I’ve received more emails and calls from clients on the failure of SVB Bank than I did on the stock market crash in April of 2020. That tells me there is wide concern today about the stability of the economy and financial markets.
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When you listen to politicians and pundits discuss the complexity of what went wrong, you can easily zone out. Here is what basically happens with a bank failure.
Banks make money by borrowing from customers in the form of short-term obligations like checking accounts, savings accounts, and certificates of deposit, then loaning that money on longer-term loans to borrowers. A short-term loan normally carries a low-interest rate, providing inexpensive funds that the bank can loan out at a higher rate. The longer the term of the loan, the higher the interest rate the borrower will pay the bank.
Suppose a bank loaned 100% of its short-term deposits out on long-term loans. If any holders of checking, savings, and CD accounts wanted to withdraw their money, the bank wouldn’t have any available. To avoid this, bank regulators require that a bank must keep a certain percentage on hand to meet the normal day-to-day demands of their customers.
Any bank will fail if all of the short-term depositors want their money all at once – known as a “run on the bank.” This is what brought down SVB, Signature, and Credit Suisse. It could bring down even more banks if depositors panic. It isn’t that the bank has no assets, but the assets are tied up in loans. So the bank is unable to access enough money to meet the demand for cash.
If a bank kept all its deposits in short-term investments, it would essentially be earning the same as it was paying customers on their short-term deposits. It would not make enough profit to exist. The key then for a bank is to balance the need to earn maximum profits through longer, higher-interest loans, yet keeping enough in short-term loans to meet unanticipated spikes in the withdrawal needs of their customers. The more a bank keeps in short-term deposits, the less it can pay its depositors in interest. Regulators and politicians are beginning to demand that the amount banks must keep in reserve be increased. The downside to this is lower interest rates for depositors.
Read the full article here by Rick Kahler, Advisor Perspectives.
