The Banking Mess

The Fed Faces an Important Test

The Federal Reserve’s most important attribute is about to be tested: its integrity.

Chairman Jay Powell and the rest of the Federal Open Market Committee has been fighting doggedly (after a very late start) to tame inflation.

Powell has generally sided with the hawks, persistently raising interest rates even when many said the battle was won. This week’s inflation news—buried in the deluge of articles on the disgraced and shuttered Silicon Valley Bank—vindicated his continuing hawkishness.

Consumer prices rose 6% over the past year, with the increase in February down slightly but far from the Fed’s goal of 2%, and far from any reasonable standard of monetary stability. Due to inflation, workers continue to take home less (in real terms) despite impressive wage gains. And bank portfolios continue to suffer losses.

But the FOMC (the Fed’s interest-rate body), which meets next week, is now facing pressure to ease up on the inflation fight. With the banking crisis apparently not over, political pressure for a grace period is mounting.

Monetary forbearance will not help banks any more than it has helped workers. The only thing that will settle bank portfolios—and calm financial markets--is a return to financial stability. Stabilizing the value of the currency must be the priority.

Remember how we got here. S.V.B.’s crisis emerged when it booked a $1.8 billion loss on the sale of long-term bonds. But the problem began much earlier.

The bank had aggressively courted deposits from its Valley friends and funneled the money into long-term bonds. The bonds paid a higher rate, juicing earnings—but the yield was fixed. When rates began to rise, the market value of the bonds plummeted.

The point now is that S.V.B. is hardly alone. Banks have always purchased a mix of short-term and long-term securities, but over the past decade, the ratio of long-term securities crept steadily higher. And when rates began to climb, so did embedded, unrealized losses.

According to the F.D.I.C.’s 2022 year-end release, the total of  unrealized losses within all bank portfolios was $620 billion.

The F.D.I.C. barely sounded concerned. It noted that unrealized losses were down 10% from the previous quarter, while remaining “elevated.” How elevated? Over the previous decade, unrealized losses were scarcely if ever as high as $100 billion.

In retrospect, it is clear that, after the 2008 financial bust, when the Fed applied the therapy of maintaining interest rates at atypically low levels, some banks, at least, got greedy and reached for yield. Every investor worthy of the name knew that this entailed risk: rates go up as well as down.

But some bad actor or foolish actor was bound to overreach. The regulators’ job is to think about what happens when people in the private sector make mistakes.

Regulators, no less than investors, may been lulled by the apparent stability. No banks failed in 2021, and no banks failed in 2022. At year-end, the FDIC counted only 39 “problem banks.” S.V.B. was obviously not one of them, because total assets of problem banks were $47.5 billion--less than a quarter of those of S.V.B. alone.

It should be said that S.V.B. was an extreme case. Accounting rules require that banks recognize losses on securities they own only if they classify such holdings as “available for sale.” They needn’t recognize losses on securities that are deemed “held to maturity.”

The average bank had divided its assets between the two buckets in roughly similar amounts. But at S.V.B., an unusually high proportion were “held to maturity,” minimizing its requirement to book losses. That was aggressive bookkeeping.

Perhaps regulators, like S.V.B. itself, did not consider Treasury bonds to be risky. But as the Wall Street Journal pointed out, even creditworthy bonds face market risk. In lay terms, any obligation—even those issued by the U.S. Government -- will fetch a lower price when rates are rising.

Senator Elizabeth Warren has charged that regulators, burned by the failure of big banks in 2008, were too relaxed regarding regional banks. Congress endorsed this permissiveness in a 2018 law that weakened the requirements for middle-tier banks. (Greg Becker, the CEO of S.V.B., lobbied for the change.) It was after the regulatory easing that S.V.B.’s asset total skyrocketed. “This business model [funneling deposits into long-term bonds] was great for S.V.B.’s short-term profits,” Senator Warren wrote, “but now we know its cost.”

We also know the cost of inflation. Even uncertainty regarding future inflation raises interest rates and punishes bond values. And experience has shown that pretending the problem is going away is not a solution. The only way to shrink the unrealized losses in bank portfolios is to bring inflation back to an acceptable level. For the Fed, that means staying the course. Permitting inflation to remain “elevated”—or worse, to reaccelerate—will only add fuel to the monetary fire.

When S.V.B. failed, I was highly disturbed by the regulatory largess shown to the bank’s large depositors. The galling aspect of the seizure was the insuring of depositors above the F.D.I.C.’s $250,000 limit—that is, beyond the bank’s coverage—as detailed in a New York Times article on the history of deposit insurance here.

But regulation is not an all-or-nothing game. Relatively little attention has been focused on the related actions of the Federal Reserve. In the wake of the runs on S.V.B. and on (the also-seized) Signature Bank, other banks faced runs, generally less severe. These banks were solvent but not necessarily liquid—meaning, they had assets they could not sell without realizing a loss.

To forestall broader or possibly systemic runs, the Fed stepped in with emergency loans to these banks, against their assets. This was not only proper—it is the very thing the Fed was created for, to be a banker to banks, indeed, a “central” bank.

The Fed now faces another test. Preserving banks is part of its charter. So is defending the currency.