Banking Conversations

With last week's failure of Silicon Valley Bank (SVB), I have answered many questions about the security of money held in banks. While

I am not a banking professional and

I don't feel qualified to discuss here what happened at SVB, what I have realized is that most people don't truly understand how banks operate.

Yet because this has been the topic of so many conversations over the last week, I felt the need to at least provide some insight.

In my research for this piece, I consulted quite a few resources, of course, but I have gathered a list of terms relative to the current situation and thought a bit of explanation might be helpful. We're hearing these thrown about in the news, but do we understand them?

Bank run – A bank run occurs when too many bank customers request their funds from the bank at one time. Think about George Bailey in “It's a Wonderful Life.” Banks, as most people know, don't literally hold your cash on hand. They take my money and lend it out to others for a premium cost, then return a tiny bit of that cost to me for my allowing them to use my money. No bank typically holds enough in reserve to actually cover all their customers' deposits, so a fear of insolvency – either real or imagined – can become a real thing.

Bank runs have played a major role in financial crises. During the Great Depression, for instance, thousands of US banks failed in part due to bank runs. “Loss of confidence caused anxious depositors to create ‘runs' on banks as they tried to withdraw their money before the banks collapsed,” a US government archive notes.

Financial contagion – This occurs when a failure in one institution ripples through a sector. Fear is contagious; this is why my phone rang so much last week. World Economic Forum states, “Contagion often occurs during periods of intense financial unrest and can happen at a regional, national and international level. Moreover, since economic markets are heavily interdependent today, financial contagion can pose a particularly significant threat.” Last week's anxiety was especially acute for smaller banks, who have less “backup”.

Credit risk - This is the risk that a borrower will default on their loan. You might be thinking of you/me being the borrow, but banks borrow money, too. Smaller banks borrow from larger banks, and so on, and banks have a scoring system to measure their own risk. Banks attempt to lower their credit risk in many ways. Mitigation strategies include taking steps to ensure borrowers are trustworthy and that loans are structured in ways that limit potential losses. That's why not just anyone can walk into a bank and be granted a loan.

Again from World Economic Forum, “Recent interest rate hikes, however, have made borrowing more expensive, which makes it harder for banks to finance themselves and reduces the value of their existing loans. The fallout from SVB's collapse has increased credit risk around the world as investors feared further failures in corporate debt markets.”

Hedging – This is a financial strategy that investors and banks use to limit financial risks.

Hedging entails balancing investments to make sure that potential losses are offset by gains elsewhere. A specific investment trade aimed at lowering risk is often referred to as a hedge. As I explain to my clients, maintaining a diversified investment portfolio is also a form of hedging as it mitigates total potential losses if there is a downturn in a single economic sector.

Moral hazard – This is something we discuss a great deal in my profession. A moral hazard in economics refers to a situation where a bank or investor has an incentive to increase financial risks because they are insulated somehow from the potential consequences of the risk. Investopedia gives this definition: Moral hazard is the risk that a party has not entered into a contract in good faith or has provided misleading information about its assets, liabilities, or credit capacity. In addition, moral hazard also may mean a party has an incentive to take unusual risks in a desperate attempt to earn a profit before the contract settles.

Think about this in terms of everyday life. How much more likely are we to take a risk if we feel we have little consequence if the risk fails or if we'll never be “found out”?

Many economists maintain that moral hazards in financial markets increase the risk of harmful economic activity. On the other hand, maintaining incentives for limiting financial risk could help markets avoid excessive and reckless risk-taking, experts say.

As I have said many times over the last week, I am not afraid of my money being in a bank. And I see no purpose in doing business with 5-6 different banks. I certainly do not have more than the $250,000 FDIC limit in any bank, however, nor will I ever. I prefer for my dollars to be making dollars, rather than pennies.