The collapse of the Silicon Valley bank could trigger the next financial crash – but we can’t bail out failed bankers again

Depositors cannot withdraw their money. Payrolls could not be met next weekend. And small businesses, especially in the fast-growing technology industries, could soon face closure as their assets are frozen. Nervousness will be high when financial markets open Monday morning following the collapse of the US Silicon Valley bank and the Bank of England’s decision to take control of its London branch.

In fact, this is more than justified. There is a real danger of a full blown bank run. Central banks must act quickly and decisively to prevent the situation from spiraling out of control. And yet they must learn the lessons of 2008 and 2009, the last time the financial system was in such trouble. Depositors should be protected. But bondholders and shareholders should be left to their own devices. And, just as important, there should be no return to the easy money of the last decade. Otherwise we have learned nothing from the crashes of 2008 and 2009 – and risk repeating all the mistakes of last time.

If anyone thought we could get out of 10+ years of near-zero interest rates, unlimited amounts of printed money, and double-digit inflation without pain, they’ve just had a very rude awakening. Over the weekend, the Silicon Valley Bank had to close after what seemed like a very old-fashioned bank run. Amid jitters about the losses it’d suffered on its bond holdings, clients, in this case mostly tech companies, rushed to cash out.

Once it starts, it’s almost impossible to stop. The US regulator, the Federal Deposit Insurance Corporation, took control on Saturday morning. Anyone with cash in the bank can withdraw up to $250,000. Over this side of the Atlantic, the London branch of SVB is going bankrupt. Depositors will be protected up to £85,000, with the rest being offset through asset liquidation where possible.

The story goes on

The Markets will be nervous when they open on Monday morning, and rightly so. This is the worst bank failure since 2008 and we all know what happened back then. Equally worrying is that this is due to a series of “accidents” in the financial system.

In the cryptocurrency space, where perhaps the most extreme risks have always been taken, digital bank Silvergate ran into trouble last week, and of course it’s only been a few months since the FTX exchange crashed spectacularly. Likewise, last autumn in Britain, the LDI crisis exploded in the wake of a disastrous mini-budget, threatening pension funds with huge losses and forcing the Bank of England to step in with emergency liquidity to keep them afloat (and, coincidentally, the government of the unfortunate Liz truss as collateral damage).

Each breakdown can be explained on its own. But they all have a common denominator. In the background, central banks, led by the Federal Reserve, have been rapidly raising interest rates and scaling back, and in some cases even reversing, quantitative easing. The era of easy money came to an end. The result? A collapse in bond prices. This caught the SVB with enormous losses in their portfolio. It hit pension funds with LDIs assuming bond yields would never rise. And the outflow of liquidity and the return of real returns on real assets like treasury bills caused the price of weaker alternatives like bitcoin to plummet, triggering the FTX crisis. The circumstances were different. In any case, the tightening of monetary policy was the root cause.

Will it spread? That will be the big question for everyone on Monday and the rest of the week. The answer will depend on how quickly and decisively central bankers calm the nerves and show they have learned the lessons of the last major crash. In truth, it won’t be easy.

There used to be an easy way out. The Fed, Bank of England and European Central Bank could announce an emergency rate cut and pump a few hundred billion additional liquidity into the system. Ben Bernanke, the Fed chairman at the time of the last crash, or Alan Greenspan would have done that. Bond prices would go up and the banks would have extra cash, and that would solve the problem. This time, with inflation already spiraling out of control, that’s simply impossible. Lowering interest rates and printing more money now would guarantee hyperinflation, with dire consequences for any developed economy.

Instead, they really only have one option. Depositors must be protected, if necessary with public funds. When you have money in the bank, you need to be able to get it out. Anything else guarantees an outright betrayal of trust in any form of financial institution and very quickly in fiat currencies as well. But unlike in 2008 and 2009, the banks themselves are to be closed. When bondholders and shareholders lose their shirts, that’s just bad luck. We cannot go back to saving failed bankers again. More importantly, we cannot go back to easy money to paper over the cracks in the system. A decade of that was more than enough.

It’s going to be a high-wire act that will take a lot of skill to pull off. The Fed is fortunate to have the highly experienced Jerome Powell at the helm, well into his second term, and if anyone can calm markets, he can. It’s less fortunate to have the unfortunate Joe Biden in the White House. If anyone can make a mess of this, they will.

Similarly, Rishi Sunak, who has a background in banking, will be aware of the risks that need to be managed, but Andrew Bailey was useless as Governor of the Bank of England and could easily pass that test. Can politics restore confidence in the markets and prevent bank runs while continuing the fight against inflation? Only possibly. But as the Duke of Wellington might point out, it’s going to be a very close affair – and no one would expect it to succeed at the moment.