Following the collapse of Silicon Valley Bank earlier this month and the extraordinary measures taken by officials in Washington to set up an emergency fund to guarantee deposits across the U.S. banking system, we turned to three Dartmouth economists to make sense of the news.

Andrew Levin, a professor of economics; Bruce Sacerdote ’90, Richard S. Braddock 1963 Professor in Economics; and Eric Zitzewitz, a professor of economics, spoke to Dartmouth News last week about the downfall of the regional bank and what it says about the banking system and the broader economy.

All three stressed that the Federal Deposit Insurance Corp., established after widespread bank failures following the 1929 stock market crash, insures all deposits up to $250,000, protecting the vast majority of individual and many small business depositors.

The main problem for Silicon Valley Bank, with a large proportion of its business from West Coast tech industry and venture capital clients, was that many of their depositors exceeded that cap, so when concerns over the bank’s access to cash were raised, it triggered a race among high-wealth clients to withdraw their money.

“It’s called a run. A run means, get your money out the door before everyone else. You saw it in the movie It’s a Wonderful Life. When everyone gets worried about the bank and they all want their money, of course the bank can’t give it to everyone at the same time,” says Levin.

Some analysts have suggested that the tech industry culture financed by Silicon Valley Bank was itself a major factor in the run, Zitzewitz says.

“There was some talk about how venture capitalists had realized the bank may be in difficulty and told portfolio companies, ‘Hey you guys should all pull your money out,’” Zitzewitz says. “So this panic, if you want to call it that, may have been accelerated by this networks of venture capital firms and their portfolio companies.”

All three economists agree that the bank’s decision to invest a significant portion of assets in long-term government bonds was the primary source of the initial concern. Treasury bonds are safe in that investors will recoup their investment with interest, but only when they mature in, say, 10 or 15 years. In the short term, the trading value of bonds fall precipitously as interest rates rise.

Inexplicably, Silicon Valley Bank—which the Associated Press reported Sunday is being acquired by First Citizens Bank—was moving assets into long-term government bonds without offsetting the risk with other investments, or “hedging.” And they were doing this, Sacerdote says, even as the Federal Reserve began signaling its intention to raise interest rates to try to ease inflation.

“For a while they were spending money to hedge those bonds, and they were making a lot of money. Then they decided, ‘Oh, interest rates might actually go down, so let’s not hedge.’ This is just exactly what banks should not do. And this has ignited a host of fears among depositors and investors,” says Sacerdote, who has himself served on boards of small community banks.

“And it’s a regulatory failure, because the regulators are normally very on top of issues that are far more innocuous than this, and it’s a terrible management failure,” he says.

“This is called maturity matching. If banks are borrowing short term from depositors, they should lend short term, so when interest rates move they can raise what they can pay on deposits and they get paid more on assets—that’s maturity matching,” Sacerdote says.

Containing the contagion

With the collapse of SVB, regional bank stocks dropped sharply, erasing millions and millions of assets in financial institutions around the country, and investors and analysts began scrutinizing the asset matching at banks big and small, Zitzewitz says. As regulators stepped in to take over SVP, market alarms and the flight of depositors at New York-based Signature Bank, primarily focused on real estate investments, prompted regulators to seize that institution. In an effort to stop the “contagion,” the Fed, the FDIC, and the U.S. Treasury announced a fund to pay all depositors, at SVP, Signature Bank, and any future troubled bank, in full.

The move calmed markets, and seemingly stopped any cascading failures, but analysts and investors have stepped up the “due diligence now being undertaken with respect to every bank that might have SVB’s issue with short/long-term deposit/asset term structure mismatch,” says Zitzewitz.

“How extensive the Fed’s guarantee to depositors is, remains to be seen, and the extent to which they will end up having to extend that guarantee to lots and lots of other banks, making it ever more expensive, also remains to be seen,” he says.

Meanwhile, the Fed, which both sets interest rates and oversees the banking system, has a new consideration to weigh as it sets interest rates, says Levin, who worked at the Federal Reserve Board for two decades. It was the rapid increase in interest rates to counter inflation that stressed these banks in the first place.

“In many countries, the agency that regulates the banks is totally different from the central bank that sets the monetary policy,” Levin says, but in the U.S. the Fed essentially does both, leading to a heated debate about whether the Fed, at its March meeting, would hold rates steady after eight consecutive increases. Ultimately, Fed Chair Jerome Powell announced on March 22 another quarter-point increase, but signaled that the hikes might end sooner.

At the root, the Fed is trying to instill confidence, Levin says. So showing resolve in combating inflation, while giving a nod to concerns about the banking sector and demonstrating that there is no cause for panic, is the goal. No simple trick.

“Powell’s goal Wednesday was to make minimum news, to not move the markets. Part of the reason for being vague—just vague enough—is so that people will hear what they want to hear. That’s the whole idea,” Levin says.

The question remains, Sacerdote says, why would SVP position its assets in a way that was so wildly out of line with fundamental banking practices. He also points to problems at FTX, the cryptocurrency exchange that collapsed in February amid fraud allegations.

“Why would an intelligent person do that? ” Sacerdote asks. “At the heart of most of these financial crashes is people just being crazy, and greedy, and doing things that we know ex-anti and ex-post, you should never do,” Sacerdote says.

“In fact, that deserves its own college class. This is exactly what we want to teach Dartmouth students to not do.”