2 bank failures have the federal government taking extraordinary action

Transcript

LEILA FADEL, HOST:

Two bank failures has the Federal Government taking extraordinary action. The U.S. Federal Deposit Insurance Corporation, FDIC, announced this morning it's transferred all deposits of the Silicon Valley Bank to a newly created bridge bank. Customers will regain access to their money today. That bank, which had around $175 billion in deposits, collapsed Friday, making it the second-biggest bank failure in U.S. history. And regulators in New York shut down Signature Bank over the weekend. So how stable is the American banking system right now? Douglas Diamond is a professor of finance at the University of Chicago and a Nobel laureate for his research into how banks fail. Good morning, Douglas.

DOUGLAS DIAMOND: Good morning.

FADEL: Thanks for being on the program. So before we talk about how these banks failed, I think the big question for people right now is, does this spread? Are we going to see other American banks failing?

DIAMOND: I think that's exactly what the Fed and the Treasury were concerned about.

FADEL: Yeah.

DIAMOND: And I think the action they took, which was, you know, guaranteeing all the deposits for these two banks and have - setting up this lending facility to lend against government bonds and things like that that are worth below a hundred cents on the dollar because interest rates went up, I think that should basically slow down or basically stop it. So I think, probably, this is a good enough intervention. They should just be asking themselves how they got to this point where they had to do this.

FADEL: To allay fears that people have...

DIAMOND: Yeah.

FADEL: ...In other banks.

DIAMOND: Yeah.

FADEL: So how did Silicon Valley Bank get to this point? How did it end up collapsing?

DIAMOND: Right. So Silicon Valley Bank sort of violated the two basic rules of how banking is supposed to work. Banks do their magic by diversifying their asset risks, you know, having lots of different types of loans, in particular avoiding an overload in any particular risk. The one that they loaded up on too much was interest rate risk. If interest rates went up a lot, they were going to become insolvent. And they also - you're also - that's part of it, use asset diversification. You're also supposed to use diversified funding sources. These are the conclusions of my research in the 1980s that, you know, people cite as what's the theory of what banks are supposed to do.

So the banks and the supervisors made a huge mistake avoiding, you know - ignoring these basic tenets. So it was a management mistake. And this is an unusual run. Usually, the story that Phil Dybvig and I talk about in "Bank Runs," in our model, is that banks have some loans that are hard to sell for the full price. If everybody demands their money, then that'll make the bank fail. Sixty percent of the assets of Silicon Valley were things that are very close to government bonds. They were government agency securities, basically government bonds. They could sell those pretty much for what they were worth.

The problem was they weren't worth a hundred cents on the dollar because they were long-term interest rates. Interest rates went up. They had to sell them at a discount. So this was not your standard run. And it could have been avoided if the supervisors had said, look; we realize interest rates might be going up. Banks had better, you know, dial down their interest rate exposure. Or maybe the Fed should have been thinking, I shouldn't raise interest rates this quickly if it's going to wipe out certain parts of the financial system. Maybe they made a mistake by saying interest rates are going to be low for a very, very long time.

FADEL: Is that also what happened at Signature Bank?

DIAMOND: Signature Bank, I know less about their types of assets that they invest in than I know about Silicon Valley. But they had - didn't have diversified funding sources. A lot of their deposits came from crypto firms. They were sort of the clearing bank for - who was willing to deal with crypto firms. A lot of other banks wouldn't deal with crypto firms. They also had a little niche in dealing with law firms and holding, like, you know, escrow accounts for law firms. So they had two - and so that's pretty - that stuff doesn't tend to run as much. But having runnable, uninsured deposits, which both of them have, leaves you very susceptible to a run.

FADEL: Now, President Biden is expected to address these failures this morning. What should he say, or what must he say, to calm fears?

DIAMOND: Basically, he should say the - I think this is true. The financial system as a whole is in very strong shape, particularly, you know, the very big banks who don't have these huge interest rate risk exposures that these two banks had. Both have a lot of capital. And they're not exposed to this type of risk. It's a very - it's a much simpler type of bank failure than we had after the Lehman thing, where everybody was thinking maybe there was some default risk and hidden default risk in mortgages. This is just - these two banks had assets that were relatively straightforward. They just weren't - they had just gone down in value because interest rates went up. He should say things are probably fine. And we've taken steps, to the extent they're not fine, to make sure deposits are not losing a lot of money.

FADEL: Douglas Diamond is professor of finance at the University of Chicago. He was awarded the Nobel Prize last year for his research into how banks fail. Douglas, thank you so much for your time.

DIAMOND: My pleasure. Transcript provided by NPR, Copyright NPR.