The Risks of Bailing Out Silicon Valley Bank’s Uninsured Depositors and How to Make the Banking System Resilient

On Sunday evening, the Biden administration decided that all customers of the failed Silicon Valley Bank will have their millions and possibly billions in the bank completely covered by the government far in excess of the $250,000 limit for each depositor under law. A parade of horribles had been presented over the weekend of what would supposedly happen if every depositor wasn’t made whole in a push by both progressives and wealthy investors.

The progressives made specific arguments about woke ESG-friendly businesses going under if a total bailout for depositors over the FDIC limit wasn’t put in place. On CBS’s “Face the Nation” on Sunday morning, following Yellen’s comments on the program that there would be no bailouts for investors and owners of SVB and lack of specifics on relief for depositors, Rep. Ro Khanna (D-CA) – whose district includes part of Silicon Valley – sounded the alarm by claiming that not giving “all depositors” protection and “full access to their accounts” by Monday would set back Biden’s legislative priorities of a Green New Deal-lite.

He proclaimed that “the companies that are doing the climate work, … all of them are at risk.” This would in term harm “all of the legislation we passed in Congress, the IRA [Inflation Reduction Act] to tackle climate, the CHIPS Act.”

The broader argument for the SVB depositor bailout and for proposals to hike deposit insurance to massive levels harkens back to the events of the Financial Crisis of 2008. Specifically, the pundits dredge up ghosts of that crisis, and scream that it’s the “Lehman Brothers moment.” The dominant narrative about the 2008 crisis is that because the government didn’t bail out Lehman Brothers, its collapse spread “contagion” throughout the financial system necessitating the trillion-dollar Troubled Asset Relief Program – begun in the Bush administration and continuing through the Obama administration — to bail out multiple financial institutions.

But for anyone who does not want to see history repeat itself – or rhyme – the real focus should not be the feds government letting Lehman Brothers fail in September 2008. Rather, the focal point should the feds coming to the aid of the much smaller Bear Stearns six months earlier in March 2008. Much evidence shows that it was that bailout itself that spread the financial market contagion.

Bear Stearns was the smallest of Wall Street investment banks. Yet when it experienced trouble from mortgage investments that soured in March 2008, government officials rushed to its rescue.  Treasury Secretary Hank Paulson – a Wall Street Veteran who headed Goldman Sachs just before coming to his post in the Bush administration – and Federal Reserve Bank of New York President Tim Geithner — who would replace Paulson as Treasury Secretary in the Obama administration – put forth $29 billion in government assistance to save it from bankruptcy in an arranged acquisition by JP Morgan. Geithner justified this bailout in his memoirs by arguing that “our fear was that Bear was ‘too interconnected to fail’ without causing catastrophic damage.”

Yet in retrospect, it’s actually the saving of Bear Stearns likely spread the financial contagion further. That bailout sent the message to big financial firms that they had a pretty good shot at a government bailout if they screwed up, so many of them took on more risk and avoided the hard decisions about restructuring and cutting costs.

There is debate about the extent to which the Lehman Brothers bankruptcy worsened the financial crisis, with some experts saying the economy was already in freefall and others saying later bailout missteps put the proverbial nail in the coffin. However, had it not been for the Bear Stearns bankruptcy, there is a good chance that Lehman may not have imploded or at the very least other firms and investors would have been much more cautious in dealing with it.

As former Fidelity Investments President Robert Pozen wrote in the Harvard Business Review, “If Bear Stearns was too big to fail, then many investors assumed that the Fed would bail out Lehman since it was twice as large as Bear.” Pozen and others have noted that Lehman Brothers CEO Dick Fuld reportedly believed this as well, and this is why he turned down an $18-per-share offer from the Korean Development Bank.

The Bear bailout also caused Lehman’s peers to be less prepared for hard times. As David Skeel, Professor of Corporate Law at the University of Pennsylvania Carey Law School, writes for the liberal Brookings Institution, “If regulators had not bailed out Bear Stearns, the consequences for Bear would have been unpleasant, but the markets and managers of troubled, systemically important financial institutions (“SIFIs”) would have known they needed to prepare for bankruptcy if they fell into financial distress.”

Unlimited deposit insurance would seem to have similar perverse incentives that would lead to greater risk. Even the wealthiest, most financially sophisticated individuals would have much less incentive to monitor what their banks were doing – by for instance, looking at private credit rating issues for the bank by firms such as Moody’s and Standard & Poor’s – if they knew the government were to guarantee any amount of money they put in a bank. With much less oversight from their largest customers, banks would have more incentive to mismanage their risks, particularly to please their political overlords through causes such as ESG.

Policymakers should now practice good risk management by weighing risks to the resilience of the financial system as a whole. Prudent banks suffering the fallout from SVB should not be punished by a flood of counterproductive red tape. The Consumer Financial Protection Bureau’s proposed price controls on credit card late fees and curtailing of optional overdraft services will sap revenue from community and regional banks working to maintain financial stability. And as I testified before the House Financial Services Committee last month, approval of financially sound new banks and credit unions is crucial for overall resilience in American finance, as ‘a lack of new entrants in the banking sector increases the chances a large bank failure could severely curtail the supply of credit and availability of financial services’. That in turn sets the stage for a continuing cycle of government bailouts.”