A Classic Bank Run

A Classic Bank Run

By now you’ve likely seen the headlines or done some deeper digging into the recent collapse of Silicon Valley Bank (SVB). As of Sunday, March 12th the Federal Reserve (Fed), in coordination with the US Treasury and Federal Depository Insurance Corporation (FDIC), has implemented a new program to provide liquidity to the broader banking system in response to SVB’s failure to meet the massive withdrawal requests of its depositors.

The collapse of SVB was the result of a classic bank run. Banks make money by “borrowing short” and “lending long”. Short-term borrowings are brought into the bank from depositors. Banks then turn around and lend those deposits back out to other borrowers, typically into investments that have a longer time-horizon. In a bank run, banks can be forced to liquidate these longer-term loans and investments to meet abnormally high withdrawal requests from depositors. When that occurs, the bank may be forced to take losses on otherwise fine investments.

For example, even though a bank knows that a 10-year US Treasury Bond will come due at its full face value when it matures in 10 years, it could trade today at a deep discount to its purchase price if, as has been the case over the past year, interest rates have moved up sharply since the bond was originally purchased.

If enough depositors force a bank to take enough losses, the bank may become insolvent. A bank could also just make bad investments, but in a bank run it is usually the forced liquidation of investments at low prices that creates the insolvency.

To try and head off a cascade of bank runs, the Federal Reserve has implemented a new program – the Bank Term Funding Program (BTFP). The BTFP allows banking institutions to borrow money from the Federal Reserve by pledging qualified assets (like US Treasury Bonds and Mortgage-Backed Securities) as collateral at par value (or full face value) in exchange for cash. Effectively, the banks will not have to sell investments at a loss to access liquidity. This program has been put in place for one year.

In theory, BTFP will help relieve depositors’ fears about future bank runs.  And if successful, then banks will not have to rely on borrowing cash through this program at the Fed in the first place.

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