INTERVIEW: Back to Adam (Smith)

By Reuvain Borchardt

People look at signs posted outside of an entrance to Silicon Valley Bank in Santa Clara, Calif., Friday, March 10. (AP Photo/Jeff Chiu, File)

George Selgin, an economist and banking historian, discusses the failures this month of Silvergate, Silicon Valley, and Signature Banks.

Selgin is a senior fellow and director emeritus of the Center for Monetary and Financial Alternatives at the Cato Institute, and professor emeritus of economics at the University of Georgia. He also previously taught at George Mason University and the University of Hong Kong.

His research covers a broad range of topics within the field of monetary economics, including monetary history, macroeconomic theory, and the history of monetary thought.

A critic of central banking and of many forms of financial regulation, which he argues have done more harm than good, Selgin is the author of numerous articles and books on monetary theory, banking, price levels, and the Federal Reserve.

He is a co-founder of the Modern Free Banking School, which draws its inspiration from the writings of F. A. Hayek on denationalization of money and choice in currency.

Selgin holds a BA in economics and zoology from Drew University, and a PhD in economics from New York University.

He spoke last Thursday with Hamodia from Granada, Spain, where he is enjoying the emeritus lifestyle while working on new books for the Cato Institute.

There were two high-profile bank failures this month, SVB (Silicon Valley Bank) and Signature Bank, and a far less famous one, Silvergate Bank. How did these failures come about?

The basic problem with SVB and Signature, though it was more spectacular with SVB, is that they both relied on a highly risky strategy that unraveled when they faced heavy depositor withdrawals. SVB was quite an outlier in this regard. The Silvergate situation is somewhat different.

George Selgin (Cato Institute)

To focus on SVB, the specific problem it had — which was also a problem for many other banks, though not to the same extent — is that because interest rates were so low in the last few years, before the Fed started raising them, it tried to squeeze a little bit more interest out of its portfolio by loading up on longer-term Treasury securities. There’s no default risk with U.S. Treasury securities, but because they’re long term, their price can vary as interest rates vary. SVB went very far out on that limb. But that was just part of the problem. Even SVB could have gotten away with its strategy had it been able to hold the bonds until maturity, which would have meant not having to actually take any losses. That is, SVB could have waited for the bonds to mature and gotten exactly what the bonds were worth. But it also took another sort of risk: It relied very heavily on large deposits held by a relatively small number of uninsured depositors — mostly tech startups that kept more, often a lot more, than $250,000 in their accounts. SVB was a niche bank in that regard. It may have seemed like a clever strategy, but it meant that if some of its major, uninsured depositors thought twice about keeping their money with it, there was a good chance that its other depositors would do the same.

Well, those depositors did think twice once they became aware of its unrealized but substantial paper losses, as they did when it announced that it needed to raise more capital. That news triggered a mass exodus from SVB, which was then obliged to start selling long-term Treasurys off of its portfolio to meet the withdrawals. But that only brought the cat that much further out of the bag, because it meant booking what had been paper losses only, which depleted its capital still further, giving its depositors all the more reason to take their money out, and so on, in a spiral down to the bottom.

Now, there’s another catch to all this, something that’s a little subtle. The startup companies banking with SVB were in many cases doing so because their venture capitalists, who were responsible for giving them their seed money, made a deal with SVB, under which SVB would help them with their finances, supplying credit at good rates to complement their venture capital. The catch was that they had to keep their cash at SVB.

This extra factor helps explain why there were so many startups with so much uninsured money in one bank: It was a way for these companies to get a whole financial package all wrapped up with a big pink bow. But in accepting that package, those companies also went out on a limb, though they presumably had no idea just how weak that limb could get.

In short, you start with a bank with heavy liability concentration, load it up with long-term bonds, add some heavy-duty Federal Reserve inflation-fighting that calls for raising interest rates a lot, and you’ve got all the ingredients for a perfect meltdown.

What about the Silvergate failure?

With Silvergate, a lack of diverse liabilities was also a problem, but it took a different form. Silvergate’s niche was the cryptocurrency market. And, of course, there have been problems in that market for some time, including the November 2022 collapse of FTX, the ripple effects of which affected many banks and other firms heavily involved in that market. Silvergate was hit especially hard, and it has been in trouble ever since. So, in its case, the recent outbreak of depositor runs was more in the nature of the straw that broke the camel’s back.

President Joe Biden announces the government would guarantee in the Roosevelt Room of the White House in Washington, Monday, March 13, 2023. (AP Photo/Andrew Harnik)

So the fact that Silvergate failed just before SVB did was coincidental and unrelated?

I think there was some connection, in that the failure of any niche bank would have made the depositors dealing with other even vaguely similar banks more wary. These people talk to each other. Between those two banks, we’re talking about a pretty tight-knit community of depositors. And, as you know, bank failures can have contagion effects, but usually they’re very contained. Usually, it’s the discovery that banks have problems in common that causes fear to spread. What happens, in a nutshell, is that one bank fails, other depositors elsewhere take a closer look at their own situation, and alarms start going off. The problems at SVB were there for some time, actually. But it took some bad news to be the canary in the coal mine to alert people that they couldn’t count on the bank’s troubles just going away.

Then, just after SVB failed, so did Signature Bank. What happened there?

Signature had very similar problems to SVB with long-term debt, and its losses were very large.

Was there also the factor that because the Fed raised interest rates, these bonds the banks previously purchased at lower rates now dropped in value?

That’s right. The banks can get away with having all this duration risk if people don’t try to cash out their deposits, but if they face large-scale customer withdrawals, of course they have to liquidate some substantial part of their portfolio. And if it’s heavy with long-term bonds, they’re going to have to take what were paper losses and turn them into real losses, as they realize on those depreciated bonds. So their strategy of holding until maturity is undermined by the large-scale withdrawals.

What do you think of our whole system of fractional reserve banking (in which banks keep only a small fraction of deposits on hand for withdrawal, while investing the rest)?

Well, I’m in that beleaguered, shrinking group of people who think fractional reserve banking itself is fundamentally a good institution. This goes back to Adam Smith, who pretty much got all this stuff right. He said in 1776 that while fractional reserve banking can have many benefits, it’s a lot riskier. And it was Smith who was among the first to famously recommend that banks had better stick to short-term lending if they don’t want to find themselves in hot water.

So with regard to the particular sort of risk to which SVB and Signature and some other banks find themselves exposed, this episode takes us all the way back to the days of Smith and his argument that banks should stick to short-term lending. Today, though, one might say that they should stick to either short-term lending or owning short-term Treasury securities.

But there’s more to it than that. In Smith’s day, it was taken for granted, with good reason, that people were aware of the risks banks took — there was no deposit insurance — and that they would practice due diligence.

Due diligence, as in people looking into the bank’s activities and investments and making sure that it’s on sound footing before depositing their money there?

Right — and not letting government authorities convince them that any bank that they supervise is one to be trusted.

The problem is with trying to replace market discipline or due diligence with regulatory discipline, in which a bunch of supervisors and regulators are supposed to make sure banks are all right. Once that’s attempted, customers — even uninsured ones — are much more inclined to just go after a few extra basis points of interest, or to put money in a bank just because that bank is offering to take part in a financing package that they’ll benefit from, and to do so without regard to the risks they’re exposing themselves to. That can work out, in theory, if government regulators are themselves making up for the lack of private diligence, by preventing all the banks that they’re in charge of from doing anything that could cause a catastrophic failure. The problem is that, in practice, the attempt to substitute regulatory discipline for market discipline is a recipe for a never-ending string of failures. That’s because, besides being subject to political pressure not to close certain banks, regulators aren’t omniscient. Of course, they do learn from experience — every particular kind of failure that they deal with causes them to look out for that kind of problem. But that sort of learning isn’t sufficient to prevent them from overlooking a problem that they haven’t themselves encountered yet, even if earlier generations of regulators had.

The economist and philosopher Adam Smith (1723-1790)

Others would argue that the average person who is not a wealthy investor and just uses a bank to deposit his paycheck, pay his bills, and maybe save a little, doesn’t have the knowledge or capability or finances or time to investigate a bank before depositing his money there.

There’s nothing wrong with that argument; I think it’s true. Though a part of me wonders, why shouldn’t the Average Joe spend at least as much time choosing a bank as he spends choosing a cellphone? I used to ask students in my Money and Banking class, “How many of you have spent several hours trying to decide which cellphone to buy?” Many hands went up. “How much time did you spend checking out whether you were dealing with a fly-by-night bank?” “Huh? What?” And of course, it’s not rational to care how safe your bank is if your account is fully insured by the FDIC.

But the fact that deposits are insured to a limited extent is itself not fatal to the existence of market discipline. But when you start insuring everyone 100%, whether the insurance is explicit or implicit, so there’s an expectation that in the end the government’s going to bail out everyone, then of course there’s no one left except the regulators to police the banks. In the days before such extensive insurance coverage, it was always the big (and supposedly smart) bank customers who did most of the policing of banks. They’re the ones who have an incentive to look out for and avoid risk.

You’re obviously opposed to the government bailing out the depositors — though not the shareholders — of SVB and Signature Bank.

This is an important point: When you rescue the depositors, that’s what takes the market discipline out. It’s not the shareholders. Some depositors need to bear some risk, or all the responsibility for diligence falls on the regulators.

What you want to have is a system that convinces bigger depositors that they really have to worry about risk and take steps to guard against it. And people with accounts of more than $250,000 can afford to put some special effort into looking into things. There’s no reason why a competent treasurer of a company worth half a million or more could not have known that SVB was risky. The fact that the San Francisco Fed didn’t know it, that’s a low bar. This was a really egregious case of overlooking a particular, notorious kind of risk. In any case such a Treasurer should have warned his company not to keep all or most of its cash at one bank.

People on the right talk about “moral hazard,” in this case the fear that when you bail people out you’re going to incentivize these bank executives to continue to make risky bets. But although the depositors were made whole, the executives lost their jobs, their stock dropped, and they endured public embarrassment and reputational harm. Isn’t that sufficient disincentive for them to be reckless? If that’s not sufficient disincentive, why would the further fear that depositors could lose their money somehow be the disincentive that guards against excessive risk-taking?

It’s the depositors who ultimately determine how the banks behave.

I also used to teach this to my Money and Banking students. I would first give them a scenario where there’s a risky bank and a less-risky bank, but the risky bank paid more interest, and I would take a straw poll, and I’d say, “Assuming you’re not insured, who would put their money in this bank, and who would put their money in that bank?” You’d always get some risk takers and some risk avoiders, so that both banks might stay in business. Then I would say, “Okay, now assume everybody’s insured, so, wherever you put your money, you’re going to get committed interest, and your principal back.” Then most would say, “In that case, I’m going to put my money in the risky bank.”

Then I follow up and say, “Okay, now suppose there is no insurance, and you have the opportunity to run a bank, and you can either run your bank like the risky bank, or you can run it like the safe bank.” Again, some would say they would run risky banks, and some would say they would play it safe. Then I’d say, “But in a world with insurance, what kind of bank would you be?” Once in a while, a student would say, “Well, I want to run a safe bank,” and I would remind him or her of the answers to the previous questions and say, “Your bank isn’t going to get any business!”

So that’s why punishing the shareholders isn’t enough. Because in the end, if the depositors have no incentive to avoid risk, then the risk-taking bank is the only game in town, because all depositors will go there to take advantage of its higher — guaranteed — interest rate without being at all concerned that they might lose their deposits.

If there is a bank down the street taking all the risks, but everything’s insured, and the clients are all moving to that bank, the owners of the other banks are going to have to take similar risks, even though they will risk getting wiped out.

Some on the left are blaming these failures on Trump deregulation. Do you believe there’s any connection?

No, I can’t see any connection.

As a banking historian, is there any other bank crisis that this is comparable to?

Every time there’s a big variation in interest rates, when they start going up a lot, typically because of inflation, you have problems in banking. It happened in the 60s and 70s, as interest rates rose. Ultimately, the widespread Savings & Loan failures of the 1980s were a result of interest-rate risk exposure. So that would be a precedent right there, though their problem was with long-term mortgages rather than long-term Treasury securities.

Igor Fayermark, right, of the FDIC, enters Silicon Valley Bank’s headquarters in Santa Clara, Calif., on Monday, March 13. (AP Photo/ Benjamin Fanjoy)

I’d like to ask about an issue you’ve written extensively on, and maybe you can briefly distill it here: You don’t like central banks, you don’t like the Fed. What sort of banking system would you like to see?

I do have a nostalgic fondness for certain banking systems of the past that didn’t have central banks, yet had relatively good — often very good — records. But I’ve always admitted that we can’t wave a magic wand that will make that sort of system viable today, for all kinds of reasons, starting with the fact that not having a central bank or other central monetary authority means you have to have a gold standard or commodity standard, and fat chance that we’ll see a return to any such standard in the foreseeable future.

So the kind of system I recommend for here and now is one that takes the present fiat system for granted — not because it’s the cat’s meow but because there’s no easy way to replace it. I also favor opening up opportunities for substitutes, but in the meantime, you have to keep the present ship from sinking. Given this starting point, I’d like to see fiat money in a way that keeps total spending — not the price level — stable, because that is the best way to guard against business cycles and inflation and big interest-rate movements of the sort that have contributed to the recent crisis. I’d like to see deposit guarantees — and implicit ones especially — rolled back, so as to revive bank-customer due diligence. And I’d like to see more emphasis on structural strengthening of our banking system, which means having more banks that are both well-diversified and neither tiny nor enormous. But to delve into how that outcome can be encouraged would require a deep dive into the regulatory weeds.

But finally, I think we have to have a system where occasionally banks fail, and depositors are forced to take some losses. Unless you have that, you are continuing down the road where everything depends on the bank regulators being good substitutes for diligent depositors. We’ve been going down this road for a long time, and all that has done is to bring us more and bigger bank failures.

Do you see crypto as the realization of your goal of decentralized money?

Not really.

Stable coins have some potential to do that — they are more likely to catch on as money because they are relatively close dollar substitutes, and therefore potentially useful as alternatives to either paper money or bank deposits.

But the problem with those is that they aren’t well integrated into the existing payment system, and the Federal Reserve isn’t making it easy for them to be integrated. That lack of integration makes stable coins both less convenient and less safe than they might be otherwise. So I don’t see them really competing effectively at this point with ordinary bank accounts or, I’m sorry to say, proposed Central Bank Digital Currencies.

On the other hand, I don’t see any non-dollar-exchange media becoming particularly important as a rival to the dollar. In the crypto world, besides stable coins, you have “free-floating” options like Bitcoin that are completely independent of established fiat monies or commodities like gold. But these really face an uphill battle in competing with the U.S. dollar for all kinds of reasons, starting with the tremendous network of established dollar users. There is such a thing as “network economies” that make staying in or joining a large payments network much more attractive than opting for a relatively tiny one. That’s why even die-hard Bitcoin fans who live in or do business in the U.S. must also take part in the U.S. dollar network, whether they like to admit it or not.

Two more banks didn’t fail — yet — but appear to be in trouble: First Republic, which got cash injections from other banks, and Credit Suisse, which got a loan from the Swiss Central Bank. What happened with those banks?

Credit Suisse’s troubles long predate the recent crisis; it has been ridden by scandals, and was losing money for some time when the recent wave of bank failures began. Like SVB, it is weighed down with long-term debt, and has suffered from poor risk management practices. So it isn’t surprising that SVB’s failure gave Credit Suisse’s uninsured creditors a case of the willies, especially after it admitted, in the midst of the turmoil, that its 2021 and 2022 financial reports were flawed. But since Credit Suisse is roughly twice as big as SVB, which is to say a huge part of the Swiss financial system, it’s hard to imagine the Swiss National Bank letting it fail.

Is this another 2008? Or is this situation going to be contained and go away soon? What do you see happening going forward?

Fortunately, some people have done some good local legwork looking at the different banks and their exposure to similar risks. And SVB and these others are outliers. They really had gone way out on a limb. I don’t think there are any really big banks, at least, that are in the very same boat, though there are a few, alas, that are in terrible shape for other reasons.

Talking about hedging, we could have a different sort of crisis, but I don’t think we’re looking at 2008.

Finally and most importantly, you are definitely the first economist I’ve spoken to who, in addition to your economic degrees, has a BA in zoology! How did that happen?

As a child I dreamed of serving on the Calypso with Jacques Cousteau! And I did in fact end up studying marine and freshwater biology, among other subjects, both at my college (where a zoology major was the closest thing) and at the Duke Marine Lab, Woods Hole, and the University of Rhode Island, among other places. Economics was the afterthought. How it came to be so is a long story, but suffice to say that I tried combining my interests, unsuccessfully. I think it was my desire to understand inflation, which was an even more serious problem when I left college, that diverted me into monetary economics.

This interview originally appeared in Hamodia’s Prime Magazine.

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