Nobel Laureate and bank run expert Douglas Diamond argues that the Fed’s choice to signal long-term low interest rates, and then suddenly reverse course by raising interest rates in response to inflation, is a major reason for the collapse at Silicon Valley Bank.
Last week, Silicon Valley Bank collapsed. The bank had experienced over a billion dollars in losses as their long-duration treasury investments lost value to rising interest rates from the Federal Reserve. Nobel prize-winning economist Douglas Diamond says the Fed’s interest rate journey, not the 2018 rollback of Dodd-Frank that eased stress test requirements for mid-sized banks, is to blame for the collapse.
Chicago Booth professor Douglas Diamond won last year’s Nobel Prize in economics for his research on bank runs. In a recent interview with ProMarket’s partner podcast, Capitalisn’t, Diamond laid out a clear case for why he believes the Fed is responsible for SVB’s collapse.
According to Diamond, the Fed had signaled to the public for some time that it would keep interest rates low for the foreseeable future. Indeed, in March 2020, during the Covid-19 pandemic, the Fed not only slashed rates but also made emergency funding available to keep the economy afloat. Last October, Diamond indicated in an interview with Fortune that “high deficits and zero rates ensure that inflation will eventually go up.”
It was during that low-rate era, particularly in 2020 at the beginning of the pandemic, that SVB received an influx of deposits, primarily from the tech sector, and put those deposits into long-duration treasury securities. Long-duration treasury securities carry higher coupons to accommodate the risk of increasing interest rates, but two years ago when interest rates were zero, these coupon rates were maxing out at around 2%, said Diamond during the Capitalisn’t episode. As long as interest rates remained low, these investments were reasonable. The Fed’s public communications conveyed this would be the case.
Diamond pointed out that even in the Fed’s 2022 stress tests, banks were not tested at treasury yield rates above 2%. Although SVB was not subject to a stress test, it likely would have passed under those parameters.
However, due to rapid inflation beginning in the middle of 2021, the Fed began raising interest rates quickly in 2022. Today, the effective Fed funds rate is 4.57%. This sudden reversal, which according to Diamond was not well-telegraphed by the Fed, is the reason that the market value of SVB’s securities began to plummet.
Who Saw This Coming?
Diamond did not address the fact that at some point, the Fed did signal that it was going to slow down the economy by raising interest rates. Presumably, SVB could have acknowledged this new reality and adjusted their securities holdings accordingly. Undoubtedly, there was a lack of risk assessment inside the bank for not doing so.
“In hindsight, what I would have done if I realized that there was a significant chance you’d have to increase interest rates, I would have gone and looked at the balance sheet of every single bank large, medium and small, and see how exposed they were to like five and six percent interest rates. And then encourage those banks to either use interest rate hedging and futures or swap markets or unload their longer term stuff so that you really could use the macro prudential regulation to keep the banks safe if you later had to raise the interest rates,” Diamond said.
And as Diamond warned in his October interview with Fortune, rapidly increasing interest rates could cause trouble for the financial industry: “One of the Fed’s reasons for existing is to promote financial stability…But when the Fed moves real and nominal rates around, that has a spillover effect on financial institutions and their borrowers that the Fed better not ignore. The Fed left rates too low for too long with no spinouts going around the track. Now, they have to ease on the brakes. But if they slam on the brakes, they will cause a crash,” said Diamond.
Prudential Financial Regulation
In the Capitalisn’t interview, Diamond said that monetary policy tools that address inflation and unemployment also affect financial stability, but that regulators often take offense, insisting that prudential financial regulation alone impacts that stability.
“Because they didn’t deal with [financial stability] with prudential financial regulation, I wouldn’t be surprised if the next interest rate increase is 0%. l’d be shocked if it’s half a percent,” Diamond told Capitalisn’t host Luigi Zingales.
Zingales, also a professor and economist at Chicago Booth, pointed out that if the Fed does indeed slow or stop rate hikes, inflation will go up again.
What the Fed Wants?
Diamond did not argue, although many do, that this kind of failure of poorly financed institutions is exactly what the Fed wants when it raises interest rates. Institutions and investors that have taken on too much risk are meant to fail when interest rates are raised. This is an uncomfortable but necessary part of slowing down the economy.
Why, then, did the regulators choose to create an emergency lending facility for SVB and other banks in similar situations? Diamond said that if the emergency facility was created to stop risk of widespread bank runs, then it was the right call by the Fed.
Although some have blamed the 2018 rollback of Dodd-Frank provisions for the collapse of SVB and Signature Bank, Diamond said that this was not part of the problem. The banks likely would have passed the stress tests anyway, given that they were not tested over 2% (remember we are now over 4%). In a piece for ProMarket, Chicago Booth professor Anil Kashyap also makes the case that Dodd-Frank does not address funding risks and therefore would not have prevented SVB’s collapse.
Articles represent the opinions of their writers, not necessarily those of the University of Chicago, the Booth School of Business, or its faculty.