risk to push the financial system over the edge and punish banks for not adjusting quickly enough to sharply higher interest rates?
And the Fed cannot plead ignorance here. The balance sheets of Silicon Valley Bank and others were hardly secret, and any credible regulator could have noticed months ago that the composition of holdings in the face of rapidly rising interest rates was a potential problem. Nobody pointed this out, and while the management of many banks may indeed have been sloppy, careless, aggressive and even downright incompetent, none of that excuses the Fed, with its hundreds and hundreds of highly trained economists and a culture steeped in gaming out risk scenarios, from his negligence here.
It is not yet clear whether this particular own goal is a one-off or the start of a crisis. Either way, it was entirely avoidable and the result of reckless policy. The best the Fed can do now is to pause and reassess its current inflation-fighting path. Otherwise, it may succeed in taming inflation, but only at the cost of destroying an otherwise stable and healthy economy.
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