I know bank runs.
In 1998, I was Director for Financial Advisory Services (FAS) for Deloitte & Touche in Budapest. FAS was the investment banking arm of Deloitte, and I had been chosen to lead the privatization of Hungary's second largest bank, Postabank. It was run by Gábor Princz, a short, squat man with a bad reputation.
Most Americans are not familiar with postal banks, but many European countries have them. These allow members of the public to deposit and withdraw cash at their local post office, handy for a country with thin banking coverage. As a result, postal banks are the most retail of all retail banks, true widows-and-orphans institutions, the place Hungarian retirees would go to collect their meager pensions in cash.
Postabank should have been a boring bank, but this was post-communist Hungary. One could hear on the street that "Postabank stands behind" such and such an entrepreneur. This would be truly bizarre posture for a commercial bank. You will never hear, for example, "Bank of America stands behind the Stop-'n-Shop." However, we might instead expect to hear that from a private equity or hedge fund. And that's exactly what Princz had done with Postabank: transformed it into his own personal hedge fund. Princz used Postabank to bankroll any number of dodgy characters, many of them with better political connections than business expertise.
As was the case with everything in Budapest, this was widely known and a cause for concern. The Socialist government of Gyula Horn was keen to privatize the bank. The problem was, however, that none of the Big Four accounting firms was willing to sign off on the bank’s audit. Well, none except Deloitte & Touche. Some senior partners at Deloitte had historical ties to the Socialist Party from way back in the socialist days. (There is a direct line from this to Russia's capture of Hungary's foreign policy, by the way.) Over howls of protest from the auditors, Deloitte certified Postabank's books. No doubt purely by coincidence, Deloitte was promptly awarded the mandate to privatize the bank.
I was chosen to be the privatization lead.
A week or two later, at 10 am on February 28th of 1998, I was at my desk when I saw a murmuring among my Hungarian staff, flurries of emails, and hushed phone calls. I naturally asked what was going on, to be told that Postabank was rumored to be failing and depositors were queuing to get their money out. By noon, it was all over. The bank had failed. In that two-hour stretch, Hungary had lost more than 1% of its GDP.
This colorful, if disastrous, story from post-communist Hungary is a tale of a classic bank run, of depositors -- panicked that bank management had lent their money to shady or uncreditworthy borrowers -- stampeding to withdraw their money.
This is not the story of SVB.
No one has accused SVB of reckless loans to bad clients. SVB did not and does not have a non-performing loan problem. Indeed, half of its deposits were invested in US government treasuries and agency-backed (government guaranteed) mortgage securities. Lending money does not get safer than that, and indeed, Investopedia notes that "the interest rate on a three-month U.S. Treasury bill (T-bill) is often used as the risk-free rate for U.S.-based investors." To all appearances, SVB set conservative lending standards.
So why the run on SVB?
It is a story of bad management, not at the commercial banks, but rather at the US Federal Reserve Bank and Treasury. The most important error was one of construction. The Fed believed that the pandemic downturn was the equivalent of the Great Recession and required a ‘go big’ policy. As Fed Chairman Jerome Powell saw it in October 2020:
"Too little support would lead to a weak recovery, creating unnecessary hardship for households and businesses. Over time, household insolvencies and business bankruptcies would rise, harming the productive capacity of the economy, and holding back wage growth. By contrast, the risks of overdoing it seem, for now, to be smaller. Even if policy actions ultimately prove to be greater than needed, they will not go to waste."
This view underpinned the Treasury’s decision to push the Federal Funds Rate (FFR) effectively to zero.
Only twice in the prior century had this happened, during the Great Depression and the Great Recession, with the FFR held at zero not for a few months, but for seven years at a time. Because both qualified as depressions, zero interest rates had virtually no effect on either asset prices or inflation. In the Great Recession, for example, home prices did not regain their 2006 peak until 2017.
But the pandemic was not a depression, but a suppression. This is the difference between Jimmy getting the flu and Jimmy being grounded. The economy was not sick during the pandemic, it was locked down. Imagine that the parents ground Jimmy and say, "Stay in your room, but here's $2,000 in spending money." It's clear that Jimmy would be in a mood to spend when conditions permitted. In the meanwhile, Jimmy contemplated what to do with easy money, and went out and invested in real estate and stocks. From Jan. 2020 to June 2022, house prices increased nationally by 45%, and this during a period when a chunk of the economy was shut down. Stocks similarly benefitted, with the S&P 500 doubling in value. But this was nothing compared to the tech stocks. Tesla's valuation, for example, increased 25-fold in less than one year. Unlike the Great Recession, zero interest rates exploded house and tech company valuations. This happened because the Fed and Treasury misunderstood the essential nature of the downturn. It was not a depression, and not even a recession by traditional metrics, as the economy bottomed in less than one quarter. It was a suppression, an external force -- covid and resulting lockdowns -- preventing the economy from operating. By mistaking the nature of the downturn, the Fed and Treasury vastly overstimulated the economy.
For SVB, this would prove the perfect storm. Soaring valuations led tech companies to raise capital and deposit the money in, well, Silicon Valley Bank. SVB's deposits quadrupled during the pandemic. But how should SVB invest the funds? Given rock bottom interest rates, SVB took a conservative approach and invested half of its funds in 3-month treasuries and mortgages guaranteed by the US government. SVB did not make unusually bad loans. No one has suggested that they did.
So what happened?
As it turns out, the action is all on the liabilities -- customer cash deposits -- side. As readers will recall, US Treasury Secretary Yellen and Fed Chair Powell assured the public as late as mid-2021 that inflation was 'transitory'. This faith was based on a rejection of the Quantity Theory of Money (QTM), which holds that the price level is a function of the quantity of money in the economy. This concept is best captured by the famous quote from the Nobel Laureate economist Milton Friedman, who said, “Inflation is always and everywhere a monetary phenomenon, in the sense that it is and can be produced only by a more rapid increase in the quantity of money than in output.” Alas, Friedman’s view had fallen out of fashion, most notably at the Treasury and Fed, giving Powell and Yellen the confidence to blow out the money supply by nearly 40%.
QTM would have cautioned that the price level should rise by near 40%, that is, that the US should experience inflation summing to 40% (less real GDP growth) over a period of, say, 2-4 years. Not so, said Yellen and Powell. At worst, inflation would be transitory.
This notion was not entirely unfounded. From late 2007 to just before the pandemic, increases in the money supply should have generated a cumulative 60% increase in prices. Instead, over those twelve years, the US saw only 20% inflation in total. However, that period saw the Great Recession (really a depression), as well as the rise of China and aging demographics in the US, with all this playing out over more than a decade.
By contrast, the Fed injected a massive amount of liquidity into the economy in 2020, with the resulting dynamics closer to those of the 1970s oil shocks. But even here the comparison is qualified. The second biggest injection of liquidity in the last sixty years came in 1971-1972. During a two-year period, the money supply grew enough to imply a 14% rise in prices. By contrast, in 2020, the Fed injected liquidity three times the 1971 precedent -- and all in one quarter! It is hard to overstate just how aggressive monetary and fiscal stimulus was during the pandemic. The result was persistently high inflation, leading to a change of heart at the Fed.
