What a year!

It has flown by but we have reached the year milestone since the collapse of Silicon Valley Bank.

Why cover such an unpleasant milestone? Especially when, hopefully, it is firmly in the past?

A few reasons:

• What has changed.

• What hasn't.

• The sticky spot that the Federal Reserve and the broader financial system increasingly finds itself in as it underwrites more and more of the banking system.

On the first point, one of the reasons to mark this anniversary is simply the fact that it can be a useful reminder for just how much can change in a wild 12 months. Time flies!

Last March/April, as the banking system creaked and people were stunned to watch their neighbors line up outside their neighborhood banks it might have seemed insane to think the market could end the year up over 20% and then truly take off in 2024.

We will admit to being nervous last spring! And as we wrote at the time, it was difficult to envision markets heading higher from the ruins of the American regional banking system but, provided the entire system did not go down, we thought things would hold.​

The reason for that (cautious) optimism is was for a very simple reason: we are well aware of the power of the Federal Reserve's ability to act as a lender of last resort.​

From one perspective, there is nothing to earth shattering about that. The Federal Reserve has played that role for well over a century now, after all.

But often during financial panics that long track record can get bizarrely lost. Humans panicking is not a good condition for careful consideration.

Additionally, it is simply very difficult to remember, after a decent interval, just how much power some of the grey and boring sounding institutions (and their appointed leaders) have in Washington, DC. It is one thing to know that theoretically it is another to watch it take place.

The reason that institutions like the Federal Reserve system and the Treasury are so powerful is they can underwrite the entire financial system, if they chose to. They also have unlimited firepower.

The US central bank used some of that firepower in the Spring 2023 and the current situation is the direct result. The banking system and therefore the economy was saved.

That changed history in the sense that the banking panic and follow on credit crunch didn't really happen or it did happen but was very brief and truncated. That was a huge positive. One possible version of 2023's history was halted in its tracks.

But in other respects, history marches on!

This brings us to the second point which is to say that, yes, much has changed in the macro environment since March, 2023 - and a lot of that was as a direct result of the Federal Reserve's interventions.

But that the vulnerabilities we outlined last year are still very much present. In fact, from one perspective it seems like we may have learned nothing from Silicon Valley Bank's collapse.

That is the flipside of forgetting the central bank's power. Often after the power of the state has been deployed we sigh with collective relief and then quickly forget what got us in trouble in the first place.

Both of these tendencies are very human. They are also concerning.

That is because regional banks are still very vulnerable and there is no evidence that we won't fall into the trap of Spring 2023 all over again.

And that reality isn't really new either. In fact, as the video we included in the introduction made clear, this is srto of the ever present human condition when it comes to finance.

Here it is again:

It is often forgotten these days but the whole reason we have a central bank was the inability of the US financial system to self-regulate. In fact, there were nearly a dozen US banking panics in the century which led directly creation of the Federal Reserve system after the nearly cataclysmic 1913 panic.​

This introduced the idea of a government lender of last resort to backstop the financial system for the first time.

Unfortunately, the system as it was first created was pretty flawed. This became very apparent in the Great Depression when endless bank runs and distress associated with a banking system that operated without deposit insurance.

The Federal Reserve eventually overhauled itself to act, perhaps for the first time, as a truly lender of last resort and in doing so saved the banking system and perhaps the country.

Innovations like deposit insurance meant that bank depositors knew that some amount of their capital was safe and backed by the US government.

But even that didn't bring the end of bank runs.

A brief postwar history might look like:

• 1970: problems with US shadow banking required significant central bank intervention.

• 1974: a failed bank had to be wound up.

• 1984: savings and loan crisis - dozens of banks in trouble.

• 1987: the stock market crashes and the Federal Reserve has to step in and pump in liquidity.

• 1998: the central bank had to step in to help manage the collapse of Long Term Capital Management.

• And then of course the 2008 Great Financial Crisis that truly underlined to nearly everyone that the financial system cannot operate unsupervised whatsoever.

• And then of course both Covid and March of last year which was, in many respects, the echo of the pandemic's distress.

The issue is that each time the US central bank takes on more power and extends itself over more deposits and institutions. This saves US banks and the wider financial system but also has had the extremely negative but direct side effect of the US government backstopping more and more of the financial system.

Now here we are. Until this week and the symbolic anniversary of SVB's implosion no one was talking about the American banking system and its vulnerabilities. But, as we tried to detail last week], we are actually still living with the consequences of those collapses and also, the countermeasures taken to wind up those disasters and save the wider system.

Furthermore there is the issue that regional banks are still extremely vulnerable. The issue that brought down SVB, interest rate risk, is still very much a threat to the US banking system.

In that sense, nothing has changed. We are still operating in "business as usual" mode.

This brings us to the third point: the remaining challenges from last year's heroic actions to once again save the financial system from itself.

Because, when you get into the weeds a bit, the central bank and the US Treasury actually did make some interesting changes and ones with possibly unpleasant consequences down the road.

There are three big innovations, in our assessment:

1. The first is that, for the first time in a rescue, the Fed took government bonds at face - not market - value. That means that they were taking on collateral that they knew was worth less than they were guaranteeing.

2. This leads to the next change which is that the US central bank was exposing itself to losses on securities it knew could decline further in price.

3. The third is that the central bank essentially made some insolvent banks whole and let others fail. By picking winners and losers it made an example of some and let others off a very nasty hook. It did so by a few routes but most especially by introducing a credit program to help banks only after a few others went under.

There are uncomfortable implications for each of the above points. The biggest one might be that it has encouraged moral hazard to run wild. What depositor, large or small, will fear being uninsured and therefore acting irresponsibly with their capital?

This is less a problem for Jill-six-pack and more for the large accounts of the very rich and corporations. These are precisely the types of clients that should know better.

On this theme, there are also unpleasant questions about the political connections and wealth of some of Silicon Valley Bank's largest and supposedly sophisticated account holders and depositors?

“Available evidence indicates that major corporations, with hundreds of millions of dollars in deposits, were the main holders of large uninsured accounts and were the major drivers of runs in 1984, 2008, and 2022-2023,” detailed Jonathan Rose, a senior economist at the Federal Reserve Bank of Chicago.

“In comparison, household and small business depositors appear to have played a limited role.”

Oh.

Does anyone truly feel that uninsured depositors would have been treated so kindly if the bank was in the Ozarks or Appalachia? What does it say about a regulatory system where those the most able to pay for their mistakes are the most protected due to political, as well as economic, power?

Finally, the Federal Reserve quietly crossed a big bridge last year. It went from being the lender of last resort to guaranteeing, if only for a moment, the whole US banking system and doing it for a bank who's wealthy and powerful customers actually would have been just fine if the bank was wound down.

Remember, the bonds that SVB held had lost value but most estimates had them down 8-10% and so most depositors would have, in the worst possible scenario, have lost only a small percentage of their capital.

The US central bank became not just the lender of last resort last spring. It became the guarantor of first resort and did so first and foremost for the wealthy and the sophisticated. These actions may also be directly in the historical track record of the central bank but that doesn't make them not a shame.

That isn't just a shame. It is also a mistake.

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