When banks fail

  • Themes: Economics, History

The collapse — and bailout — of Silicon Valley Bank is part of a cycle of complacency, woven throughout banking history.

The run on the Northern Rock bank in September 2007.
The run on the Northern Rock bank in September 2007. Credit: Duncan Hale-Sutton / Alamy Stock Photo

The late Queen Elizabeth was, I think, the first to put it so succinctly: ‘It’s awful — why did nobody see it coming?’ she inquired while opening the New Academic Building at the LSE during the Lehman Brothers crash of 2008. Now Gillian Tett, the uncrowned queen of the Financial Times, has asked much the same question: ‘How could regulators have missed the risks at Silicon Valley Bank?’ Everyone in the business could see that SVB was sitting on a massive, unhedged portfolio of long-term Treasuries. Tett points out that, last year, J.P.Morgan had circulated to its clients shocking calculations of losses that, if realised, could wipe out SVB. Yet the regulators didn’t move a muscle.

We grope for explanations in such circumstances and devise high-sounding terms such as ‘confirmation bias,’ but most such rationales usually boil down to blind complacency. It is a complacency that seems to be congenital in the history of banking. In his essay Lombard Street  150 years ago, Walter Bagehot pointed out the extreme fragility of the banking system. Never had the ratio of cash reserves to bank deposits been so small: ‘a bystander almost trembles when he compares its minuteness with the immensity of the credit which rests upon it’.  But Bagehot goes on, we are good at finding ways of reassuring ourselves: ‘It may be said that we need not be alarmed at the magnitude of our credit system, for that we have learned by experience the ways of controlling it, and always manage it with discretion.’ But look at the ‘astounding instance of Overend, Gurney and Co. to the contrary’. Ten years before Bagehot wrote his essay, it was the best-known bank in the City. Now, in 1866, it was bust and its partners ruined; ‘and these losses were made in a manner so reckless and foolish, that one would think a child who had lent money in the City of London would have lent it better’.

Yet ten years on, the great collapse of Overends was already beginning to be forgotten. ‘Most men of business think — “Anyhow this system will probably last my time. It has gone on a long time, and is likely to go on still.” But the exact point is, that it has not gone on a long time,’ Bagehot writes. The memory of the City is so pathologically short. In former times, some merchant banks would keep on a few elderly directors into their 80s – at Warburgs they were known as ‘the Uncles’ – whose great virtue is that they were old enough to remember the mistakes that had been made in the crisis before last. Bagehot also points out the inherent dangers of a low-interest rate environment, very like the one we have enjoyed over the past decade or so. ‘The history of the trade cycle has taught me that a period of a low rate of investment inexorably tends towards irresponsible investment … People won’t take 2 per cent and cannot bear a loss of income. Instead they invest their careful savings in something impossible — a canal to Kamchatka, a railway to Watchet, a plan for animating the Dead Sea’ — or those cutting-edge, hi-tech start-ups SVB specialised in lending to.

And when banks totter towards the edge of the cliff, the last few panicky steps are always pretty much the same. Adam Smith in The Wealth of Nations  (1776) described with merciless acuity the collapse of the Ayr Bank while he was writing his book. This new investment bank had started off with such high hopes. The existing banks had been too ignorant and timid ‘[to] give a sufficiently liberal aid to the spirited undertakings of those who exerted themselves in order to beautify, improve and enrich the country’. The Ayr Bank had no such qualms. It lent like crazy to all and sundry. In no time, it was running out of cash and scrabbling to borrow and re-borrow far and wide. In a glorious simile, Smith says: ‘The project of replenishing their coffers in this manner may be compared to that of a man who had a water-pond from which a stream was continually running out, and into which no stream was continually running, but who proposed to keep it always equally full by employing a number of people to go continually with buckets to a well at some miles distance in order to bring water to replenish it.’ How this recalls the last days of Northern Rock and RBS — and more recently of SVB before its merciful relief.

Smith doubted whether the existing rules were enough to deter this reckless ‘roundabout trading’. To prevent banks from gambling with their customers’ money, there had to be a separation between the two types of banking: the sober retail business and the riskier investment branch. What Smith called ‘the obligation of building party walls’ was only rediscovered more than two centuries later after the collapses of our own dear banks.

Yet a few years after each panic and the erection of those walls, the banks and their political supporters start campaigning to be freed from these restrictions, which are said to be shackling economic growth. With these lovely low interest rates, where’s the risk in loosening the rules? The regulators themselves are lulled into an inattentive inertia. As Tett says, they are fighting the last war, still fretting over credit and liquidity, while failing to be alert to the risks to solvency, which inevitably come with a sharp rise in interest rates.

Those of us who don’t know much about banking may still be mystified by this myopia. After all, if we look at our own household budgets, we can see instantly how a jump in mortgage payments sends our personal calculations haywire. Margaret Thatcher was much mocked in her day for comparing the economic affairs of a nation to a family’s finances. But there are times when this homely analogy has its uses.


Ferdinand Mount