Don’t forget that SVB’s depositors bear responsibility too

There’s been a vast discussion of Silicon Valley Bank and it’s failure over the past week. It has been of extremely high quality, and I owe great thanks to all those who have both produced and guided me to useful information including Frances Coppola, Dan Davies, Morgan Ricks, Peter Conti-Brown, and with my apologies too many others to name them all.

On the academic side of the discussion (but less so on the finance side), I see a tendency to dismiss the depositors’ role in the crisis. For example:

In fact, much of the current discussion expresses an extremely critical view of banking itself, including for example Morgan Ricks who views deposits as inherently government guaranteed and Matt Klein who writes “Banks are speculative investment funds grafted on top of critical infrastructure. This structure is designed to extract subsidies from the rest of society by threatening civilians with crises if the banks’ bets are ever allowed to fail.”

I do not rely on the current US (or European) banking structure for my model of banking, so I worry that these approaches risk throwing the baby out with the bath water — while at the same time acknowledging that especially in the US (with which I am more familiar) the current banking system is deeply corrupted by government guarantees leading to just criticism that it privatizes the gains and socializes the losses.

Banking, when it works well, always involves a remarkable balance of public and private risk-bearing, interests and power, and is a delicately structured coordination problem in which government, banks, non-bank businesses and other bank creditors all play a role.

The US, however, since the end of Bretton Woods, seems to be on a particularly dangerous path of using its monetary and financial system to gain power on the international stage — at the expense of slowly but surely eliminating the private risk-bearing capacity of the financial system itself by providing ever broader public guarantees to the ‘so-called’ private sector. The loss of the risk-bearing capacity of depositors with more than $250,000 in their accounts is just one more step along that path.

So let me relate some history in hopes of reframing the understanding of what banks are meant to do when they operate well. Consider the development of English banking in the years when banking spread throughout the length and breadth of the country, 1760 to 1824.

Bankers had unlimited liability and were typically well-to-do landowners, i.e. people with something to lose in the event of bankruptcy. Their clients were all in business — although after 1797 small banknotes could sometimes circulate at the retail level. During this period the number of English banks outside London grew from about 12 to 780 declining to about 550 just before the 1825 crisis (in which more than 10% failed).

The key to success in this foundational banking experience was that everyone understood the relationship between ‘depositors’ and their bankers. In the event that a well-run bank faced a liquidity crisis, the large merchants in the town where the bank was located would get together and announce their support for the bank. Why did they do this? Because as a contractual matter they were not depositors, they all had credit lines to draw at the bank, and they were only ‘depositors’ when their account balance was not in the red. They knew the importance of the bank’s credit lines to their local economy, and that their fortunes were closely tied to those of the bank. So it was a matter of course that they supported their local bank (Pressnell 1956).

The fact that each banker was a wealthy businessman with unlimited liability ensured that it was rarely non-bank creditors of the system who incurred the ultimate losses on a badly managed bank. (The exposure of other banks to a bad bank that forced them to bear the losses of a bad bank was a different matter.)

This culture of banking played a crucial role in government finance, because in 1797 when the Bank of England went off gold, it was a matter of course that it was able to assemble the London merchants and get their support. It was almost certainly because of its highly developed culture of banking that England was able to shift smoothly to a paper monetary standard in 1797 with minimal adverse effects on the economy — indeed to avoid adverse effects financial conditions became loose and the economy boomed for more than a decade.

While this model of unlimited liability banking with ‘depositors’ who understand the need to support a bank in crisis is a very idealized model of banking, it does make clear why banking exists: businessmen want to borrow money, and a well-run bank can support a much higher level of borrowing than an entity that does not fund using monetary instruments. Businessmen understand where their bread is buttered and therefore stand behind the bank.

(Note that this model of banking was wiped out in 1825. Monetary mismanagement of a government debt conversion caused the Bank of England to whipsaw the money supply, increasing it by more than 10% in October 1824, and more than reversing the increase over the course of the next 4 quarters. The costs of the crisis that ensued were borne by the bankers — even though true to the expectations of their day and the realities of the situation they faced, they stood by the Bank of England: when the government refused to permit it to go off gold, they accepted paper instead anyhow. After the crisis entry into unlimited liability banking collapsed. Those bankers who stayed in the business were very cautious about their lending. The economy did not thrive. The Bank of England was subject to intense Parliamentary scrutiny — and blamed the crisis on the bankers. Joint-stock banking was authorized and over time banking would be dominated by limited liability joint stock banks.)

This history does not provide any immediate solutions for how we address the current problems with the banking system, but it does provide a few reminders: 1. Depositors are part of the complex system that makes a banking system work. Is there any historical evidence that replacing them with government is a reliable solution?
2. With the knowledge of how the British capacity to issue debt was so closely tied to the banking system and the banking system’s support of that capacity, should we not worry that sovereign state capacity may also be part of a very complex equilibrium and that it might be better not to test the boundaries of that capacity?
3. And we must certainly ask, why did the depositors of Silicon Valley Bank, most of them closely tied to Venture Capital funds that should have been able to provide sophisticated financial advice, not do a better job of bearing risk? As the historic example above demonstrates, the answer definitely is not because bank depositors are never capable of bearing risk.


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