The Fed’s dissonant monetary policy and the 2023 March Banking Crisis: Part I — Silicon Valley Bank

Mehmet Uluğ - PhD in Economics, University of Siena

We are witnessing a Global Banking Crisis. In the past two weeks, three banks — Silvergate Bank, Silicon Valley Bank, and Signature bank — have failed. It’s also astonishing to see that Credit Suisse was taken over by rival UBS. While rating agencies such as Moody’s and Standard & Poor’s are busy downgrading the credit ratings of other banks, the Federal Reserve once again collaborated with other major central banks such as the ECB, the BoC, the BoE, the BoJ, and the SNB in order to provide U.S. dollar liquidity through its swap lines facility. These swap lines are not new! They come into play whenever there is distress in the global financial system.

Much has already been written and many have discussed the causes and implications of the current crisis across various platforms such as Twitter, Financial Times, and Econ blogs. One of the immediate responses of commentators was to recall the 2008 Global Financial Crisis (GFC) and its wider implications for the global financial system as a whole. They have very good reasons to worry and remember the impact of GFC, as it happened 15 years ago.

It’s been 15 years since we lived through the nightmare of the Global Financial Crisis. Here, once again, we are discussing about the stability of the financial system, monetary authorities, and their policies that ignore the inherent characteristics of finance, debt, and money. In his latest post, Steve Keen[1] tirelessly highlights the dissonance between the Fed’s monetary policy models and the reality of the financial system and its practices. Nersisyan and Wray[2] have called for a change in Fed’s mandate, arguing that it should prioritize financial stability over inflation targeting. Michael Hudson[3] takes his argument to the next level by stating that the Federal Reserve is now waging a war against the banking system. In summary, this is both not 2008 and 2008 for two different reasons.

First, this is not 2008 because the underlying causes of the current crisis (2023 March Banking Crisis) are different from those of 2008. Scholars, including myself, who studied the financial crisis of 2007–2008 focused on the housing boom, the Eurodollar market, shadow banking, or its complex financial instruments such as asset-backed commercial papers, and repurchase agreements (repo). Today, however, we are trying to understand the current state of the global financial ecosystem and the list of factors is long but fundamentally different from the factors mentioned above: raising interest rates, inflation, the government bond market, deposit franchise, bank risk management, venture capitalists, start-ups, cryptocurrency, and regulations.

Second, this is 2008 for two reasons: (1) bad lending practices by banks when granting loans. This is an issue that the commentators have overlooked while focusing on the combination of loose regulations and rising interest rates. However, this may have been a major issue for SVB because it appears that the bank had developed its own approach to customer management by imposing contractual obligations on them when granting loans (I will return to this issue in another post). (2) The bank failure occurred in the U.S. financial system, which has significant consequences for the global economy, given the role that the Fed interest rates and the U.S. Treasury market play for the rest of the world.

What went wrong?

Well, a lot of things went wrong.

Before delving into the factors that complicated things, which ended up with the collapse of Silicon Valley Bank, there is something else I would like to clarify: the nature of finance.

In today’s globalized financial world, a comprehensive understanding of the relationship between the financial system and the real economy necessitates a proper grasp of finance. This entails differentiating between concepts like money and credit, which are often conflated, especially in mainstream economics. On the other hand, post-Keynesian scholars have devoted significant effort to the theory of endogenous money, which emphasizes the importance of bank lending. When reading the chapter on Credit, Money, and Central Bank in Marc Lavoie’s book Post-Keynesian economics: new foundations (2022), it becomes clear that trust and confidence are fundamental elements of any financial system. This understanding of the financial system is built on the notion that money is a social relation between debt and credit. This starting point is crucial if we are to understand the reality of what banks do and their special role in creating money when they make loans.

More precisely, banks create money in the act of lending thus, loans make deposits, not the other way around. As such, the relationship between a borrower and a lender (either between two banks or between a bank and a household/business) is based on trust and creditworthiness. Considering the nature of debt and its relation with credit, it is therefore important to note (1) money always emerges as a debt, (2) money is a promise and the production of a promise involves trust. “This is the whole theory of money” as in A. Mitchell Innes (1913): “Money, then, is credit and nothing but credit. A’s money is B’s debt to him, and when B pays his debt, A’s money disappears.”

The Fed’s dissonant monetary policy

When the Fed began to raise the interest rates to combat the supply-related sources of global inflation, unintended consequences for the financial system began to materialize, and certain segments of the financial system (such as long-term government bond markets) were hit hard. As a result of higher interest rates, long-term government assets previously bought by SVB lost their value, and SVB became one of the first victims of these aggressive interest hikes. The bank was sitting on significant amounts of longer-term assets and watched as the value of these fell below the level of its liabilities. It’s worth noting that SVB isn’t the only bank whose assets lose value due to Fed’s interest rate hikes.

To reiterate, it was the Fed’s dissonant monetary policy, based on interest rates that complicated the workings of the financial system. Rising interest rates eroded the value of long-term assets, which is a risk that everyone is familiar with — the relationship between interest rates and bond prices is inverse, meaning that when the interest rate rises, bond prices fall, and vice versa.

Conclusion

The response of the FDIC/Fed/Treasury was no doubt extraordinary. In the first place, Silvergate Bank, Silicon Valley Bank, and Signature Bank were victims of the Fed’s dissonant monetary policy, which posed a significant interest risk for their large quantity of long-maturity securities. With the significant measures taken in the aftermath of SVB’s failure, particularly the full protection of depositors (including those whose deposits exceeded the insurance cap of $250.000 by FDIC) and expansion of the discount window through a new crisis facility program called Bank Term Funding Program (BTFP), the Fed not only accepted the consequences of dissonant monetary policy but also went beyond Walter Bagehot’s classical principles in times of crisis.

In the next post, I wish to explore an important factor that contributed to SVB’s failure, which is the bank lending practice or conditional lending behavior of the bank.

References:

Lavoie, M. (2022). Post-Keynesian economics: new foundations. Edward Elgar Publishing.

Innes, A. M. (2004 [1913]). What is Money? (p. 14). Edward Elgar Publishing.

Footnotes:

[1] https://www.patreon.com/posts/silicon-valley-79926691?utm_medium=social&utm_source=twitter&utm_campaign=postshare_creator&utm_content=join_link

[2] https://thehill.com/opinion/congress-blog/3905479-the-collapse-of-svb-shows-why-monetary-policy-is-the-wrong-tool-to-fight-inflation/

[3] https://profstevekeen.substack.com/p/why-the-banking-system-is-breaking