Too Big to Fail Keeps Getting Bigger
Government-backed bank buyouts are worsening the risk of collapse
Early last week, First Republic Bank officially collapsed, making it the third and largest US bank to fail in 2023 so far. The FDIC, a federal government agency, stepped in and quickly sold the remains of First Republic to JP Morgan Chase. Not long ago, JP Morgan was one of the banks at risk of failing during the 2007-2008 financial crisis. Due to JP Morgan’s large size at the time, the federal government declared that the bank was “too big to fail” and that, if necessary, government aid would be provided to prevent the bank from collapsing. Rather than mitigate the risk of repeating the too-big-to-fail problem, the federal government is doubling down and just made JP Morgan, already the largest US bank, even larger.
Silicon Valley Bank also failed earlier this year. When selling off both Silicon Valley and First Republic, the FDIC made the unusual move of guaranteeing some of the failing banks’ loans against losses. This guarantee means that the buyer of the defunct banks will be, at least partially, protected against potential losses from the loans of the failing banks. The FDIC likely thought that guaranteeing the loans would make selling the defunct banks easier because potential buyers would be protected. But given the fact that the FDIC sold the defunct banks almost immediately after the failures makes it seem like the guarantee was unnecessary. In fact, the guarantee likely was unnecessary because risky loans were not a major factor in the Silicon Valley nor First Republic failures.
The primary factor in the failures is our current interest rate environment. As interest rates rise, existing loans with fixed interest rates fall in value. For instance, if a bank lends money for a five percent return and then the market interest rate rises to seven, the existing five percent loan would be worth less because the bank could make the same loan for the higher seven percent return. This is true regardless of the riskiness of the loan. The two defunct banks held large portfolios of long-term bonds and treasury bills (i.e., loans to the government) which have steadily fallen in value due to the Fed’s recent interest rate increases. This has made the banks’ assets quickly loose value relative to their obligations.
A bank’s obligations are its customers’ deposits, which brings us to the second factor that triggered the bank failures. An unusually large number of the defunct banks’ depositors had deposits in excess of the FDIC’s $250,000 deposit insurance limit. As the assets of the defunct banks fell in value, many of the large depositors lost faith in the banks and started pulling their money out. This created a crunch for the banks, so they had to sell their already stressed bond and treasury bill portfolios. Since these portfolios had lost too much value, the banks were eventually unable to make good on their depositors’ withdrawals and they collapsed.
Unrelated to the primary factors of the failures, the FDIC guaranteed the defunct banks’ risky loans and, in some cases, provided cheap loans to help facilitate the buyouts. This means that the buying banks were given unnecessary risk protection that the FDIC will eventually have to pay for. Since the FDIC is funded by fees it levies on member banks, the costs of the risk protection will be paid by the member banks. The member banks will then pass some or all of the costs to their customers. Since most US citizens bank with FDIC insured banks, we will be the ones paying the costs. Costs that are wholly unnecessary.
Worse yet, the FDIC is likely setting up another market crisis in the banking sector. By providing cheap loans and risk protection, the buying banks are able to take on extra risk that would not be advisable otherwise. The extra risk could lead to an old-fashioned debt crisis similar to 2007-2008. In the meantime, the FDIC’s support of big banks as smaller banks fail will lead growing numbers of high dollar depositors to move their money to big banks for the apparent security. This will further stress banks that have similar problems as Silicon Valley and First Republic, which we may already be seeing signs of today.
Surely, the FDIC does not intend to cause these problems, but its actions are leading that direction, nonetheless. It would be best for the FDIC to stick with its intended function of insuring depositors up to a stated limit and stop helping big banks get bigger. Growing the size and risk-taking appetite of the too-big-to-fail banks is a decidedly bad idea. We should support pro-liberty legislators that will reduce government intervention so that they can remind the FDIC of its intended, limited role.