Did the Fed Contribute to SVB’s Collapse?

SVB’s balance sheet mirrored this aggregate phenomenon, as seen in Figure 2. Deposit inflows at SVB in the third quarter of 2019, before quantitative easing, were less than $5 billion, whereas they averaged $14 billion per quarter during quantitative easing. However, once quantitative easing ended and switched quickly to quantitative tightening, the flows reversed. SVB started seeing uninsured deposit outflows, no doubt some of it coincident with the downturn in the tech sector, because the bank’s stressed clients also started drawing down deposits.

2. Profitable ‘carry’ trades turned risky

Second, many banks, showered with this firehose of deposits, parked them in liquid longer-term securities such as Treasury bonds and mortgage-backed securities so as to generate a profitable “carry” in the form of an interest-rate spread. Ordinarily, this would not be risky. Long-term interest rates had not moved up much for a long time. As important, even if they did, depositors are usually sleepy and accept low deposit rates for a long time, even when market interest rates move up. Banks felt protected by history and depositor complacency.

Yet this time was different because these were flighty uninsured deposits, and they flowed out when the Fed shifted course.

Indeed, because large depositors can coordinate more easily, the actions of a few can take more with them. Even at healthy banks, depositors, having woken up both to bank risk and the superior interest rates available at money market funds, wanted to be compensated with higher interest rates. The juicy interest-rate spreads between investments and somnolent deposits that banks enjoyed in the recent past were threatened, impairing bank profitability and solvency. As the saying in the financial sector goes, “The road to hell is paved with positive carry.”

3. This time it’s magnified

The third concern is that the first two concerns are magnified this time around. When the Fed last switched to quantitative tightening and rate hikes (2017–19), the rise in policy rates was less sudden and to a lower level, and the quantity of interest-sensitive securities held by banks was lower. Consequently, the unrealized losses that needed to be absorbed on bank balance sheets were small (less than $50 billion).

There were no depositor runs, though many of the same ingredients were in place. This time, both the quantum of rate rises, their rapidity, and the bank holdings of interest-rate sensitive assets are all much larger, with the Federal Deposit Insurance Corporation suggesting that losses on available-for-sale and held-to-maturity bank securities holdings alone are over $600 billion, as seen in Figure 3.

4. Supervisors were not blameless

The fourth concern is unwitting supervisory coordination. Clearly, too many supervisors did not see the rising bank interest-rate exposure or were unable to force banks to reduce it. Had supervision been more forceful (and we are still trying to gauge how forceful it should have been), it’s likely fewer banks would be in trouble today. But supervisors’ closer scrutiny of the largest banks, including through stress tests, without applying similar standards to all banks, may have also caused a migration of risky commercial real-estate loans (think half-empty office buildings postpandemic) from larger, better capitalized banks to relatively weakly-capitalized small and midsize banks.

The broader point is that the vulnerabilities in the banking system are, no doubt, partly banker created. But the Fed also created some of the vulnerability. Periodic bouts of quantitative easing have expanded bank balance sheets and stuffed them with more uninsured deposits, but reversing quantitative easing is much harder because banks have become dependent on the easy liquidity. In general, the larger the scale of quantitative easing and the longer its duration, the more time the Fed should take to normalize its balance sheet and, ideally, also interest rates.

No stability mandate

Unfortunately, these financial stability concerns conflict with the Fed’s inflation-fighting mandate. Markets now expect rate cuts in a time of significantly-above-target inflation, and some observers are calling for a halt to quantitative tightening even as the Fed provides liquidity in large quantities once again through the discount window and other channels.

If financial-sector problems do not slow the economy, such actions could make the fight against inflation more protracted and costlier. As it reexamines bank behavior and supervision in any postmortem, the Fed cannot afford to ignore the role its own monetary actions, especially quantitative easing, played in creating today’s difficult conditions.

Viral Acharya is the C. V. Starr Professor of Economics at NYU.

Raghuram G. Rajan is the Katherine Dusak Miller Distinguished Service Professor of Finance at Chicago Booth.

This is an edited version of an essay that first appeared on ProMarket, an online publication of Booth’s Stigler Center for the Study of the Economy and the State.