In the previous post, I wrote about a few underappreciated aspects of banking panics in the wake of the Silicon Valley Bank collapse. Since publishing the post, the not-so-serious banking crisis seems to be getting serious.
First Republic Bank, which was experiencing a bank jog, found its white knight in Jamie Dimon. After frantic attempts, banking regulators were able to cajole J.P. Morgan into acquiring the almost-dead bank. By size, First Republic now has the distinct honor of being the second-largest bank failure in Amrika.
Other regional banks are experiencing wild stock moves as investors figure out the next domino to fall.
As the banking crisis metastasizes from a bruise to a pus-oozing wound, traders also seem to be struggling with banks with “Pacific” in their names. They can’t seem to figure out the good Pacifcs from the bad.
Since the last post, there have been several cool papers on various facets of this not a serious banking crisis yet. You might be wondering why this fascination with the not a serious banking crisis in America when I’m in India. As one random guy on the internet famously said, “It’s the dollar’s world, we’re just living in it.” If this not a serious banking crisis yet becomes more serious, it won’t matter if we’re in India or Tanzania—we’re all buggered.
The other thing about this not a serious banking crisis yet is that it has led to profound questions about banks, questions that are relevant in India as well. We Indians have been lucky that the Reserve Bank of India has been pretty good at handling banking issues throughout history, but that doesn’t mean we won’t have a serious banking crisis in the future (#AtmanirbharBharat🤞).
I’ve read all these papers several times. Since we’re living in a post-reading world of 60-second TikToks and reels and since turning 30+ page papers into 60-second financial performance art videos is a tad difficult, here are a few interesting highlights from the papers so that you don’t have to do disgusting things like read them in full.
It’s not your grandfather’s banking crisis.
What causes a banking crisis?
Well, obviously, the causes and context vary around the world.
Despite the differences between banking crises, there are surprising similarities across history. Looking closely, you can identify a common set of causes and factors in almost all banking and financial crises. Carola Frydman, a research associate at Northwestern University, and Chenzi Xu, Chenzi Xu, a research fellow at Stanford University, published a wonderful paper reviewing studies published in the last 20 years about banking and financial crises from 1800 to 1980.
In the literature review, they tease out the common characteristics of banking crises throughout history. The paper is also peppered with fascinating historical anecdotes that you will enjoy if you’re a banking geek. The one issue, as they note, is that most studies focus on banking crises in advanced economies, given the size of the banking systems and the easy availability of data. It’s sad that there aren’t a lot of studies on banking crises in emerging economies, but they include the available studies. What’s surprising is that a disproportionate number of studies focus on the Great Depression of the 1930s.
Stylized descriptions of past crises are helpful in understanding not just the crises but also the structure of financial systems. A case in point is the thousands of research papers and books that were published in the wake of the 2008 financial crisis. All the papers and books have done more to sensitize people about modern finance than anything else. The polarized views about the financial services industry are a sign of that.
The common characteristics of banking and financial crises.
Leverage increases financial fragility. Since 1800, all banking crises have been preceded by rapid credit growth and asset price bubbles (with apologies to Eugene Fama). Financial crises are more likely when there’s rapid credit growth for households and the non-financial sector. In 18 advanced economies from 1870 to 2020, there was a 36% probability of a financial crisis when leverage, as proxied by the ratio of private credit to GDP, was higher compared to a 22% probability with low leverage.
In the post-war period, there’s been an increased correlation between financial crises, asset price booms, and rapid credit growth. Not all leverage increases fragility. Higher leverage among households in the non-tradable sector leads to financial and banking crises than leverage in the tradable sector.
What causes leverage to build up?
Correlative evidence shows that prolonged periods of stability and low volatility lead to increased leverage and end with banking crises. This is the exact thing Hyman Minsky wrote about in his financial instability hypothesis: stability breeds instability.
Downturns with higher leverage following financial crises are much sharper and prolonged than regular crises. In crises with low leverage, economic stagnation is shallower, and growth returns to the trend by the end of the fifth year; this isn’t the case with crises caused by high leverage.
The level of public debt to GDP affects the subsequent recovery through the private sector’s deleveraging and the fiscal space of governments.
Additional reading: Do higher public debt levels reduce economic growth?
Much like the Silicon Valley bank failure, the social networks of depositors play an important role in the diffusion of information and the spread of banking crises. The popular notion that uninformed depositors are more likely to run doesn’t seem to hold. Banking panics in the UK in 1854 and 1857 show that both informed and uninformed depositors are likely to run.
On average, banks with higher deposit outflows and maturity mismatches pre-crisis are more likely to get into trouble. While banking crises get all the attention, shadow banks have been at the heart of several historical crises, but these entities are understudied.
As an aside, I'm fascinated by shadow banks and have written about them in two of my previous posts.
How crises spread
The geographical proximity of banks and interbank bank funding networks were key nodes for the propagation of crises. Emerging markets’ sovereign debt is a common vector through which crises spread internationally as forced fire sales create a vicious feedback loop. Hot money inflows into emerging markets also import financial instability. The other important node is overseas funding sources. This was the route through which the 2008 financial crisis spread to Europe. The European banks were funding themselves in the US wholesale funding markets.
Following the collapse of a major interbank lender in 1866 London, 17% of international banks headquartered there failed, many of which had to close their subsidiary operations abroad. Xu (2022) shows that these failures not only had a direct impact on the supply of credit where operations ended, but also that bank connections transmitted the heightened cost of credit in the London interbank market to other countries.
Crises are often transmitted to institutions that themselves were not exposed to asset value declines. For example, runs on trust companies—the shadow banks of the era—during the 1907 Panic were triggered by fears that a few trust company directors were involved in a speculation scandal that was unrelated to their corporate clients. Frydman et al. (2015) show that non-financial firms that had board interlocks with the most affected trust companies experienced worse outcomes. These affiliations alone can account for more than 18 percent of the aggregate decline in corporate investment in the U.S. in 1908. The effects were worse and more persistent for smaller firms, pointing to a potential role for asymmetries of information in aggravating the economic contraction.Banking Crises in Historical Perspective
Monetary policy stance is also an important determinant of the severity of crises. We saw this in the recovery of Europe and the United States after 2008. Europe pursued a policy of austerity and saw anemic growth, while the United States threw the monetary kitchen sink at the crisis and experienced relatively better growth—emphasis on relative.
Real economy effects
Financial crises lead to dramatic changes in people’s political choices. As I wrote in the previous post, they can radicalize people and lead to political polarization, jingoism, and xenophobia. The more pernicious effects of banking crises are the long-lasting scars they leave. Crises can alter people’s risk perceptions throughout their lifetimes, affecting everything from how they eat, and how they invest to the type of job they prefer.
While the short-run effects of banking and financial crises get all the attention, the long-run effects are far more harmful. Bank failures during the Great Depression of the 1930s led to a reduction in patents, harming innovation. The other interesting observation is that cities with continued credit access at the depths of the 1930s saw a reallocation of labor to higher-paying jobs and faster recoveries. On the flip side, credit contractions in the aftermath of crises depress real economic activity for a long time—the more severe the crisis, the longer the adverse shocks last.
Banking crises can also depress international trade, and the effects can linger for a long time. This was the case during the 1866 banking crisis, which started in London but spread globally through British banks, the biggest financiers of global trade.
The evidence on whether deposit insurance stabilizes banking systems or destabilizes them is mixed. Given the SVB collapse, maybe we’ll see more research on the topic.
This isn't part of the paper, but one of the interesting things about deposit insurance is that it played a key role in the rise of shadow banking or non-bank intermediaries. Since the deposit insurance cap is limited—it's $250,000 in the US and Rs 5 lakh in India—large cash pools like corporate treasuries, pensions, endowments, and others can't use bank deposits. They need an alternative to bank deposits. So capped deposit insurance led to the emergence of alternatives like collateralized repurchase agreements (repo) and money market funds. These instruments aren't regulated by the banking regulators and are prone to destabilizing runs. Nathan Tankus, who wrote about this, recently appeared on the Forward Guidance podcast to talk about it.
The SVB bailout led to loud and crass debates between the let the world burn libertarian anti-bailout crowd, the stop the contagion crowd, and the avoid another Great Depression pro-bailout Keynesian/Bagehot crowd. Historical evidence in the paper shows that timely interventions by central banks and regulators help arrest panic and stabilize banking and financial systems.
One of the earlier examples was the intervention of the Bank of Amsterdam. In 1763, a major bank failed and caused a credit crunch, and merchant banks were unable to roll over short-term credit. As credit dried up, the banks were forced into fire sales. To contain the panic, the Bank of Amsterdam expanded the range of assets eligible for collateral. This is not unlike the decisions by the Fed to buy mortgage backed securities (MBS) in 2008 and backstop the corporate and municipal bond markets in 2020.
A consistent theme across history is that as central banks learn from crises, they have become unhesitant to intervene and stabilize financial markets. The growing interventions of central banks have led to the topic of moral hazard becoming a permanent topic of debate among banking observers. The authors note that despite the concerns about moral hazard, there isn’t much quantitative evidence.
Early central bank interventions often targeted specific institutions and were in that sense more akin to specialized rescue missions than widespread liquidity injections. For example, when the Comptoir d’Escompte found itself in financial difficulties in 1889, the Banque de France promptly provided liquidity and ensured an orderly liquidation of what was clearly an insolvent institution (Hautcoeur et al., 2014). To counter moral hazard, the Bank applied severe and observable penalties to managers and directors
Where no central bank existed, lender-of-last-resort interventions were sometimes engineered by private organizations or prominent individuals. Prior to the establishment of the Federal Reserve, privately organized clearinghouses helped restore confidence in the banking system during American panics. The Panic of 1907 is a good example. The New York Clearing House provided loans to member commercial banks that had engaged in fraud and were experiencing runs. But “shadow banks” (trust companies) had no access to similar liquidity, and when the runs spread to them, panic ensued (Frydman et al., 2015). In the end, J.P. Morgan organized a series of timely rescues that were instrumental in resolving the crisis.Banking Crises in Historical Perspective
I understand that you have an attention span of 60 seconds, but I recommend skimming the paper in full.
The age of social media bank runs
As the Silicon Valley Bank saga unfolded, a curious narrative took hold on Twitter: Silicon Valley Bank collapse was the first Twitter-fueled bank run. If you read my previous post, you know how simple stories can spread rapidly.
Anthony Cookson, Corbin Fox, Javier Gil-Bazo, Juan Felipe Imbet, and Christoph Schiller published a paper showing how Twitter fueled the SVB bank run.
This paper presents comprehensive evidence that exposure to social media conversation about bank stocks amplifies classical bank run risks. Our empirical tests show that banks with a large preexisting exposure to social media performed much worse during the recent SVB bank run, particularly if they have large mark-to-market losses and a large percentage of uninsured deposits.Social Media as a Bank Run Catalyst
The Federal Reserve’s postmortem of its supervision of SVB also highlighted the role of social media in the demise of the bank:
Uninsured depositors interpreted SVBFG’s announcements on March 8 as a signal that SVBFG was in financial distress and began withdrawing deposits on March 9, when SVB experienced a total deposit outflow of over $40 billion. This run on deposits at SVB appears to have been fueled by social media and SVB’s concentrated network of venture capital investors and technology firms that withdrew their deposits in a coordinated manner with unprecedented speed. OReview of the Federal Reserve’s Supervision and Regulation of Silicon Valley Bank
The Cookson et al. (2023) paper led to a lively debate on Twitter. While most people used the paper to perpetuate hot takes that the paper confirmed their priors that Twitter caused the bank run, banking experts like Peter-Conti Brown, Frances Coppola, and George Selgin posted nuanced takes.
It also seems to me that this debate about whether Twitter caused the Silicon Valley Bank run is over a semantic difference or misunderstanding between “caused” and “fueled” or “contributed.” I don’t agree with the notion that Twitter caused the Silicon Valley Bank (SVB) run. Bank runs don’t materialize just because a bunch of loudmouths on Twitter decide to cause panic. The Twitter sentiment did play a role, but that isn’t the same as saying it caused it.
You could point out the GameStop and AMC Entertainment incidents about how social media mobs moved stock prices, but SVB depositors didn’t flee because the stock price was down. Moreover, the anecdotal evidence shows that the depositors were coordinating on WhatsApp, Slack, Discord groups, and on phone calls. All those things are unobservable. SVB depositors were savvy and informed; they monitored the bank’s fundamentals and fled when they realized it was beyond redemption.
To be fair, there have been historical instances of banking panic affecting sound banks, but that wasn’t the case with Silicon Valley Bank.
The way a panic unfolds can also inform models of bank runs. The failure of a savings bank triggered runs on the EISB in 1854. Although there was no evidence of insolvency, uninformed depositors were more likely to close their accounts (O Gráda and White, 2003). Once the panic unfolded, more sophisticated depositors joined in, consistent with selffulfilling runs without fundamental shocks to bank solvency (Diamond and Dybvig, 1983). Yet during widespread runs across the country in 1857, informed depositors were the first to run on the EISB. This latter case is instead suggestive that changes in bank health information in an environment with incomplete information, as in Gorton (1985) or Chari and Jagannathan (1988), may play an important role in diffusing financial instability.Banking Crises in Historical Perspective
I also loved this money shot by Gillian Tett.
However, the unpalatable fact is that even if all of these steps are implemented, it might still not be enough to stop the contagion arising from social media panics. So the final move that needs to be made is for governments to recognise that the only truly effective option to quell a cyber panic in a hurry is to backstop the system themselves, by protecting depositors.Wake up to the dangers of digital bank runs
The SVB drama suggests that governments will indeed do this — if needed. But that raises two more big questions: if the only way to quell a Twitter panic is for governments to backstop depositors, does that mean banks must become utilities? And, most crucially, will governments also backstop non-banks such as money market funds if they fall prey to a Twitter run?
Curse of specialization?
One of the criticisms of Silicon Valley Bank was that it specialized in catering to a narrow set of tech startups, and this concentrated business model played a role in its demise. This begs the question: is specialization uncommon, and is it bad? Kristian Blickle, Cecilia Parlatore, and Anthony Saunders analyzed the loan portfolios of 40 stress-tested US banks. They find that most banks develop a specialization in lending to certain industries and lend more to such industries.
The average bank invests 8% more of its portfolio in its most favored industry than a fully diversified bank. Moreover, banks have – on average – one or two preferred industries, in which they are over-invested to a significant degree. In all other industries, they are either not invested or invested in accordance with diversification expectations.
Moreover, banks have – on average – one or two preferred industries, in which they are over-invested to a significant degree. In all other industries, they are either not invested or invested in accordance with diversification expectations.
We can see that specialization is associated with differences in loan terms and loan performance. It appears that loans in favored industries are larger, with lower rates, have a longer maturity and – perhaps most importantly – are less likely to become non-performing. This would imply that specialized banks may have an advantage in selecting or monitoring loans in industries in which they have specialized.
More good stuff
Articles and papers
Videos and podcasts
An interesting premise worth pondering from the podcast:
Felix Salmon: I have a reasonably strongly held belief, I’m not sure about this, but I’m, you know, I believe it to be true that if Silicon Valley Bank and First Republic had been like credit unions or not publicly traded, that they wouldn’t have failed that it was actually the proximate course in both cases of the bank failure was the share price going down and the share price causing that erosion of trust in the institution, and I do worry that people are over extrapolating from volatile share prices.