Silicon Valley Bank (SVB) and First Republic Bank (ticker symbol FRCB) recently failed as a result of a combination of unrealized interest rate losses from their long-term, fixed-rate assets and the loss of the low-rate deposits that had funded these assets. Longtime observers of the financial system will see a parallel with the 1980s thrift debacle in which approximately 1,300 savings and loans and savings banks failed, due in large part to their exposure to interest rate risk and their loss of the low-rate deposits that had been used to fund these assets. Both then and now, the interest rate losses on the decline in asset values were largely not recognized in financial statements or regulatory accounting ratios unless the assets were sold, leaving open the question of how the regulators should deal with depository institutions whose mark-to-market value of equity was close to or below zero.
In the 1980s, accounting gimmicks—such as creating net worth certificates to artificially boost reported equity—compounded the failure to force recognition of losses. To be sure, thrifts faced pressure to rebuild capital through the acquisition of higher-rate assets. Unfortunately, these higher-rate assets often carried much higher credit risk, meaning that thrifts' attempts to grow out of the losses often ended up only increasing them.
Similarly, in the 2022–23 period, banks faced no pressure to recognize the losses, and supervisors seemed willing to give banks time to improve their capital positions. Unlike banks in the 1980s, though, SVB and FRCB relied heavily on uninsured deposits. Their uninsured depositors realized that they might not take a credit loss if all of them continued to fund the banks with low-rate funding, although they would suffer substantial opportunity losses from receiving low rates on those deposits. If, however, enough depositors withdrew funds, then those who remained would face exposure to losses. To be sure, SVB and FRCB's assets had very little credit risk and so could be expected to be repaid over time and thus, these "unrealized losses would disappear over time" (see here
, here , and here 
for examples of such reasoning). Therefore, the thinking went, these banks need not have been closed if only the Federal Reserve had lent funds sufficient to cover the lost deposits.
Then as now, many economists analyzed developments from a public policy perspective. Two outstanding banking economists analyzing the developments in the 1980s banking and thrift industries were George G. Kaufman and Edward J. Kane. Two of their observations especially bear recollection as we deal with the current interest rate-related losses.
Kaufman addressed the argument that the problem was not so much the bad decisions of bank and thrift managers who took too much interest rate and credit risk. Rather, some observers argued, the problem was the actions of the depositors: if only they would have "faith" in their bank and not withdraw their funds, the bank could recover from its losses and the depositors would be made whole. To this assertion, Kaufman replied , "One of the major misconceptions the public has about banking is that one needs to have faith in his bank and banker," adding that "Nothing can be further from the truth! Faith belongs in churches; good assets belong in banks."
To be sure, a bank can become illiquid and fail if depositors "lose faith" even when the market value of the bank's assets exceeds that of its deposits prior to a mass withdrawal because its assets cannot be quickly liquidated at market value. However, Kaufman's fundamental point remains. If a bank has sufficient value in its assets, then it can borrow against them (including from the Federal Reserve) and wait for the funds to return when depositors see the bank is solvent. But if the bank does not have assets with sufficient market value, then why should depositors or any other creditors continue to supply it with funding—especially if the bank needs below-market-rate funding to have a positive interest margin?
Scenarios of this sort raise the question of why the insolvent thrifts of the 1980s were able to retain almost all their funding (deposits). The answer is that depositors were not relying on the ability of the thrift to honor its deposits but rather on the ability of the deposit insurer (implicitly backed by the US Treasury) to honor those deposits—which brings us to Kane's important insight (see here and here ). Kane observed that what prevented runs on otherwise underwater banks and thrifts was that the Federal Deposit Insurance Corporation implicitly substituted its equity capital for the shortfall in the capital supplied by the bank or thrift's owners. Moreover, the deposit insurer was not being rewarded for its implicit capital contribution and the risk that the depository will suffer even larger losses. Instead, all the rewards went to the depository's equity holders if the market value of equity subsequently exceeded zero.
Although history is not exactly repeating itself, it is rhyming. The regulators are not bending the rules to allow underwater banks to "grow their way out of trouble." However, as noted above, accounting and regulatory rules still require most of the losses to go unrecognized. The argument against forcing recognition is that interest rate losses on the asset side are offset by gains from paying low rates on deposits. However, as the 1980s and 2023 show us today, this strategy of relying on low-rate deposits to offset asset-value reductions works—until it doesn't. When deposits start leaving because of concerns about asset values or to get a higher rate of return, all that remains is the interest rate losses on the bank's assets. Thus, the argument against recognizing losses appears strongest when it is least important: when interest rate changes are relatively small as the deposits are less likely to leave. However, the argument is most likely to fail when measuring values accurately is most important, which is in response to large interest rate movements when depositors are likely to withdraw their funds.
Another way that history is not repeating but rhyming is the treatment of depositories with large interest rate losses. Although deposit runs forced SVB and FRCB into resolution, the (market value) losses started with rate increases in 2022, and the losses exceeded book capital by the third-quarter 2022's financial statements. Yet the banks did not become candidates for resolution until after their depositors started to run. Moreover, recent academic studies (see here, here, and here ) suggest that these banks were not the only ones that would have been critically undercapitalized or insolvent had they been forced to recognize their losses. Once again, it appears that the depositor insurer is being required to provide implicit capital while the owners of underwater banks retain the upside.
By Larry Wall, research center executive director of the Atlanta Fed's Center for Financial Innovation and Stability