What's Happening with Silicon Valley Bank?

EconBuff #45 with Eric McKee

Dr. Eric McKee talks with me about the recent events at Silicon Valley Bank. Dr. McKee walks us through what happened and why it is important. We discuss why SVB failed and Dr. McKee argues that the banking system is top heavy, with a few major banks wielding disproportionate power. We explore how the Federal Deposit Insurance Corporation took over and attempted to sell off SVB to prevent it’s collapse. Dr. McKee addresses the differences between default risk and interest rate risk. Finally we explore the potential for moral hazard if the FDIC raises the limit on deposit insurance.

GeekWire Photo / Nate Bek

Transcript

Stitzel: Hello, and welcome to the EconBuff Podcast. I'm your host, Lee Stitzel. With me today is Dr. Eric McKee. Eric is a professor of Finance at West Texas A&M University. Eric, welcome.

McKee: Thank you. I'm happy to be back on again.

Stitzel: It is. it is good to have you back. Our topic today is the failure of Silicon Valley Bank. It's a one of the major bank failings in recent history. Can you just start us off by telling us what has happened with Silicon Valley Bank and why is it important?

McKee: Yeah. Well, I'll answer the last one first. So, this is the second largest bank failure in U.S history. The largest one was Washington Mutual back in 2008. And also, over the weekend another bank failed which was Signature Bank, and that was the third largest bank failure in the, again, in U.S history. So, these were pretty large failures in terms of historical context. I didn't adjust the numbers for inflation, but, you know, it's still pretty big. And what happened to Silicon Valley Bank is there was a bank run, just like what you might, what, you know, saw in It’s a Wonderful Life (1946), except it was mostly corporations [and] large deposit holders who are doing the bank run. And you could do it over the internet, instead of running out in and going in person.

Stitzel: So, what precipitated the bankruptcy? What caused these holders to want to pull their deposits?

McKee: Yeah. Well, for, I mean, for any bank on it --- it's generally a collapse in confidence. So, all the, or some of the depositors got nervous that the bank was going to fail. And they rushed to get their money out, and they created their own worry here. They --- it becomes a self-fulfilling prophecy. Everyone trying to earn. Even just a large number of people trying to pull it out. Yeah, the bank doesn't have enough cash available for all of its depositors. So, if you try to withdraw too much all at once --- boom the bank's in big trouble.

Stitzel: So, why is that for the listeners that might not…

McKee: Yes. Yeah.

Stitzel:…be familiar with that, why is it that not everybody can get their money out of a bank at once?

McKee: Well, you should just watch It's a Wonderful Life again. But it's because a commercial banks operations basically it borrows money from people who open checking account [and] savings accounts, and then it lends that money back out to other people at higher interest rates. So, the difference between the interest rate you get, if you get anything, and the interest that the borrowers are paying the bank is how the bank makes any money. Or most of most of how the bank makes money. What that means the cash isn't sitting in the bank's vault. It's in someone's house. It's in someone's car and so on. So, the bank has basically a lot of illiquid assets that are hard to convert into cash. And all of its credit or all of its depositors can demand that they immediately get cash right away. So, if everyone demanded cash, bank’s again, bank’s in trouble. They're going to have trouble finding enough cash to pay everyone.

Stitzel: So, in this case was there something specific, that you said it was mostly large depositors of people that were holding a lot. Are these other institutions or are they individuals or?

McKee: Yeah. There was a couple of things abouts SVB that created this problem. So, we have after the (right or during) Great Depression, we have the Federal Deposit Insurance Corporation. So, if you have a bank account and your amount is less than, right now it's $250,000, then you're fully insured. And the bank pays an insurance fee to the FDIC. And, you know, if the bank fails you'll, you won't lose any money. But for Silicon Valley Bank it was something more than 90% of their depositors had accounts that were larger than $250,000. Because just you can, kind of, guess just from the name Silicon Valley Bank they’re based around San Francisco. They have a lot of tech companies [and] startup companies that are in the Silicon Valley as their customers. And if you're a business, you know, sounds like a lot, but, you know, if you have to make payroll every week, I mean all your all your, kind of, working capital short-term expenses, [then] that adds up to be pretty large amount. So, a lot of these businesses are going to have to have more than $250,000 in their account just for their short-term pain to keep the lights on --- that kind of stuff in their accounts. So, that so most of their depositors were these kind of businesses that were not fully protected with the deposit insurance. So, that's why they were actually. That's why you wouldn’t be worried at all. Because if you have the insurance, you're not going to be too worried the bank run is going to happen, because even if the bank fails, FDIC will just give you the money anyways. But the protection is, at least for now maybe it’ll change after this event, is limited to just amounts underneath that cap.

Stitzel: Is it unusual for a bank to have mostly depositors that are over the $250,000.

McKee: From what I've read, yes. I'm not an expert in banking, but it seems like SVB was very not diversified, and who they were borrowing from, or (who they're) who is putting deposits in. And so, that made them more vulnerable to this problem. So, other banks that are more diversified in who has deposits for them should be kind of lower in terms of having less than 90% of their the depositors at any kind of risk.

Stitzel: From the perspective of a listener, a lot of times I think we think of banks as mostly serving, like, individuals and, you know, maybe people like you and me. And those are going to be relatively small needs. I don't know about you, but I'm covered by the FDIC Insurance. So, I'm not making any, I'm not making any bank runs until I don't believe in the FDIC deposit insurance anymore.

McKee: Yes. Yes.

Stitzel: But now you're saying it's unusual how undiversified they are, but that there are banks that kind of service these are.

McKee: Yeah. they sort of specialized with corporations, particularly corporations around San Francisco. I mean, not every bank’s going to do that. Certainly, if you look at, say, market prices, like the other kind of mid-sized regional banks that have kind of operations in a couple states but not every state like the big four, they, you know, their stock prices were, sort of, crashing because they're the ones who are potentially not as diversified and at risk of more bank failures. And the really big banks ---- Chase, Citigroup, Wells Fargo, and Bank of America their stock prices if you look at it there was nothing that happened. They just stayed pretty much what the overall market was doing because no one was concerned about their depositors.

Stitzel: So what made these large depositors with SVB think that they might need to pull their money out?

McKee: Yeah. Yeah. So, there's a couple things. So, first of all, the kind of the trigger from what I've from my understanding is that the CEO of the Silicon Valley Bank said some kind of dumb things. So, he said, and he said one that they had a big write-off for their loans. So, their loans drop in value. And we're probably going to talk about why that happened in a few minutes too. And then he also said: hey, we're hoping or trying to (forget the exact word he used) to raise cash by selling ownership [and] selling equity in our company. And I think the big mistake there was he said we're hoping. That means he hasn't actually found someone to give them more cash. And if he said: oh, yeah, we found someone who's gonna, you know, inject cash into us so we're gonna be fine, [then] that would have been O.K. But if you start saying we’re in trouble, and we don't really know if we have enough cash, then we are going to go ahead and get started getting nervous. So, I think those remarks were, kind of, one of the sort of things that triggered the collapse in confidence there. But oh. I'm sure.

Stitzel: So, if I’m a large depositor.

McKee: Yes.

Stitzel:  And I see.

McKee: Sorry. Yes.

Stitzel: Sorry, say that again.

McKee: Oh. I'm sure you're gonna ask me why they had to do a write down. So, I can talk about that too.

Stitzel: Yeah, can you talk about that a little bit?

McKee: Yes. Basically, what's been happening the last year has put a lot of pressure on probably every bank's portfolio, but it was especially bad, again, for Silicon Valley Bank for a couple reasons. So, one thing that we always teach our students in finance classes is that bonds --- and this is true for any kind of debt of an inverse relationship with interest rates. So, if interest rates go up, the price of a bond goes down. And that'll be true for any debt too. So, a bank loan that they made (isn't a bond), the value of that loan goes down too. And that's just because you have a fixed interest rate that you lent out, say, last year back when interest rates were zero, and now interest rates are 4.5%, because the Fed's been raising rates really rapidly. It's not nearly as good of a deal anymore. So, it's kind of bad for the bank and good for the person who locked in that low rate. So, if you try to sell those loans on the open market, maybe because all your depositors are trying to get cash from you, you’re not going to get a very good price for it. So, if you, I believe, Silicon Valley Bank they were --- they had basically had all their equity wiped out, almost all of it just based on the market prices of their loan portfolio dropping. Now you're thinking it wasn't because there was going to be a default. They appeared --- they apparently had a lot of invested in things like U.S treasuries [and] government-backed securities. So, things that are really safe in terms of default risk. But they manage their interest rate risk, the risk that interest rates go up, really poorly. And then, the other problem they had was that also interest rates went up. And most of their customers were things like startup companies and tech companies that have an easy time raising cash when interest rates are zero. And everyone's just throwing cash around because interest rates are zero you can borrow much easier. And now things have --- interest rates have gone up a lot and it's harder to borrow. And so, those tech companies can't easily just borrow more cash if they need it. And so, they start withdrawing their cash from the deposit anyways just naturally because the interest rate environment no longer lets them raise money so cheaply. So, they had pressure from their depositors needing to pull cash out, and their book declining value at the same time. So, that's why they had a big write down of their asset losses. The value of their loans went down in market value terms.

Stitzel: So, before the bank run there was already pressure from depositors trying to pull money out?

McKee: Yes.

Stitzel: And then, probably all banks, or virtually all banks are feeling this pressure that you're describing from raising rates?

McKee: Yes. I would expect so. And again, Silicon Valley Bank because how (because of how) undiversified they were in their depositors, I think they were uniquely, sort of, pressured there. But, yeah. I mean, this high interest rate environment --- the Federal Reserve is kind of running an experiment. They've raised interest rates really rapidly. They've also started reducing their balance sheet, and they’ve never really done that before. So, we're finding out that maybe it'll break some things in the banking system.

Stitzel: So, you're saying the combination of letting stuff roll off their balance sheet and also raising interest rates is unique?

McKee: Yes. As far as I know, the Federal Reserve has never done that. Now part of it is because the Federal Reserve didn't really buy assets before the financial crisis in 2008. So, there hasn't been much time for them to have done this sort of tightening thing. But it is something that's never happened before. Yeah.

Stitzel: So, right? Because before 2008, the Federal Reserve had, you know, very little on its balance sheet.

McKee: Yes. Yes. It very dramatically increased the balance sheet. And the quantitative…

Stitzel: Right.

McKee…the name is and technical term for it --- which is just them going on the open market and buying stuff ---- they didn't really do that before 2008 financial crisis. That was just something that was, like, theoretically maybe we could do this, but no, we're not gonna. We haven’t done this ever yet. And then the financial crisis happened, and banks (central banks) all over the world started doing that pretty universally.

Stitzel: So, why would it be, sort of, increased pressure to raise interest rates, which is something we've seen the FED do and manipulate the balance sheet the way that the FED has done? Why would those two things in combination increase pressure on banks?

McKee: Well, it's sort of reducing the supply of money, and if we're talking about the FED, which is probably more your expertise than mine, they're actually not just going out to people and saying: hey, raise interest rates. They are making open market transactions. The committee that sets interest rates is called the federal FOMC. And the OM is for open market. So, they tell the New York Fed: hey, go out and buy or sell U.S treasuries generally. And that will push the rates up rates interest rates up or down based on if they're buying or selling. So, you know, if we're also saying: hey, we're going to further contract things by just letting debt roll off our balance sheet and not reinvesting that cash, that's just putting further pressure in the same kind of direction as what they're doing when they tighten and when they raise it on the short-term rates.

Stitzel: So, frequent listeners to this podcast will have heard both Dr. Mattson (frequent guest) and myself say repeatedly, right: that the balance sheet operations are also part of why whatever it seems like the FED is doing with interest rates, is not nearly as much inflation fighting as it would as it would seem. And so, you know, that's consistent I think with what you just said.

McKee: Yeah, I mean, if you look at their Fed balance sheet, it's slightly come down just a little bit. But it's extremely high versus how it was even two years ago before the pandemic started. It went up a lot and after COVID happened.

Stitzel: So, now you've said a couple times that SVB, maybe managed its risk poorly and was, like, sort of, uniquely situated to get hit, because of the corporations that they were serving, their depositors, and sort of, the combination of the types of risks that they were facing. Do you think there are broader implications maybe for other banks that are saying: O.K., this is, kind of, a peculiar situation that we shouldn't expect, you know, systemic --- I don't seem to expect systemic because there is systemic --- risk, but that expects some kind of problem throughout the system?

McKee: Yeah. I mean, another bank failed --- Signature Bank. But it was also pretty similar in terms of the problems SVB had. I think it had even higher percentage of depositors that were, you know, not FDIC protected, and it was apparently pretty heavily involved in cryptocurrency, which has kind of means probably a lot of his clientele were also tech startups sort of depositors. It certainly could have caused big problems. The fact that we're not looking at, you know, a collapse by now that means it probably won't cause a collapse. You know, the FDIC has sort of figured out a way, right?

Stitzel: So, if those dominoes fall they kind of follow it, right?

McKee: Yeah. So, a lot of companies would have failed to make payroll if they couldn't get their cash back out. And that would have had some pretty bad effects. But it didn't actually happen. The regulators were able to figure out a way to get to get the cash back to the companies by Monday morning. So, things worked out O.K.

Stitzel: Let's talk about what the regulators did. So, there's this bank run. And this happens over the weekend. Do I have that right?

McKee: Yeah. I believe it happened late Friday. Around then is when the SVB, sort of, said: we're not letting anyone else withdraw. We're shutting, you know, we're shutting down. And the FDIC took over the company essentially. Yeah.

Stitzel: O.K. so let's talk about that part which regulators were involved and how at that point.

McKee: Well yeah. So, FDIC is always the one that, sort of, gets involved first once the bank actually fails. And their standard procedure --- because a few banks fail every year pretty much, usually not banks this large --- is to try and find another bank who will purchase the failed bank and assume all the deposits that bank had. And that's actually what happened with some of SVB's subsidiaries. So, over in the UK, HSBC one of the big British Banks they purchased SVB’s subsidiary for one pound. For the kind of the parents in the U.S., FDIC was not able to find a buyer. But they always try to find one --- selling, they put it up for auction and say: hey thanks, is anyone willing to buy this bank at a very low price of course and take over? So, that ended up not actually happening. But they tried. Like that's, sort of, the standard way you would try to try to solve this problem. And that's the ideal solution.

Stitzel: So, the FDIC wants to try to find a buyer to take over the failing bank?

McKee: Yes.

Stitzel: And so, how does that work? Is that is a market type situation where the FDIC is asking buyers to come in and they were refusing to do it? Or are they, like, kind of, have connections to potential buyers?

McKee: Kind of both. I mean so they put it up for auction. And I'm sure there's a lot of talk between the FDIC, who are now the owners of this bank, and potential buyers. Say hey, you know, how can we make this deal work? We don't want this bank to fail. And it will cause a lot of stress in the financial system if it fails and we just have to, like, pay out from our own funds. But I am not a member. I'm not --- I don't work at the FDIC. So, I don't know exactly how they try to talk with people in a situation like this. But they did put it up for auction I believe on --- sometime on during on --- Sunday is when they, like, basically try to hold an auction to sell it.

Stitzel: And nobody purchased it.

McKee: Yes. Yes. So, no one actually purchased it. And so, what ended up happening was that we used the --- it's not a deposit Insurance fund ---- so it was an additional fee from kind of legislation around the financial crisis area that banks paid into. And so, that was used as a way to, sort of, backstop the funds that the FDIC wasn't actually insuring.

Stitzel: So, is it unusual that nobody buys a bank that's failing.

McKee: I think it is pretty unusual. But this was kind of an unusual situation where the bank was really large. So again, it's really kind of a market transaction. So, if there's no bank that says: hey, we think this is a good deal for us, then, you know, no transactions might appear. You can't force, like, JPMorgan to buy this bank. Yeah, that's not how it kind of works, you know, free market system.

Stitzel: So, they open up the auctions and they say: all right, we're going to sell this bank, and the opening bid is a penny on a dollar. And nobody came through to buy that. I mean, that means the other potential buyers, the other financial institutions that are potentially interested in buying that, I mean, they just they literally wouldn't even meet the FDIC's, like, first opening offer.

McKee: Yeah. Apparently. Yes. Hmm mmm.

Stitzel: Yeah, so that seems extreme. You know, it's like if how bad a shape does it have to be in? So, is that related to something about the way that the other banks are assessing, you know, the financial state of the bank? Or is that because they're not confident that the bank run won't keep going even if they buy it? Or because, like, stopping the bleeding is the first thing you got to do?

McKee: Yeah, I mean. I don't ---- I'm not really sure. I'm not privy to their kind of internal things like that. I would ---- I'd assume it's more they just thought it was a bad deal because, again, I'm basing this off of market prices because I'm in finance, you know. The market prices for these --- the big four ---they didn't really do anything. Everyone seemed to think they were ---the markets seemed to think that those guys were perfectly safe. Maybe the market's wrong about that. But well, I certainly hope not.

Stitzel: And a week later we seemed to be O.K.

McKee: We've been up with another podcast about how you know about how Bank of America failed or something. I sure hope not. I mean it's, like, well this happened in 2008 too. Lehman Brothers --- the regulators tried to find a buyer and some other subsidiaries got purchased by people. But the main company ---- just no one wanted to buy it, so it failed and went bankrupt. Sometimes that just happens because there isn't someone who thinks it's a good deal.

Stitzel: Normally, when we see bank failure like this, and, you know, people think it's not sufficiently bad situation, they're not going to step in and buy up the bank. Systemic risk would be a concern. It doesn’t seem to have snowballed into that just yet, and yet you describe SVB as a big bank. How do we square all of those facts and observations?

McKee: Well, I mean it's big. But it's kind of dwarfed by the big four. So, those big --- those guys are like way bigger than the kind of mid-sized bank that SVB is. And I mean, I said it was second largest, because remember that's not inflation-adjusted. So, bank failures way in the past might have been kind of a bigger deal is kind of relative to the whole financial market, just because inflation-adjusted dollars are going to be very different from regular dollars. So, it's, you know, it's a big deal. But also, it's not, you know, it's not the biggest banks out there. And those banks are much larger than what a single regional bank kind of looks like.

Stitzel: So, on a recent episode we were talking about the number of banks. And so, in the American. So, but there's only two to four hundred banks. I forget the exact number that Dr. Mattson was quoting. But you're saying, not only is are there relatively few banks, but the system's really top heavy in terms of those big four…

McKee: Yes.

Stitzel:….banks?

McKee: Yes. Unlike Dr. Mattson, I can't, like, quote you exact numbers, but yes. The big four banks have a pretty large market share. In fact, one of the probably the biggest worries or potential consequences from this --- which probably won't happen because there's a, kind of, a larger deposit guarantee now ---- is that hey like maybe people will just yank their money from the regional banks and go to the larger banks that are, kind of, more diversified and safer for the depositors that are above the FDIC limit. And then, we would see even further bank consolidation and, kind of, larger market share for the big four, which is probably not what we want to see. Competition is generally a good thing. Certainly, I'm much happier with the customer service I got at the regional bank here in Amarillo than I did with one of the big four.

Stitzel: If I'm a depositor that didn't get my money out in time, because presumably people showed up to pull their deposits that were or at least as much as what would make their deposits go down to $250,000 that's going to be insured, and then the bank fails, and then the FDIC does not find a buyer, I just lost my money, right? I'm just caught holding the bag as it were.

McKee: At least, yeah, at least for the short term. And I believe that the deal that they managed to work out was ended up that you were able to withdraw all of your money as of, you know, Monday morning. But if it hadn't worked out, then yeah. You would have been kind of stuck. You probably won't get out up to $250,000 probably. But the rest of it is kind of things would have to would take a while for you to get anything unless you decided to sell it to someone else. I know there was a --- there was, like, at least one hedge fund going around saying: hey, we'll buy your deposit for, you know, $.60 cents on the dollar [or] $.80 cents on the dollar. So, some, you know, it was kind of a bad deal, but if you really desperately need the cash to make payroll or something, that might have been a potential solution if the regulators hadn’t found a way.

Stitzel: So, the hedge fund is literally gambling on some deal coming through allowing them to collect?

McKee: Sort of, that. And also, sort of, the bank wasn't really, like, going to go bankrupt. It was purely, kind of, a mark to market interest rate risk problem. A lot of their book was things like U.S. Treasuries which are not going to default. So, it eventually would pay off --- might take a while. But it wasn't like they were buying subprime mortgages or something which is much more likely to have defaults.

Stitzel: So, let's talk about mark to market and the role that it plays. Can you define what mark to market is first?

McKee: Yeah. So, mark to market is when the bank or other financial institution they say: hey, we're not going to record on our accounting statements the value of our debt at cost when we first lent it out. We're going to record it as what we think the current market price is. So, in the case here we've had interest rates go up the past years, so the market price of everything on every debt is going down. So, the price of stuff that they mark to market is smaller. And there was, kind of, a push after 2008 for banks to mark things mark to market more often, because it's, well, it's more accurate with the current value is that they needed to sell it. But it also isn't necessarily a problem. The problem here with the price wasn't that there was higher default risk than people originally thought. It was, oh interest rates are higher. It's interest rate risk, not default risk. They're two different risks. And if the banks have just held onto this debt until it matures, you know, the lower price right now doesn't really matter. They would still get what they were promised. And so, it would actually, kind of, match what their initial book value would have been. And banks are allowed to keep it at the book value, but only if they are certain that they're going to hold it until maturity. And, right, there are kind of regulation rules about this. And if they start selling, because maybe their depositors are demanding the cash, then suddenly they can't mark to market anymore. And from what I have read that this bank they tried to go to the Federal Reserve as the lender of last resort. So, you know, they're desperate here. They’re going to say: hey Fed, we'll want to borrow money from you. We'll put up our U.S Treasuries as collateral. And apparently, the Federal Reserve only accepted it at the market prices [and] not at the book price, which is kind of the problem that the bank has, which is our market price is lower even though over time it should be O.K. Yeah. So, that's mark to market. And what mark to market is how it's kind of affected SBV. That's why they had that big breakdown, because they had to mark to market a lot of their...

Stitzel: So, they were doing mark to market instead of the book value, and so that drove this down? That put them in the situation for their depositors to feel like they might need to pull out their deposits?

McKee: Yes. Yes. That required them to book pretty large losses on their, you know, quarterly financial statements.

Stitzel: So, what's your view of that policy and the way that that works? Because I assume the listeners are going to, kind of, pick up on the tension of those two things, right, where on one hand, you know, the current value of the assets that the bank is holding are lower. But as you said, if they're not selling them, then those losses aren't realized. And so, it doesn't, it sort of doesn't make sense. What's your take on that? And do you have any policy prescriptions because of that?

McKee: Yeah. So, actually I do have a policy prescription, but there is a tension here, right? So, there was kind of, again, there's kind of a push to have more mark to market. Because during the financial crisis some of the problems were not caused by interest rate risks. They were caused by default risk. And that, kind of, reduces how likely you are to ever receive money at all from that debt. So, it makes a lot of sense to use mark to market there, because that's, like, if there's a default, you know, you're not getting anything. But in this case, it wasn't default risk that was reducing the value. It was interest rate risk, which wouldn't cause a problem so long as the bank was able to hold on and just wait till the things mature. So, I don't really have a great, like, solution for the regulators. I'm, like, how much mark to market should you require. But one thing I would say is, you know, the Federal Reserve when it's acting as the lender of last resort, it probably should take book value, especially if it's not things that are high default risk. You know, if the bank has U.S Treasuries and it needs [funds], and it's going to the Federal Reserve as the lender of last resort because it's desperate, you should just take the book value. Don't insist on mark to market there because that's the problem for the bank, probably is because it's mark to market. And it's, you know, the Federal Reserve is going to be fine. It doesn't. It can just hold on to that debt until it matures, and it won't even lose money. Because again, there's no default. There's no real default risk issue there.

Stitzel: You've talked about default versus interest rate risk a couple times. Can you just kind of briefly sketch that out for the listeners?

McKee: Yeah. Yeah. So, in finance we, like, categorize. We consider we can, sort of, classify types of risks. For things like that, there's a couple different types of risks. Default risk is saying: hey, the person who borrowed money from you might not pay it back. That's obviously a problem if you want the money. And then, interest rate risk is based on if the current interest rate changes, and now if you tried to sell this debt to someone else, they would demand a lower price, because it's not a very good rate versus if they just loan out to someone else a new fresh loan. So, that's kind of the difference. So, if we're for interest rate risk, if I hold the debt and I don't sell it, it doesn't matter what the market price is. I'll still get what I am owed based on the loan contract. With default risk, well, if someone defaults, [then] I'm not going to get what I was promised.

Stitzel: So, the other thing that you mentioned is, you know, sort of, the FED declining to, sort of, lend to help keep them. That's pretty unusual, right?

McKee: Yeah. They didn't decline to lend a hand. It was just they said: hey, we're only going to accept this collateral at its market price, not at the book value, which means they can lend less. Yeah. The amount of what you can get from the FED is then reduced.

Stitzel: And then, the amount that they lent them turned out not to be enough to keep SVB afloat.

McKee: Yes. Yeah, I mean SVB was kind of scrambling around trying to raise cash in lots of ways, you know, they're trying to sell equity, which they’re hoping to. You know, and there's other lenders you can go to. You can go to other banks [and] offer collateral to try and borrow from them. Generally, one of the main purposes of a central bank is not just people controlling the supply of money with the interest rates, but it's also being a lender of last resort providing liquidity cash if a bank gets into trouble or, you know, basically a kind of a bank run purpose. And so, the Federal Reserve in some sense sort of failed here as a lender of last resort. And I think if they would accept that that's really safe, just has a low price. Because things like interest rate risk, they would probably be a better lender of last resort what happened last week.

Stitzel: O.K. so Eric would I'd like to turn to now is one of the sort of, policy responses is that’s being discussed is raising the amount that the FDIC guarantees, in terms of deposit. And so, I think this has a potential moral hazard problem. So, can you talk a little bit about what happens what the FDIC might do and how that might have a moral hazard issue.

McKee: Right. So, that would essentially be raising the $250,000 caps. So, it's a higher number or an unlimited sort of number. Now it somewhat depends on how it is where the money comes from. So, if it's coming from the insurance payments that banks make, or the additional fees they put into the deposit Insurance fund, which is another fund that's has, kind of, a similar purpose, and we're sort of paying for it right? Maybe hopefully it's a fair price. And in that case there's an actual cost to it. And I wouldn't be too worried about a moral hazard. But if it's just, you know, are coming from the general taxpayer fund, then the kind of the moral hazard there is, you know, banks are not going to be as punished if they fail at sort of their interest rate risk management, right? So, banks can just say: we're not going to worry about interest rate risk management. Congress will bail us out. It sort of depends on how they implement it. If they implement it in a way that results in the shareholders of the company of the bank getting wiped out. And I wouldn't be super worried about moral hazard because shareholders don't like getting wiped out. So, there's a pretty big cost if you do and end up bailing them out. And that is, of course, what has happened with SBV. The shareholders are wiped out and, you know, have lost all the money they invested in there. What I would really like to see happen is that the Federal Reserve kind of do a better job as a lender of last resort. One of the main purposes of the central bank is to provide cash in, kind of, emergencies like this. And apparently they required that the collateral that SVB was offering be put up as mark to market base, even though there weren’t any real default risk concerns. You know, there wasn't like it was subprime debt. It was very safe debt. And probably a better approach would have some more flexibility, be more willing to say: hey, we'll lend this to you at cost because we think that that risk is relatively low. And that might have been enough to salvage he situation for SVB. Maybe not, but it would generally mean the Fed is better at that kind of lender of last resort. And then, we wouldn't have to worry so much about moral hazards.

Stitzel: If the deposit insurance, you know, really functions as insurance --- and you're saying that's going to give a cost to the bank which is then going to be passed on to depositors, and that'll, sort of, potentially accurately reflect the risk of unlimited FDIC guarantees ---- you say that won't present any moral hazard issue?

McKee: Again, if the cost is correct it might not be. You know, the role of the regulation or legislation that sets it might set a price that is not very, that's much too low or something like that, and then there would be kind of a moral hazard problem. But assuming the price is right, big assumption I know, I wouldn't be as worried. Because, you know, you're getting insurance. But I'm not --- moral hazard is, sort of, an issue with insurance that insurance companies know how to handle.

McKee: So, to bring it in for our landing I wanted to get your thoughts on if instead of the unlimited deposit insurance guarantees being backed by increased fees, and essentially an appropriate price as you call it, what do you think would be the outcome of a policy if these deposits were backed by federal taxpayers, and that policy was stated such that people knew that was going to be the plan?

McKee: Hmm mmm. Well in that case, you definitely have a potential moral hazard here, where banks don't have to worry or won't worry as much about their kind of interest rate risk. And, you know, that kind of increases the risk. But someone will have to get bailed out. Now the one solution --- I don't like the solution, but it's kind of more heavily regulate how much to make sure they're handling their risk better. But yeah, it would kind of encourage the banks to say it. You're going to be fine. Don't worry about rescue. You know, banks are probably going to do that.

Stitzel: My guest today has been Eric McKee. Eric, thanks for joining us on the EconBuff.

McKee: Thank you. Thank you for having me on.

Stitzel: Thank you for listening to this episode of the EconBuff. You can find all previous episodes on YouTube at Econbuff Podcast. You can check out our website at econbuffpodcast.wixite.com. That's wixsite.com. You can contact us at econbuffpodcast@yahoo.com.