We Cannot Ignore the Fed’s Role in the Silicon Valley Bank Collapse

Image source: Getty Image/ Nikolas Kokovlis

On March 10th, 2023, Silicon Valley Bank collapsed, sending a shiver of anxiety down the American spine. The incident marks the largest bank failure since the 2008 Financial Crisis and prompted the Federal Deposit Insurance Corporation to assume control of SVB and its assets. After the tech-industry institution fell into insolvency, shares of other regional banks plummeted, creating widespread fear that SVB’s collapse could be a harbinger of broader trouble. Government officials are on high alert to ensure that the pain does not spread across the financial sector, going so far as to guarantee deposit reimbursement for SVB’s clients. 

Helping to propel this crisis are the actions of the Federal Reserve. During the pandemic, most banks—seeking a stable return amidst unprecedented uncertainty—bought a substantial number of long-term government bonds. But the Fed’s rapid pivot on interest rates in early 2022 plunged these bonds underwater, generating an estimated $620bn in unrealized losses across the financial sector (Yuk 2023). Silicon Valley Bank invested heavily in such bonds, and when the breakneck speed of interest rate increases collided with a struggling tech sector—by far the most important industry for SVB—the bank was unable to raise the liquidity necessary to cover its withdrawals without incurring considerable losses. Given the impact of the Fed’s policies on SVB’s collapse, it is worth examining what the Fed is trying to accomplish, and the implications of its tight money policies for the financial system.

Currently, the Fed is hyper-focused on fighting inflation, which has stubbornly persisted since the economy reopened. Raising interest rates is a tried-and-true method of managing inflation—so long as the cause of inflation stems from the demand side of the economy. Higher interest rates are a natural drag on demand since they raise the price of borrowing money, which reduces consumer spending and business investment. As demand falls, the economy slows, reducing both employment and inflation. Federal Reserve Chair Jerome Powell has identified wage growth and a tight labor market—key contributors to strong demand—as primary catalysts of inflation, which explains his policy of raising interest rates. But Powell’s approach looks increasingly flawed. 

Relative to pre-Covid trends, every single advanced economy faces increased inflation, suggesting that inflation is a global problem rather than a domestic one (Bivens 2023). Inflation’s recent moderation suggests this as well. As countries around the world lift burdensome Covid-era restrictions, bottlenecks in the global supply chain are dissipating, reducing inflation despite a continuously strong labor market. This trend runs counter to Chairman Powell’s analysis and points to the supply side of the economy as the primary source of inflation. 

The nature of wage growth indicates the same thing. Despite the Fed’s insistence that rising wages are driving strong demand, and thus high inflation, real wage growth has remained far below productivity growth throughout the inflationary period (Kuttner 2023), suggesting that it’s not a prime contributor to inflation. On top of that, the Fed’s own projections state that reducing inflation to their 2% target would require the unemployment rate to double to 7.4% (Verbrugge and Zaman 2023). Seeing as we’ve already accomplished moderate reductions in inflation from the natural easing of supply chain bottlenecks, this seems like an ineffective, brute-force approach. While Team Transitory—the collection of economists and political commentators who argued that inflation would solve itself as stresses in the supply chain eased—has been maligned for their supposedly incorrect views, we are now seeing biggest declines in inflation since the Volcker years without the corresponding recession or pain in the labor market (Ackerman 2023). It’s increasingly looking like Team Transitory identified the problem correctly, but not the timeline. If the Fed continues to perceive macroeconomic imbalances as the source of inflation, the negative consequences to the U.S. economy could be profoundly serious. 

This brings us back to the Silicon Valley Bank collapse. Tech startups have long relied on cheap money for financing, which banks like SVB were able to provide during the era of low interest rates, especially throughout Covid. Flush with tech industry deposits during the pandemic, Silicon Valley Bank prioritized short-term profits by investing heavily in government bonds, despite their own models showing that these purchases made them dangerously susceptible to rising interest rates (Gilbert et al. 2023). Those assets lost value amidst a higher interest rate environment, forcing Silicon Valley Bank to sell them for a loss when they needed to raise liquidity. After March 8th’s surprise disclosure that SVB lost $2bn selling government bonds (Becker 2023), its clients—sensing this interest rate risk—rushed to withdraw their money, creating a run on the bank that pushed it into insolvency. 

It’s important to note that without a 2018 deregulatory initiative to rollback key provisions of the Dodd-Frank Act—which Silicon Valley Bank lobbied hard for—this crisis may not have happened. Dodd-Frank required stricter regulation for banks with more than $50bn in assets, arguing that these financial institutions were systemically important and therefore required more stringent oversight. But the Dodd-Frank rollback increased that figure from $50bn to $250bn, freeing mid-sized banks like SVB from stricter regulatory requirements. Without this federal oversight, SVB was able to load up on risk and become insolvent before regulators could sound the alarm. Congress must reinstate Dodd-Frank’s critical regulations on mid-sized banks to ensure that regulators are aware of systemic risk and to prevent a similar crisis from ever happening again.

While the 2018 deregulation was a chronic mistake from Congress, it’s but another part of the story; the Fed’s actions still require close scrutiny. Banks can normally withstand increases in interest rates by slowly replacing low-yield assets with high-yield ones, but amidst the blistering pace of the Fed’s actions banks like SVB suddenly found themselves awash in low-yield assets in a high interest rate environment. If the Fed continues to raise interest rates, the sheer number of unrealized losses from government bonds indicate that this problem could spread beyond the mismanaged SVB. Economic conditions have changed, and the Fed now needs to balance promoting financial stability along with labor market strength and reducing inflation. This means decreasing or keeping interest rates flat to allow banks to move on from their Covid-era government bonds, and to ensure that depositors are confident in the financial system. It also means accepting moderate inflation in the short-term, and adjusting the Fed’s long-term inflation target from 2%—a number that the Fed’s economists admit can only be achieved with a painful recession—to 3%, a figure that a growing body of evidence suggests is a sustainable and achievable goal (Bloesch 2022). If the Fed remains tunnel-visioned on reducing inflation with a heavy-handed policy of interest rate hikes, it risks threatening the stability of the U.S. financial system and causing far more pain than any moderate bout of inflation will inflict.

References

Ackerman, Seth. 2023. “Key Inflation Measures Are Falling at Their Fastest Pace in 40 Years.” Jacobin. https://jacobin.com/2023/04/inflation-falling-volcker-summers-housing-pce-cpi.

Becker, Greg. 2023. “Q1 2023 Investor Letter.” SVB. https://s201.q4cdn.com/589201576/files/doc_downloads/2023/03/r/Q1-2023-Investor-Letter.FINAL-030823.pdf.

Bivens, Josh. 2023. “Learning the Right Lessons From Recent Inflation.” The American Prospect. https://prospect.org/economy/2023-01-10-lessons-inflation-federal-reserve-interest-rates/.

Bloesch, Justin. 2022. “A New Framework for Targeting Inflation: Aiming for a Range of 2 to 3.5 Percent - Roosevelt Institute.” The Roosevelt Institute. https://rooseveltinstitute.org/publications/a-new-framework-for-targeting-inflation-aiming-for-a-range-of-2-to-3-5-percent/.

Gilbert, Daniel et al. 2023. “Silicon Valley Bank's risk model flashed red. So its executives changed it.” The Washington Post. https://www.washingtonpost.com/business/2023/04/02/svb-collapse-risk-model/.

Kuttner, Robert. 2023. “The Economy Is Doing Great.” The American Prospect. https://prospect.org/economy/2023-01-31-economy-inflation-federal-reserve/.

Verbrugge, Randal, and Saeed Zaman. 2023. “Post-COVID Inflation Dynamics: Higher for Longer.” Federal Reserve Bank of Cleveland. https://www.clevelandfed.org/publications/working-paper/2023/wp-2306-post-covid-inflation-dynamics-higher-for-longer.

Warren, Elizabeth. 2023. “Opinion | Elizabeth Warren: We Can Prevent More Bank Failures.” The New York Times. https://www.nytimes.com/2023/03/13/opinion/elizabeth-warren-silicon-valley-bank.html.

Yuk, Pan K. 2023. “US banks: funding pressure, yes. Liquidity crunch, no.” Financial Times. https://www.ft.com/content/6fcbf33d-85b8-470d-b391-c06d59c190f1.