Behind the Bank Failures: Greed Meets Pessimism

On the surface, the recent large bank failures are the same excessive risk-taking that has been sinking banks for as long as banks existed. Look deeper, though, and you see something darker at work.

It is the greed of bank owners and executives that leads them to invest in high-risk assets in the hope of finding a higher return than they can get from the safe and liquid but boring assets that banks are supposed to put their money into. If the high-risk bets pay off, the bank owners and executives take more money home. If the bets fail, owners lose their investments, depositors lose parts of their deposits, and the bank executives may be barred from future work in banking. It is the executives who ultimately make the decisions, so perverse incentives are created by the fact that they have the least to lose from their excessive risk-taking.

The high-risk asset causing so much trouble this year is long-term bonds. It makes good sense for a bank to hold a tiny part of their assets in long-term bonds, if the proportion is anything more than tiny, the bank is putting its future at stake by gambling in this fashion.

Why are long-term bonds, which could be considered a safe investment in another context, such a risk for banks? Nearly all of a bank obligations are short-term liabilities. The mismatch between the long-term assets and short-term liabilities can lead to business failure, as the banking world has seen again and again this year.

What is the appeal of long-term bonds, then, if short-term bonds are equally easy to buy? Long-term bonds go up in value when interest rates fall. This is the effect that corrupt bank managers were betting on.

But interest rates were already low. The only scenario in which they would fall much lower would be in the event of an extended global recession.

Bank executives were so convinced that a global economic crash was on the way, as a result of deaths from a global pandemic and fossil fuel shortages from a large-scale war, that they were willing to see the banks they managed fail if any other scenario came about. They would profit from a global disaster, and they did not care about the possibility that the disaster might be smaller than they expected because they did not see how that could happen.

To be sure, a consensus of global economists expected the global economy to contract from the Cindy’s of the pandemic and then from the war. But I did not hear any of those analysts say that such an outcome was assured. The bank executives who liquidated their banks to bet on a global crash believed they had better information on the economic future than was reaching the news media and the public.

In other words, they must have believed that they had inside information that assured them that the pandemic would be more deadly than the epidemiologists said and that the war would be more damaging than the military analysts said.

This does not imply that the executives of the failed banks were in on a conspiracy to crash the global economy — but it does suggest that they believed that they were holding privileged information that told them that such a plan existed. This belief was mistaken, the faith was misplaced, and the majority of the bank failures we are seeing are the result of that mistake.

It says something about the uncertainties of the current world that banks, supposed to be among our most stable institutions, could be persuaded to put their futures on the line in a bet on global catastrophe. Optimism about the future is below the levels seen in the past.

But remember, the failures have affected a tiny fraction of banks, only about 1 in 1,000. Other banks, if they placed similar bets, kept them to a manageable scale, so that they did not end up taking the same losses.

It was only the banks that were completely convinced that a crash was on its way that are at risk of failing now.

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