What Really Broke the Banks

The Fed, among others, is blameworthy. But the ultimate culprit is COVID-19.

When the Federal Reserve board last met, at the end of January, its main concern was whether it needed to continue hiking interest rates aggressively in order to bring down inflation. When it met yesterday, it had a whole new pile of concerns, including, most importantly, whether further interest-rate hikes would destabilize more banks and aggravate the mini banking crisis we’ve been living through since the failure of Silicon Valley Bank on March 10. Those concerns help explain why, even with inflation still high, the Fed chose to raise rates only a quarter of a point.

The fact that six weeks ago almost no one was talking about banks’ balance sheets, let alone bank runs, and today everyone is makes it seem as though this crisis came out of nowhere. But its true origins go back almost exactly three years, to spring 2020. The banking system’s current woes are in a real sense a product of the pandemic.

After COVID-19 hit the U.S., bank deposits soared. The pandemic-relief measures—including stimulus payments, expanded unemployment insurance, and Paycheck Protection Program funds—put more money in people’s hands, even as consumer spending fell. At the same time, businesses cut back sharply on spending and investment. The result was a flood of money into the banking system. In 2020 alone, according to the Federal Deposit Insurance Corporation, bank deposits rose by 21.7 percent, the largest increase since the 1940s. The following year, deposits rose by another 10.7 percent. At the end of 2021, total bank deposits were an astonishing $4.4 trillion greater than they’d been just two years earlier.

You might think that would have been a good thing for banks, because it meant they had more money to play with. The problem was that they didn’t have anything useful to do with much of that money. Deposits, it’s important to remember, aren’t capital invested in a bank’s business; they’re loans from depositors. For deposits to be profitable for banks, the banks need to reinvest the money.

Unfortunately for bankers, business demand for loans plummeted in 2020, owing to the uncertainty created by the pandemic, and demand recovered just slowly in 2021. And although the mortgage market bounced back quickly, there were only so many 30-year mortgages—which also happened to be at historically low interest rates—that banks could write.

Banks could have stopped accepting deposits, or started paying negative interest rates—actually charging customers non-negligible sums for having the bank hold their money. But they didn’t. So they ended up with huge piles of cash sitting in their virtual vaults, which they wanted to put to work.

The low-risk, and most sensible, strategy would have been to put most of that money into highly liquid, low-interest-rate short-term investments (such as Treasury notes). But that would have reduced banks’ interest income, and therefore their profits. Instead, a lot of banks put many billions of dollars into long-term bonds or safe mortgage-backed securities, which offered somewhat higher yields and had no risk of defaulting. As the headline on a November 2021 New York Times article put it, banks were “bingeing on bonds.”

This was not an especially lucrative strategy, but it seemed like the best of banks’ not-good options. As the subheading of that same article noted, banks “have little choice but to buy up government debt, even if it means skimpy profits.”

The strategy had one obvious downside: It exposed banks to a huge amount of what economists call “interest-rate risk.” When interest rates rise, the value of bonds falls. If inflation—and therefore interest rates—spiked, all of those low-interest government bonds and mortgage-backed securities were going to be worth a lot less than the banks had paid for them. But in 2020, and even in early 2021, that outcome seemed to almost everyone, including the Federal Reserve itself, very unlikely.

Banks, you might say, had been lulled into a false sense of security by years of low inflation and near-zero interest rates: They were operating on the assumption that, for many years to come, inflation would remain quiescent, and interest rates would stay low. Accordingly, banks made what now seems like an obviously foolish decision: taking hundreds of billions of dollars in deposits and putting them into long-term bonds yielding only a couple of percentage points. Now that inflation has returned and the Fed has jacked up interest rates, banks find themselves sitting on piles of bonds that are worth far less than they once were. As a result, their balance sheets are much weaker than they had previously appeared to be.

This doesn’t mean the banking system as a whole is in crisis. In contrast to the situation in 2008, when banks had made trillions of dollars’ worth of bad loans, the government bonds and agency-backed securities that banks own today are not in danger of default: Whoever holds them to maturity will get their money back. And the system as a whole is still reasonably well capitalized and has plenty of cash on hand. But individual banks, particularly those that, like the already failed Silicon Valley Bank and Signature Bank, took in lots of money from companies that now need cash and from depositors who will pull out their money at the slightest sign of trouble, are at risk. In turn, what regulators are obviously most concerned about is the specter of more bank runs, which can bring down even well-capitalized banks.

There’s plenty of blame to go around for this situation. The Fed was late in recognizing the risk of inflation, which has forced it to raise interest rates steeply over the past year. Banks, meanwhile, weren’t forced to buy long-term bonds: They chose to, because they were largely oblivious of the interest-rate risk they were running. And the banks that have already collapsed were especially reckless in the way they concentrated their business in the tech and crypto industries—seemingly with no thought of what would happen if the investment bubbles in those businesses burst. Finally, bank regulators did not do enough to intervene to force mid-tier banks such as SVB to manage their exposure better, something they’d neglected to do on their own.

Yet this is not just a story of bad decisions made out of greed or carelessness. It’s really the story of how the pandemic brought an end to the era of low inflation and near-zero interest rates, and how long it took for even savvy financial institutions to realize how much things had changed. The coronavirus outbreak, it turns out, was a colossal shock to not just our public-health system but also our financial system. We’re still feeling its effects today.