The usual cocktail: Greed, panic, and regulators napping

In November 2008, just weeks after the Lehman crash, at a high-profile briefing by top academics at the London School of Economics, the late Queen Elizabeth asked a simple question. She said the massive meltdown and imminent recession were “awful”, but how come nobody saw it coming? How did all the bright minds, experts and economists fail to anticipate the financial crash of the century? There was a stunned silence. This was a simple question, yet no definitive answer has come even after 15 years. People are still searching for theories and answers that can explain the crisis. Or maybe, the answer is obvious, but nobody wants to say that the “emperor has no clothes”.

As an early response to the Queen’s query, a group of eminent British economists wrote a three-page note. It blamed the “failure of the collective imagination of many bright people”. The note also referred to a “psychology of denial” which had gripped the financial and political world and the elite, even as the crisis was approaching. There was a combination of many factors: wrong advice, neglect of vigilance by auditors, lax regulators who looked the other way, excessive lending and leverage, binge borrowing by those without assets or income. But most of all, it was wishful thinking, combined with hubris. In the aftermath of the crash, Citibank’s chairman summed up what the thinking was during the go-go years prior to 2008: “As long as the music is playing, you’ve got to get up and dance”, meaning that his bank continued to do risky lending knowing full well that it would end in disaster.

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As a response to the 2008 crisis, many governments, led chiefly by the United States, passed stricter legislation to avoid such financial crashes, brought on by excessive lending (called loan-pushing), lax risk management, and other imprudent practices. This was the famous Dodd-Frank bill passed in the US. And yet, we have a big crash on our hands. The implosion of Silicon Valley Bank (SVB) of California is testimony to the inadequacy of all the legal safeguards put in place since 2008.

Financial crises have a habit of recurring, and their frequency has increased in the past three decades. The details vary, some are not as severe, but the underlying causes are the same or similar. It’s a cocktail of greed, followed by fear and panic, herd behaviour, combined with shoddy work by auditors or inspectors, and laxity by regulators. On top of this cocktail sometimes, there is political pressure.

Silicon Valley Bank was ranked among the top 20 by Forbes’ in their America’s ‘100 Best Banks’ just three weeks before it crashed to zero. KPMG, too, had given a clean and strong bill of health. SVB had about $200 billion of deposits, of which 93 per cent were uninsured by the Federal Deposit Insurance Corporation (FDIC). And the bulk of these deposits were not given away as loans but invested in government and other “safe” bonds. The value of these bonds erodes when interest rates start to rise. The Federal Reserve has been raising rates relentlessly, and thus the benchmark rate has gone up by nearly 5 percentage points. This means that if SVB tried to sell the bonds, they would not even recover one fourth of the value that they invested. Which means that if depositors come calling, most of them would find that the money had vanished.

Why did risk management of the SVB not anticipate this? Why did the inspectors of the Fed not haul up the bank earlier for risk mismatch? In fact, the FDIC decided to shut down the bank precisely because of the risk of a bank run.

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If depositors rush to the bank to withdraw their savings, only the first few are able to get their money out. The rest find that they have lost everything, barring what is insured, which in SVB’s case was only 7 per cent of the deposits. Fearing this, everybody rushes to withdraw, and that collapses the bank.

Now, under political pressure, US President Joe Biden announced that every depositor would get his or her money back. He denied that this was a government bailout, but it is de facto a bailout using public money. The Fed will give cheap loans to SVB against virtually no collateral, to repay the depositors.

Meanwhile, another bank in New York, the Signature Bank, has been shut down. In Switzerland, Credit Suisse, a ‘bulge bracket’ bank with a global presence, has imploded. They are desperately trying to rescue it by selling it at a big discount to another bank. The failure of big banks, presently contained within manageable limits, points to a recession. This time, the Fed and other central banks cannot immediately cut interest rates since inflation is running high.

This financial crisis, although smaller than the 2008 one, flags the fragility of the bank-based financial system. Banks use public money from depositors to lend to borrowers and support growth. But the borrowed money is in assets which cannot be quickly liquidated. Whereas money can be demanded instantly by depositors. The reason this mismatch works as long as it does is because of a foundation of trust. The depositors trust that their money is safe in the bank. They trust the banks not to do risky lending or take excessive risks. They trust that greed (to increase profits via risky loans) will not overtake prudence. They trust that regulators will be vigilant and keep banks on good behaviour. They trust that auditors will check that financial statements are accurate and reflect the true picture.

But this entire edifice can crumble when there is panic and fear, and a stampede by depositors. Even banks which are otherwise healthy can crumble because of excessive leverage and the inherent instability in the banking model. Hence the trust of regulators and public leaders calming the frayed nerves of panicking and nervous depositors is very important.

Unfortunately, often, the public and taxpayers end up paying for the mess. Profits are private and losses are socialised, is a maxim that keeps recurring.

(The writer is a noted economist) (Syndicate: The Billion Press)