A Simple Solution to the Banking Crisis That No Country Will Implement

Though Silicon Valley Bank contributed to its own demise, the root cause of this crisis is the fact that private banks own government bonds. If they didn’t, then SVB would still be solvent.

Its bankruptcy was the result of the price of Treasury bonds falling, because The Federal Reserve increased interest rates. As interest rates rise, the value of Treasury Bonds falls. With the resale value of its bonds plunging, the total value of SVB’s assets (which were mainly Bonds, Reserves, and Loans to households and firms) fell below the value of its Liabilities (which are mainly the deposits of households and firms), and it collapsed.

Why do banks own government bonds? Largely, because of two laws: one that prevents the Treasury from having an overdraft at The Federal Reserve; and another that prevents The Federal Reserve buying bonds directly from the Treasury. If either of these laws didn’t exist, then banks in general wouldn’t need to buy Treasury Bonds, and SVB would still be solvent.

Neither of these laws are inviolable. As Elon Musk once put it, the only inviolable laws are those of physics—everything else is a recommendation.

The UK equivalent of the former law was broken during Covid, with the Treasury and the Bank of England agreeing to extend what they call the “Ways and Means Facility” which is “the government’s pre-existing overdraft at the Bank.” The use of an overdraft sped up the UK’s fiscal response to Covid (such as it was).

The US law only came into force in 1935. Before then, The Federal Reserve regularly purchased Treasury Bonds directly from the Treasury. “The Banking Act of 1935” banned this practice—though it too was ignored during WWII, and at various times until 1981. Marriner Eccles, who was Chairman of The Federal Reserve from 1934 till 1948, asserted that this law was drafted at the behest of bond dealers, who were cut out of a lucrative market when The Fed bought Treasury Bonds directly from the Treasury, rather than on the secondary market where bond traders made their fortunes:

I think the real reasons for writing the prohibition into the [Banking Act of 1935] … can be traced to certain Government bond dealers who quite naturally had their eyes on business that might be lost to them if direct purchasing were permitted. (Garbade 2014, p. 5)

Call me callous, but, given a choice between bond traders losing a lucrative gig, or the financial system collapsing, I’d be happy to see bond traders become rather less wealthy.

So, a simple solution to the current crisis—which was caused by The Federal Reserve itself, as its “hike interest rates to fight inflation” policy trashed the value of Treasury Bonds—would be for:

  • The Fed (and its equivalents) to buy all Treasury bonds held by banks, hedge funds pension funds, etc., at face value; and also,
  • The Deposit guarantee to be made limitless, rather than capped at $250,000; then in future,
  • The Fed should either allow the Treasury to run an overdraft, or it should buy Treasury Bonds directly from the Treasury.

If even just the first of those recommendations was acted upon, today’s crisis would be over. Banks would swap volatile Treasury Bonds at face value for stable Reserves—thus restoring the solvency they had before The Fed started to raise rates. Hedge funds, pension funds, etc., would swap Treasury Bonds for deposits at private banks—and those deposits would be backed by Reserves, rather than Bonds.

The second recommendation would mean that bank deposits—which can be huge, running into the billions of dollars for the largest companies—would be safe from any future banking crises. If they were going to be lost, it would take idiocy by the company or hedge fund bosses themselves, rather than idiocy by The Federal Reserve, or any individual bank.

The third recommendation would end the charade of pretending that the private sector lends money to the government when it runs a deficit. It would make obvious the reality that the government doesn’t borrow money, it creates money. Governments could focus on the important issue of how much money it creates, and for what purposes, rather than pretending that its spending is constrained by what it can borrow from the private sector.

So, why do I think that none of these easy solutions to the current crisis would be taken? Largely, because mainstream, “Neoclassical” economists are in control of our current system. They know nothing about the monetary system—or nothing accurate. They’ll fight against proposals like this, even though they would fix a crisis that they created themselves by not considering what interest rate hikes would do to the resilience of the financial sector that they are supposed to safeguard.

References

Garbade, Kenneth D. 2014. ‘Direct Purchases of U.S. Treasury Securities by Federal Reserve Banks’, Federal Reserve Bank of New York Staff Reports, No. 684.