The Domino Effect: How and Why Banks Collapse
RadioEd is a biweekly podcast created by the DU Newsroom that taps into the University of Denver’s deep pool of bright brains to explore new takes on today’s top stories. See below for a transcript of this episode.
Bank runs no longer look like that scene from "It's a Wonderful Life." The modern version carries some of the same functional pieces, but how it looks is different.
For this episode of RadioEd, Matt sits down with Maclyn Clouse of the Daniels College of Business to discuss the Silicon Valley Bank and Signature Bank collapses and how that banking crisis spread across oceans.
Maclyn L. Clouse, PhD, is a professor of finance at the Reiman School of Finance in the Daniels College of Business at the University of Denver. The Reiman School is the premier school of financial management education in the Rocky Mountain Region, and its program provides a strong foundation in financial theory as well as practical application.
Clouse’s primary areas of teaching are corporate finance, microfinance, and investment banking. For 30 years, he taught the Finance courses in the Executive MBA program. In addition to his traditional graduate and undergraduate Finance classes, twice a year, he takes students to New York for the Organized Walk Down Wall Street course, which was first offered in 1991.In June of 2016 and 2017, he took students to Brussels and London for a Financial Capitals of the World class.
He has also developed and presented customized financial management seminars for corporations such as US WEST, the Manville Corporation, Contel-IPC, Diner’s Club, Coast RV, Northern Indiana Public Service Company, Toshiba, Kaiser Permanente, Vail Associates, New Century Energies, OMI Inc., Galileo, Intrado, Cenveo, and First Data Corporation.
On many occasions, Clouse has been certified as an expert witness in court cases involving the valuation of businesses, small business management, and economic loss determination. Over three different time periods, he served Finance Department Chair/ Reiman School Director for a total of 25 years. He has a BA in Economics and Mathematics from Willamette University and an MBA in Operations and Systems Analysis as well as a PhD in Finance from the University of Washington.
Wall Street Journal: First Citizens Acquires Much of Failed Silicon Valley Bank
Wall Street Journal: Why Is Credit Suisse in Trouble? The Banking Turmoil Explained
New York Times: Risky Bet on Crypto and a Run on Deposits Tank Signature Bank
Emma Atkinson (00:05):
You're listening to RadioEd ...
Matt Meyer (00:07):
A University of Denver Podcast.
Emma Atkinson (00:09):
We're your hosts, Emma Atkinson ...
Matt Meyer (00:10):
... And Matt Meyer.
If I say the phrase bank run, you might imagine a scene straight out of "It's a Wonderful Life", with men in suits running down to the local depository to pull out all their cash and perhaps stuff it under a mattress. Black and white color grading with some old timey voices for good measure, a relic of a long pass world filled with analog banking and the gold standard. While the dressings of the situation might be a little bit different in modern day, the gist of it is the same. Instead of a besuited man, imagine a tech bro or broette, a puffer vest covering a dress shirt with just enough personality to be appropriate for the corporate culture. Rather than tearing down the street to the bank, he or she is pulling up a mobile app. In lieu of a mattress, folks are stuffing their money into different banks, funds, and securities.
The bank run that ultimately sank Silicon Valley Bank earlier this month, kicking off what has so far been a minor banking crisis, has its roots in the more modern environment. As its name suggests, the lender primarily served tech firms in northern California and was once valued at $212 billion. And while there's some debate around what exactly started the crisis, Trump era regulation rollbacks, poor risk management and SVB, and rising interest rates may have all played a role. The initial problems for the bank run started on social media. After rising interest rates drove down the bond market, unrealized losses started to pressurize the balance sheets of banks. Our best cloud tech entrepreneurs learned that SVB might not have the funds to cover all their deposits and that news spread like wildfire across text messages, slack channels, Twitter, and WhatsApp. Clients withdrew their money in waves and SVB's stock dropped by 60% when they attempted to raise capital to cover the losses.
By March 12th, federal regulators stepped in and closed SVB, promising to use emergency funds paid into by banks to cover the deposits, but this is only the beginning. Shortly thereafter, New York based Signature Bank folded, sparking fears of what Daniel's College of Business Professor, Maclyn Clouse, calls the domino effect. Clouse lays out the connections between SVB, Signature Bank, and the Credit Suisse crisis in Europe, which was resolved only after the Swiss bank, UBS, agreed to purchase Credit Suisse for $3.25 billion to prevent the bank's collapse. Even on the Monday before this podcast was released, SVB was purchased by North Carolina based First Citizens Bank at a discount facilitated by federal regulators. It remains to be seen if this purchase will shore up the spread of banking troubles worldwide.
Maclyn Clouse (02:38):
Yeah, the domino effect is the concern that if one bank fails because banks are so interrelated that it would cause others to fail, and that was certainly a big concern in the 2008, 2009 financial crisis and that's where the phrase too big to fail came up.
Matt Meyer (02:57):
Okay, so we have it domestically but does this jump shores? Does this impact go to other markets? Will it affect Europe and Asia and other places like that potentially?
Maclyn Clouse (03:05):
Well, we've seen that already with Credit Suisse, has now been affected and that was a surprise to see it jump across the ocean that quickly, especially because Signature and Silicon Valley were kind of niche banks. You didn't expect that it would've impacted Credit Suisse like it did.
Matt Meyer (03:28):
You call them kind of niche banks. With that, SVB is based in Silicon Valley, they deal with a lot of capital investors. Is there a difference because they're not necessarily broad consumer banks or when you say that what are you referring to?
Maclyn Clouse (03:40):
Yes, exactly. Yeah, that's correct, that they're not like a Wells Fargo that has a big retail base as well as business banking. Silicon Valley dealt more with the tech firms, the startups, the firms that were getting venture capital funding out there in the Silicon Valley. Signature had more things to do with cryptocurrency so they weren't really dealing with consumers, they were dealing with businesses and business deposits.
Matt Meyer (04:09):
I think most folks understand the concept of bank runs and that was an early part of the story in the days after SVB's collapse. I guess, how do these events impact the broader financial markets? How does this spill over to Euroized bank account or into our stock portfolios, for example?
Maclyn Clouse (04:26):
Well, the concern is that if depositors start withdrawing money, then what we saw is that the banks really don't have that much liquidity to satisfy all the deposits if everybody wanted their dollars withdrawn. And so that, we saw, is what ended up causing the failures when the banks had to sell some of their treasury securities to get liquidity, get the cash needed to meet the depositors' demands, and that caused them to fail. Their equity positions got down to the failure and the FDIC took over so that's the serious problem with the bank runs.
Matt Meyer (05:08):
You talked about it a little bit or at least mentioned some of the lack of liquidity. How much did bonds play into that? Because that was something you heard people talk about were bonds. When interest rates went up, the banks were kind of put under water by them. Are those two things tied together a little bit?
Maclyn Clouse (05:22):
Yeah, that's exactly it. The banks were actually doing the right thing with excess dollars. I mean, banks take money from the depositors and say we'll pay you this, until recently, very small amount on your deposits and then we'll lend those out as commercial loans and that's how we make our profit. Well, if you don't have loan demand, if loan demand is slowed down and you've got excess cash, then the bank is better off putting that into a treasury security and earning some rate of interest. It's considered to be safe from default. That's not a problem, people weren't worried about default. What people didn't think about was the fact that the Fed would do all these things to increase interest rates and when interest rates go up the price of those bonds goes down. So if you have to liquidate those bonds and actually sell it, even though you may have had a loss on the books but it was unrealized, the loss is only realized when you actually sell the bond and that's what these banks had to do to get the liquidity.
Matt Meyer (06:23):
This has spilled over into the larger banking industry in a couple ways. Stock prices have yo-yoed and now there are calls for increased regulation on these mid-size banks, potentially rolling back legislation from 2008. It's kind of a three-parter but what do you see happening to stock prices of banks long term and is it important to regulate these banks? Does it affect smaller banks at all?
Maclyn Clouse (06:42):
Well, right now the smaller banks are not too much of a problem because they don't have the big business deposits like these big banks have had, Silicon Valley had, and Signature had so the smaller banks are doing okay as long as we can keep the consumers from being fearful and making a run on the deposits. And, for most consumers, the $250,000 FDIC is going to cover most of their deposits. If you've got a joint account in you and your spouse's name, then that's 500,000 that is covered and that's going to cover most of the small people. The dollars are at risk from the failure deposits that are usually business deposits that are going to be over that amount.
Matt Meyer (07:36):
Do you think the stock prices of banks recover from this?
Maclyn Clouse (07:38):
Yeah, that's a great question because we've got so many things going on now that are impacting stock prices. There were some things that were causing markets and stock markets to be pretty volatile to begin with and then you now have the banking crisis, and so the bank stocks were going down in part because their profits weren't doing as well, they just didn't have the loan demand. That's one of the things that raising interest rates is going to do, it's going to reduce your loan demand, and when you start to see some of the firms decrease in employment, especially the big tech firms, then they don't need as much borrowing. They don't need to get more loans, and that's going to impact the profitability of the banks, which will have a negative impact on bank stock prices.
Matt Meyer (08:22):
To fully understand this crisis, you need to roll it back to 2008 when the Dodd-Frank Banking Legislation was brought in during the subprime mortgage crisis. The legislation did numerous things, but most important to this story is a requirement for banks with at least 50 billion in assets to undergo yearly stress tests from the Federal Reserve and maintain certain levels of liquid capital to help ward off failures. A decade later, president Donald Trump and Congress eased some of the credit restrictions attached to Dodd-Frank, with Trump proclaiming it, "a job killer." At the time, the Congressional Budget Office warned that easing restrictions would "increase the likelihood that a large financial firm with assets between a hundred billion and 250 billion would fail." Perhaps the most ironic twist of the story, one of the lobbyists for the rollback was SVB's chief executive, Greg Becker, who argued to Congress in 2015 that the thresholds were unnecessary and banks of SVB's size "do not present systemic risks."
A bank like Wells Fargo has its hands in everything but will this change the way Wells Fargo does business, a bank that deals mostly in general consumer accounts? Will this change the way the Wells Fargo of the worlds are regulated or the way it does business day-to-day?
Maclyn Clouse (09:32):
I think what's going to happen is regulators are going to try to take a look at something to offer more protection above that $250,000 limit. As I said, it sounds like it's a big limit and it is a big limit. As I said, it covers most of the consumers but when you start to get into problems where you're dealing with business deposits then 250 is a drop in the bucket for a lot of businesses.
Matt Meyer (09:59):
Quick side note here. The actions of the Federal Reserve, colloquially known as the Fed, always loom large on the economics of the United States. With the banking crisis sprouting alongside rampant inflation, they've had a particularly tricky balancing act in recent years. How much do interest rate hikes from the Fed, the labor market, and other kinds of more general economic conditions play into all this? Is it going to affect the way this plays out? Is it going to affect the way this is all regulated moving forward?
Maclyn Clouse (10:24):
Well, regulation is a good question because what we've seen is that there's a lot of evidence that, like many financial crises, there were red flags that someone should have looked at, someone should have been noticing that Silicon Valley Bank was having some risk issues. They were in a very risky position should anything happen with interest rates and someone should have been looking at that. Unfortunately, that side of the regulators is one side of what the Fed does. The other side is the side that's trying to increase interest rates to combat inflation, and if they'd talked to each other they would have said, "Hey, you realize don't you that if we keep raising interest rates there's a possibility that we may get some banks in trouble?" But I don't think anyone ever had that conversation and it should have happened.
Matt Meyer (11:15):
You can't entirely divorce these two aspects but, moving forward, how much of this is a financial issue versus a political issue?
Maclyn Clouse (11:22):
Well, there's a lot of political issue in there. The whole idea that curbing inflation is going to be done through monetary policy and through the Fed by increasing interest rates, yes, that will reduce some spending. But the other big thing that's impacted inflation has been the fiscal spending, the spending on the government sector, and the trillions of dollars that were spent during the pandemic, the trillions of dollars that Biden has spent since he was put into office. You can't really have one side of policy that's trying to reduce inflation by increasing interest rates when at the same time, on the other side of the fiscal side, you've got spending increases that's going to increase inflation. So it's hard to imagine how both those things together can get us down to the 2% inflation that Powell keeps talking about as a goal for the Fed.
Matt Meyer (12:20):
We touched on this briefly at the very beginning, but is this something that has the potential to be a financial crisis like 2008 or is this something that you think might be a little bit more manageable and a little bit more containable and at least generally a little bit more in control of?
Maclyn Clouse (12:38):
I think we learned a lot of things in 2008 and I think this is not as bad. 2008 was just a failure of a lot of bad loans. There were lots of loans that should have never been given and they defaulted, which was not a surprise at all when you look back at what was going on with all the subprime lending. This was not really mistakes of that nature. There's no subprime lending going on, it was just banks in a risky position that were subject to high interest rates.
Matt Meyer (13:12):
Is there anything else with SVB or Credit Suisse or the Fed or any of these other aspects that you feel is vital to understanding the complete picture of what's going on? Anything we haven't touched on yet?
Maclyn Clouse (13:21):
Well, I think what we're learning from this is that the regulation does need to be looked at. We need to recognize that their regulatory issues that we keep talking about, putting the banks through a stress test where you say let's see what would happen to the banks' financial position should this bad thing happen or this bad thing happen? Well, maybe we need stress tests for the regulations, to see whether regulations will work if this bad thing happens or we have the regulations in the right place and in the right manner to get us through the unexpected events.
Matt Meyer (13:58):
Earlier on this season, we had an episode on cryptocurrency that brought up testing on these situations and potential outcomes. With the big banks versus consumers, how does one go about testing this? How do you stress test bank runs or banking legislation? What do you do to make sure that this works?
Maclyn Clouse (14:13):
Well, you really set up just a lot of what if modeling where we say let's look at the bank's financial statements and let's assume that ... As an example, let's assume that 40% of their business loans all of a sudden go bad because of a bad economy. Let's see whether they could withstand that or let's see what would happen if 40% of their deposits ... There's a run on 40% of the deposits. What do they have to do to get the liquidity to do that? So you set up a lot of what ifs and, hopefully, those what ifs won't happen but if you set them to the extreme you see what kind of stress they can survive.
Matt Meyer (14:54):
And lastly, what can the future bankers and financiers kind of going through school right now, the younger folks that are getting ready to jump into this industry, what can they take from this whole situation? What will academics and students be looking at for this particular financial crisis?
Maclyn Clouse (15:07):
Well, there's a couple things. I think one thing that this suggests is that we may need some changes in regulators. There's always a story I like to tell is that when you look at the athletic events the referees are not the people that are the highest paid, the players are the people who get highest paid. Same holds true with regulation. Regulators are not the highest paid in the financial industry yet they are expected to be as fast and as quick and as smart as the game players, so there's certainly some need for regulation and careers in regulation. It might not be something that our students would want to get involved with but I think there's going to be some need for regulators and regulation.
I think the financial industry is still going to be a good place for careers, it's a good place to be in, we just need to recognize that, especially in this time when there's so many things going on, when you look at the economy with the Ukraine War, you look at the border issues. You look at the crime and all the things that are impacting the economy, and then you throw one more wrench into the mix and we say, "Oh, by the way, let's now put all the banks at risk because of what we're trying to do to curb inflation," it's difficult to understand the mix because it's a whole mix of things that have given us what we've got.
Matt Meyer (16:41):
Awesome, Mac, I appreciate your time and appreciate you sharing your expertise on this subject.
Maclyn Clouse (16:45):
Thank you very much.
Matt Meyer (16:48):
Thanks again to Maclyn Clouse, from Daniels College of Business, for diving into this new story as it unfolds. Tamara Chapman is our managing editor, and Débora Rocha is our production assistant. James Swearingen arranged our theme. I'm Matt Meyer, and this is RadioEd.