Incentives Matter

by | Mar 14, 2023

It’s official – the Federal Reserve has lost control.

It can’t keep interest rates high without driving even more deposits out of the banking system.

It can’t cut interest rates without setting the stage for massive inflation.

And, whether on the back of continued interest rate increases or as a result of rising inflation premiums, bond yields are heading higher.

That means more deposit flight, more forced losses on bank balance sheets, and more bailouts.

Powell may say he’s in charge of the situation.

He’s not.

The past weeks regulatory unwinding of Silvergate, Silicon Valley Bank, and Signature Bank have exposed the extreme fragility of a system far too reliant on free money.

The financial press attributes these failures to concentrated deposit bases. Silvergate banked crypto clients. Silicon Valley Bank catered to high-tech startups. Signature Bank dabbled mostly in real estate.

But I find that attribution superficial because it glosses over the real cause – perverse incentives.

Zero percent short-term interest rates and massive direct COVID stimulus flooded banks with literally trillions of dollars in deposits from 2020 through 2022. Moreover, that deposit boost was preceded by more than a decade of essentially free money.

Couple that confidence in cheap, secure funding with the Dodd Frank Bill that allowed banks to ignore losses on bond holdings and you get all the incentive you need to leverage a system beyond the breaking point.

Don Yocham, CFA

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