Today (March 27, 2023) I awoke to the news that First Citizens Bank of Raleigh, NC, has purchased failed Silicon Valley Bank. As of December 31, First Citizens had 550 branches in 23 states with total assets of $109 Billion. Silicon, by contrast, had only 16 branches, all in California, with $209 Billion in assets, and was the 16th largest bank in the U.S. First Citizen’s stock rose 47% on the news, suggesting that investors thought this was a good idea. The ins and outs of this merger would require more than one volume, and I won’t trouble you with it here.

More to the point, though, is the question which is reverberating around the interweb this Spring, to wit, should banks be allowed to fail? That, of course, begs the question, what do we mean by ‘fail’?

It’s helpful for a minute to consider that a bank is a financial intermediary. It’s not a business, in the normal sense of the word, in that it doesn’t actually produce anything. It takes deposits and makes loans. That’s kinda it.

Now, consider the typical bank’s balance sheet. (I realize this is getting into introductory accounting, and I apologize if you need to google “balance sheet’). On the left hand side — the assets — there are primarily two things: cash and loans. You may not think of a loan as an asset, but the bank does. The bank has a loan to an entity and expects to be paid back. Banks are traditionally pretty good at figuring out what percentage of those loans will go ‘bad’. W-a-a-ay back near the dawn of human civilization, when I earned my MBA, traditional banks, like First Citizens, figured that out of an average pool of business loans, after thorough review and underwriting, about 2% would go bad. Hence, all of the loans paid an interest rate that was slightly higher so that the good loans provided, in essence, an insurance on the bad loans. Cash was held just to facilitate day-to-day business. For example, on Friday, a bank would like a lot of cash to handle paychecks. (This is also true at liquor stores. Go figure…)

An old joke from back in those days was the 3-6-3 rule of banking. You paid your depositors 3%, you charged your borrowers 6%, and you were on the golf course by 3pm.

Some of these ‘loans’ are actually bonds. Many of the bonds are U.S. issues, like treasury bonds and mortgage-backed securities. These are considered 100% safe, and the Federal Reserve can require national banks to carry certain quantities of these as part of the FED’s monetary policy, but I’m getting off base here. (Next time some university invites me to teach Advanced Money and Banking, you’re all invited to attend.)

On the right-hand side of the balance sheet there are liabilities. The uninitiated may consider this to be highly ironic, but ‘deposits’ are the primary liability. Banks sometimes issue bonds, but generally, the right-hand-side liabilities are commitments to depositors. Also, on the right-hand side of the balance sheet is the ‘owners’ equity’ (the net worth of the bank, equal to the book value of what the shareholders own). Hence, the sum total of the assets, on the left side, minus the liabilities (mostly depositors’ balances), on the right side, equals the book value of the shareholders wealth.

Sigh… now let’s get to the heart of the matter. A bad mix of stuff on the left side often causes bank failure. Cash-on-hand is worthless to a bank — it produces nothing, but just sits around in the tellers’ drawers to facilitate withdrawals. However, if depositors get scared that the bank is mismanaged, they may want to withdraw their funds and move them to a safer bank. Hence, a ‘run’ on the bank (the sort of liquidity crisis that brought down Silicon Valley) can require the bank sell assets (bonds and loans) at fire-sale prices to generate cash and keep depositors happy. That’s what happened in California. Silicon had made a conscious decision to invest in low interest rate assets (bonds and loans) and when interest rates rose, they had to sell those assets at a loss to satisfy depositors. Ironically, even if a bond goes down in market value, because of a rise in interest rates, if it’s a solid asset, it will probably eventually pay off at 100 cents on the dollar. (At this point, it would be handy to re-watch the movie “It’s a Wonderful Life”).

Historically, on the right-hand side of a balance sheet, most of the customers of depository institutions have balances under $250,000. If all of them did, and if it was an FDIC insured institution (as nearly all are), then a liquidity crisis or a collapse of some of the assets (as happened with mortgage-backed securities in the 2010 era) would result in the gub’ment stepping in, making good on all of the deposits, and letting the shareholders get wiped out. The FDIC and other regulators would assay the value of the assets, and sell them (essentially, sell the bank) to some institution which would service the depositors (that is, assume the liabilities) and collect on the assets as they matured. The shareholders would get wiped out. Welcome to capitalism.

However, in the 21st century, $250,000 caps on depository insurance are a thing of the past. For one, many businesses need huge depository balances just to provide day-to-day working capital. Payroll for even a medium sized business (say, 1000 employees) can run $1 million a week. I serve as treasurer of one small entity and on the investments board of another, and both have these problems with excessive cash-balance needs. Aggressive cash management can mollify some of the risk (say, rolling cash into t-bills daily) but for many small and medium entities, this just isn’t a good option. Historically, the FDIC has insured 100% of deposits up to $250k and provided some sort of de facto guarantee (often 80%) on deposits above that threshold. It was that latter risk that caused Silicon’s demise.

Should the FDIC insure all deposits irrespective of size? At that point, a bank’s liabilities become Federal liabilities, and we have effectively nationalized our banks. However, we end up there anyway, because to do otherwise would be to cause undue lack of confidence in our banking system.

These are not trivial question. If 100% of deposits are insured, then banks would, in effect, not be allowed to fail. However, there would be no yin-yang of risk/reward associated with being a bank investor.

Do I have an answer to this question? Nope, but it’s perhaps the overriding question in our financial system today.

John A. Kilpatrick, Ph.D., MAI — [email protected]