It’s happened again. A bank has collapsed. And not just any bank but the 16th largest in the US. Yet there are still people who argue that banks can create ‘out of thin air’ the money they lend (and others who give the idea credence by using the phrase even though they accept that it couldn’t apply to an individual bank).
According to the thin-air school of banking, a bank’s business model is to lend money it simply creates and gets its income as the interest it charges on the loans.
This is only half the story. A bank’s income does consist of interest. However, unless it is a private bank — a polite, modern word for money-lender — and is lending its own money, it has to obtain money to lend from somewhere. One source is depositors but to attract savers a bank has to pay them interest. Banks also borrow money from other financial institutions on which they have to pay interest too.
In other words, a bank has to pay interest as well as receiving it. A bank’s actual business model is to obtain income from borrowing at one rate of interest and lending at a higher rate. Banks are financial intermediaries, not financial magicians.
The Silicon Valley Bank (SVB) was, as its name suggests, a bank based on accepting deposits from tech companies starting up. These would get money from some venture capitalist taking a punt on their success. The new company would deposit this in the SVB before spending it and topping it up with the next tranche of money from a venture capitalist. The SVB paid them interest on this and used the money to make loans, including to other tech companies, at a higher rate. They also held some of it as government and other bonds which could be converted into cash when needed.
The Federal Reserve, the US central bank, has, for various reasons, been putting up short-term interest rates. This had an effect on the SVB banking activities:
‘Silicon Valley Bank has been bleeding deposits as the Federal Reserve has aggressively raised borrowing costs to fight inflation. Higher interest rates bludgeoned many of the tech businesses that had deposited their money with the bank. As venture capitalists retreated from offering companies fresh infusions of capital to sustain their businesses, start-ups needed to burn through the cash in their accounts to stay afloat. Deposits the bank had on hand have fallen steadily over the last several months, according to S&P Global Ratings. Higher rates also meant more investments offered an attractive yield, leading some clients to pull out their deposits and put them elsewhere’ (politi.co/3yCOgtX).
With reduced deposits, the SVB no longer had enough money to honour all of its loans. It thought of raising the money to do this by selling off its government and other bonds. Unfortunately for it, one effect of rising short-term interest rates is to lower the price of bonds:
‘When banks run into trouble, they can be forced to sell off investment assets, typically US government debt and mortgage-backed securities, that they purchased to earn a return on their customers’ deposits. As interest rates climb, the price of those older securities fall — which means the banks sell those investments at a loss’.
The money raised from SVB’s sale of its bonds wouldn’t have raised enough. It was insolvent.
Its failure is a classic demonstration that banks cannot create money out of thin air. Otherwise why would losing deposits make any difference? If a bank was short of money, all it would have to do would be to conjure some more out of thin air, lend it and pocket the interest. No bank would need to fail. But they do.
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