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Unpacking this week's bank panic

PIEN HUANG, HOST:

It's been quite a week in banking news, and if you've had a hard time following, you're not alone. So - so far, here's what's happened. Over the last week, two banks failed. There was Silicon Valley Bank, based in Santa Clara, Calif., and Signature Bank based in New York. So the U.S. seized those banks, and the Biden administration is guaranteeing all deposits from both banks without using tax dollars in the process. Still, the news is causing confidence in other financial institutions to fail. One of those was First Republic Bank, based in San Francisco, where fears of a bank run caused their global rating to get downgraded. That's led a group of its competitors to pledge $30 billion to keep the bank afloat and stop another failing.

These cascading events happened so quickly, and we wanted to take a step back and talk about what's happened and why and what happens next. So we've called David Wessel. He's the director of the Hutchins Center on Fiscal and Monetary Policy at the Brookings Institution. Welcome, David.

DAVID WESSEL: Thank you.

HUANG: So, David, in short, what has happened here? I mean, what was it that drove Silicon Valley and Signature Banks (ph) to fail? And why is First Republic Bank in trouble right now?

WESSEL: I think one of the basic causes here is that interest rates went up very, very fast. The Federal Reserve was a bit behind the curve in fighting inflation. It raised rates more than four percentage points in just a matter of months. And as one of the economists on Wall Street says, when the Fed taps on the brakes, somebody goes through the windshield, but you never know who it is.

These banks made a big mistake. They took deposits, which could leave at any time, and they put much of that money into long-term government bonds. The value of those bonds fell when interest rates rose. When the deposits left, they had to sell those bonds and they sold them at a loss. And this is a classic bank panic where it happens at one bank, and everybody says, oh my gosh, if it could happen to that bank, it could happen to my bank. So I'm going to take my money out and put it somewhere safer. And that's basically what's happened here.

HUANG: And from your perspective, I mean, was it an obvious mistake, or was that kind of just how business as usual goes?

WESSEL: I think it was a pretty bad mistake, and they should have known better. There's reports that the Federal Reserve's supervisors had warned Silicon Valley Bank that you need to be more careful about your interest rate risk. Banks have somebody called a chief credit officer. Silicon Valley Bank's left, and they didn't replace her for nine months. So there are lots of red flags here.

HUANG: Can you explain a little bit more about why the failure of these two banks has led to such turmoil in the financial world, despite them not really being very major banks?

WESSEL: You have to think of this as more psychological than financial. Let's say you have money in a bank, and let's say you have a lot of money in the bank, more than the usual $250,000 ceiling on deposit insurance. And you read in the paper that a couple of banks failed, and you discover that you have money at First Republic Bank, which had made some of the same mistakes. So you take your money out. And you tell your golfing buddy that you're taking your money out, and she says, if you're doing it, I should do it. So money is flowing out of banks that look a little vulnerable because people are afraid they're going to lose their money.

HUANG: But if people have less than that amount of money in a bank, it's always been insured by the FDIC, if it is a bank that's insured by the FDIC.

WESSEL: Absolutely. There is no reason for anybody who has less than $250,000 in the bank to do anything but go on along their weekend activities. Ever since the Great Depression, the Federal Deposit Insurance Corporation has protected small depositors, and there's absolutely no risk to people who have less than that money in the bank.

HUANG: What kind of impact is this having on the stock market at large? Like, how is this affecting everyone else who doesn't bank with these specific institutions?

WESSEL: Well, I think people are worried that, A, this isn't over yet, that there are more shoes to fall, and, B, this will inevitably hurt the economy. Every bank in America is just a little more cautious today than they were two weeks ago. And when all the banks get cautious, that means they make fewer loans, and fewer people can borrow. And that will hurt people who want to buy a house or start a business or something. So if you were worried about a recession two weeks ago, you're probably more worried now because what's called a credit crunch, when banks get reluctant to lend, can very much lead to a recession.

HUANG: And people watching this might feel some throwback vibes to the 2008 bank failures. Do you think that this situation might continue to spiral? Should people be worried about a continued domino effect?

WESSEL: I don't think this is over yet, but from what I see, it's not as bad as 2008. What happened back then was a whole lot of banks had made a lot of bad loans, mostly in housing, and so every big bank was in trouble. This is much different. We have some medium-sized banks that are definitely in trouble. There's definitely going to be some more caution from the banks, but the very biggest banks are still very strong.

HUANG: Do you think that this current situation might cause any long-term permanent changes in banking regulations? I know that that's kind of been a subject of debate about whether that was the problem here at hand or not.

WESSEL: There's a big debate about whether it was the rules, the regulations that were responsible for this or whether it was the quality of supervision, which is the practice of administering the rules and making sure that the banks are behaving. In my view, it was more about supervision than regulation, but I have no doubt there will be some new regulations as a result of this. And there will be more scrutiny on banks the size of Silicon Valley Bank because they had been exempted from some rules on the theory that, well, no bank the size of Silicon Valley could topple the financial system. Well, now we know that's not true.

HUANG: And looking ahead, what are you going to be paying attention to in the next week or several weeks ahead?

WESSEL: So there are a couple of things. One big one is what does the Federal Reserve do this coming week? Do they go ahead with plans to raise interest rates to stop inflation, which they think is still running too high, or do they take a break because they think that the financial system is so fragile they don't want to upset it? Secondly, what happens to the stocks of these midsize banks like First Republic and its competitors? Do they stabilize? Does somebody come through to buy these - one of these banks, which would probably be a good thing, or does the problem get worse? And third, while all this is going on, there's a whole separate crisis in Europe about a big bank in Switzerland called Credit Suisse, which has been in trouble for years. But this has made it all worse, and that's coming to a head as well. And if that goes poorly, that could rattle markets and rattle bank investors all over the world.

HUANG: That was David Wessel. He's the director of the Hutchins Center on Fiscal and Monetary Policy at the Brookings Institution. David, thank you for joining us.

WESSEL: You're welcome. Transcript provided by NPR, Copyright NPR.