Mar 19 JDN 2460023

As of March 9, Silicon Valley Bank (SVB) has failed and officially been put into receivership under the FDIC. A bank that held $209 billion in assets has suddenly become insolvent.

This is the second-largest bank failure in US history, after Washington Mutual (WaMu) in 2008. In fact it will probably have more serious consequences than WaMu, for two reasons:

1. WaMu collapsed as part of the Great Recession, so there was already a lot of other things going on and a lot of policy responses already in place.

2. WaMu was mostly a conventional commercial bank that held deposits and loans for consumers, so its assets were largely protected by the FDIC, and thus its bankruptcy didn’t cause contagion the spread out to the rest of the system. (Other banks—shadow banks—did during the crash, but not so much WaMu.) SVB mostly served tech startups, so a whopping 89% of its deposits were not protected by FDIC insurance.

You’ve likely heard of many of the companies that had accounts at SVB: Roku, Roblox, Vimeo, even Vox. Stocks of the US financial industry lost $100 billion in value in two days.

The good news is that this will not be catastrophic. It probably won’t even trigger a recession (though the high interest rates we’ve been having lately potentially could drive us over that edge). Because this is commercial banking, it’s done out in the open, with transparency and reasonably good regulation. The FDIC knows what they are doing, and even though they aren’t covering all those deposits directly, they intend to find a buyer for the bank who will, and odds are good that they’ll be able to cover at least 80% of the lost funds.

In fact, while this one is exceptionally large, bank failures are not really all that uncommon. There have been nearly 100 failures of banks with assets over $1 billion in the US alone just since the 1970s. The FDIC exists to handle bank failures, and generally does the job well.

Then again, it’s worth asking whether we should really have a banking system in which failures are so routine.

The reason banks fail is kind of a dark open secret: They don’t actually have enough money to cover their deposits.

Banks loan away most of their cash, and rely upon the fact that most of their depositors will not want to withdraw their money at the same time. They are required to keep a certain ratio in reserves, but it’s usually fairly small, like 10%. This is called fractional-reserve banking.

As long as less than 10% of deposits get withdrawn at any given time, this works. But if a bunch of depositors suddenly decide to take out their money, the bank may not have enough to cover it all, and suddenly become insolvent.

In fact, the fear that a bank might become insolvent can actually cause it to become insolvent, in a self-fulfilling prophecy. Once depositors get word that the bank is about to fail, they rush to be the first to get their money out before it disappears. This is a bank run, and it’s basically what happened to SVB.

The FDIC was originally created to prevent or mitigate bank runs. Not only did they provide insurance that reduced the damage in the event of a bank failure; by assuring depositors that their money would be recovered even if the bank failed, they also reduced the chances of a bank run becoming a self-fulfilling prophecy.

Indeed, SVB is the exception that proves the rule, as they failed largely because their assets were mainly not FDIC insured.

Fractional-reserve banking effectively allows banks to create money, in the form of credit that they offer to borrowers. That credit gets deposited in other banks, which then go on to loan it out to still others; the result is that there is more money in the system than was ever actually printed by the central bank.

In most economies this commercial bank money is a far larger quantity than the central bank money actually printed by the central bank—often nearly 10 to 1. This ratio is called the money multiplier.

Indeed, it’s not a coincidence that the reserve ratio is 10% and the multiplier is 10; the theoretical maximum multiplier is always the inverse of the reserve ratio, so if you require reserves of 10%, the highest multiplier you can get is 10. Had we required 20% reserves, the multiplier would drop to 5.

Most countries have fractional-reserve banking, and have for centuries; but it’s actually a pretty weird system if you think about it.

Back when we were on the gold standard, fractional-reserve banking was a way of cheating, getting our money supply to be larger than the supply of gold would actually allow.

But now that we are on a pure fiat money system, it’s worth asking what fractional-reserve banking actually accomplishes. If we need more money, the central bank could just print more. Why do we delegate that task to commercial banks?

David Friedman of the Cato Institute had some especially harsh words on this, but honestly I find them hard to disagree with:

Before leaving the subject of fractional reserve systems, I should mention one particularly bizarre variant — a fractional reserve system based on fiat money. I call it bizarre because the essential function of a fractional reserve system is to reduce the resource cost of producing money, by allowing an ounce of reserves to replace, say, five ounces of currency. The resource cost of producing fiat money is zero; more precisely, it costs no more to print a five-dollar bill than a one-dollar bill, so the cost of having a larger number of dollars in circulation is zero. The cost of having more bills in circulation is not zero but small. A fractional reserve system based on fiat money thus economizes on the cost of producing something that costs nothing to produce; it adds the disadvantages of a fractional reserve system to the disadvantages of a fiat system without adding any corresponding advantages. It makes sense only as a discreet way of transferring some of the income that the government receives from producing money to the banking system, and is worth mentioning at all only because it is the system presently in use in this country.

Our banking system evolved gradually over time, and seems to have held onto many features that made more sense in an earlier era. Back when we had arbitrarily tied our central bank money supply to gold, creating a new money supply that was larger may have been a reasonable solution. But today, it just seems to be handing the reins over to private corporations, giving them more profits while forcing the rest of society to bear more risk.

The obvious alternative is full-reserve banking, where banks are simply required to hold 100% of their deposits in reserve and the multiplier drops to 1. This idea has been supported by a number of quite prominent economists, including Milton Friedman.

It’s not just a right-wing idea: The left-wing organization Positive Money is dedicated to advocating for a full-reserve banking system in the UK and EU. (The ECB VP’s criticism of the proposal is utterly baffling to me: it “would not create enough funding for investment and growth.” Um, you do know you can print more money, right? Hm, come to think of it, maybe the ECB doesn’t know that, because they think inflation is literally Hitler. There are legitimate criticisms to be had of Positive Money’s proposal, but “There won’t be enough money under this fiat money system” is a really weird take.)

There’s a relatively simple way to gradually transition from our current system to a full-reserve sytem: Simply increase the reserve ratio over time, and print more central bank money to keep the total money supply constant. If we find that it seems to be causing more problems than it solves, we could stop or reverse the trend.

Krugman has pointed out that this wouldn’t really fix the problems in the banking system, which actually seem to be much worse in the shadow banking sector than in conventional commercial banking. This is clearly right, but it isn’t really an argument against trying to improve conventional banking. I guess if stricter regulations on conventional banking push more money into the shadow banking system, that’s bad; but really that just means we should be imposing stricter regulations on the shadow banking system first (or simultaneously).

We don’t need to accept bank runs as a routine part of the financial system. There are other ways of doing things.