There is always something to worry about with the economy. There was the recent Pandemic.   With its emergence, inflation topped the worry list. The last thing we needed was a potential banking system crisis. We should have learned that safety and confidence in the banking system that is necessary for a functioning economy requires constant vigilance. The Dodd-Frank legislation following the Great Recession of 2007-08 made some banking rules tougher. But with lobbying by the banking industry, it was weakened during the Trump administration.  

The real wealth of an economy is the quantity and quality of our natural resources, our physical capital, and our human resources. The latter includes human labor and stock of accumulated knowledge in medicine, science, and technology, our work ethic, and much more. But we don’t operate on a barter system. A smoothly functioning banking and financial system in which people have confidence is crucial for enabling production, distribution, and exchange of goods and services. The recent failure of the Silicon Valley Bank (SVB) and others that created a near crisis of confidence in the system reminds us of this — once again.

Our banking system is a fractional reserve system. Banks hold deposits, technically known as “demand deposits,” for their customers. They keep some cash on hand as customers withdraw money and spend it, sending it to other bank accounts. Banks keep a specified fraction of deposits as reserves. As money circulates through the banking system, banks are able to lend amounts exceeding their deposits.  

This is not as sinister as it may sound. Quite the contrary, the fractional reserve system is the primary mechanism by which the nation’s money supply is expanded to enable an expanding, growing economy. And it’s how banks make profits — through loans for homes, businesses, and interest on its reserves. A bank’s balance sheet is the reverse of business and individual balance sheets. To businesses and individuals, bank deposits are assets, and loans owed to banks are liabilities. To banks, loans that are owed to it are assets. Deposits owed to depositors are liabilities.

Safety of banks, and, as important, confidence in bank safety, is everything to a smoothly functioning system that makes money available to individuals and businesses to facilitate a growing economy. That’s where the Federal Reserve Bank (the Fed), and the Federal Deposit Insurance Corporation (FDIC) come in. The Fed plays a major role in the regulation of banks, in addition to its role of managing monetary policy that affects employment and prices. The FDIC insures deposits, up to $250,000 to assure depositors that they have access to their money even should their bank get into trouble.

So how do banks get into trouble? Under the fractional reserve system that enables expansion of the money supply, banks hold a required fraction of their deposits in reserve. Reserves (assets) are held in securities, mostly U.S. Treasures or mortgage-backed bonds. Only rarely will depositors demand withdrawals that make a bank unable to meet its depositors’ demands (liabilities). 

So what happened with the SVB?  Critics argue over whom or what is to blame. Was it the weakening of Dodd-Frank, the Fed’s fault, the regulators’ fault, or some combination of greed, hubris, and incompetence by the bank’s managers?  

The basic problem was that the value of SVB’s reserves fell enough that it was unable to meet a rush of depositors’ demands. How did the value of the reserves fall? It was a consequence of rising interest rates, the mathematical inverse relationship of the value of existing bonds to interest rates that every college sophomore studying economics and finance, savvy amateur investors, and surely professional bankers, like SVBs CEO Greg Becker — 2022 compensation $9.9 million — understand.

But aren’t U.S. government bonds safe and secure? Yes, if held to maturity the bond holder will get back face value of the bond. But if the bond is purchased during low interest rates, and rates then rise, the current value of that bond falls, resulting in a paper loss. The FDIC reports that, in total, America’s financial institutions have $620 billion in unrealized losses, technically known as mark-to-market losses.

So why sell them at a loss? The SVB was forced to tap into its reserves to meet depositor demands. Its customer base was disproportionately large start-up businesses with huge deposits above the $250,000 FDIC limit. The necessity of depositors withdrawing large amounts to pay employees and other bills, combined with rumors that the bank was in trouble, placed demands that forced the sale of long term bonds, turning paper losses into realized losses.

Was it the Fed’s fault because it raised interest rates? No, the Fed was charged with taming inflation, and its blunt tool is to raise interest rates. Anyone who could fog a mirror knew that the Fed would raise rates during this inflationary period.   

So why did the SVB invest in long term bonds instead of short term instruments that are less sensitive to interest rate changes? It’s the usual tradeoff between high risk-high-reward and low risk-lower profits. Better to have a two percent return on long term bonds than a lesser return on short term instruments, and no return on idle balances. 

Mr. Becker was earlier hailed as the “go-to man” of Silicon Valley for start-ups. That’s a great ego trip, as long as it’s all working. Is he guilty of some combination of hubris, and maybe even incompetence? Mr. Becker is among those that urged softening of Dodd-Frank for banks of SVB’s size.

Where were the regulators that should have seen the value of bank reserves fall? Under testimony, they claim that they warned the bank, but didn’t make it public for fear of igniting a dangerous run on the banking system, claiming that their warnings went unheeded.  That sounds reasonable, but should they have leaned harder on the bank to take heed?

Fortunately, the Fed, the FDIC, and the U.S. Treasury Department took steps to avoid more serious trouble, at least for now. But this avoidable fiasco reminds us that constant vigilance is essential. Some lessons need to be relearned — again and again.

— John Waelti’s column appears monthly in the Times. He can be reached at jjwaelti1@tds.net.