It’s Important to Let the Banks Fail

It’s Important to Let the Banks Fail

By Dr. Thomas Patterson |

Joseph Schumpeter was an Austrian born economist who last century coined the term “creative destruction” to describe the method by which capitalism continually reinvigorates itself. Unlike the static monarchical guild-based economies or the now-pervasive socialist states, capitalism is in constant turmoil. Ceaseless competition produces winners, losers – and progress.

Schumpeter’s key insight was that failure is essential to capitalism’s success. The outmoded and inefficient must give way to more successful models for capitalism to work its magic as the most beneficial-for-all economic engine of all time.

But that doesn’t mean the short-term consequences of failure aren’t painful to those who bear them. Buggy manufacturers, candlemakers, and others overtaken by progress were convinced that the demise of their industries would inflict lasting damage not only on themselves, but on the economy.

But the harm was mostly short term. American lore is full of stories of honest strivers who learned from their disappointments and went on to great success. Reasonably flexible workers found employment in new fields where they were often more productive.

Schumpeter was right that capitalism is fundamentally a “no pain – no gain” deal. But that can be a hard sale in a culture that has come to believe nothing bad should happen to anyone, that pain and failure are indicators of injustice.

We ditch merit-based exams because some students may feel bad. We award participation medals. We mandate facemasks just in case.

Thus, the Obama administration, after the banking collapse of 2008–09, soothed the wounds of the too-big-to-fail lending banks by bailing them out with billions of taxpayer provided funds. But the banks were engaged in exactly the behaviors that Schumpeter believed free markets were designed to punish.

The banks (at the insistence of the feds) made thousands of “sub-prime” loans, using underwriting criteria which would previously have been considered unthinkable. Worse, when the loans began to go sour, instead of cutting their losses, Wall Street repackaged them as “mortgage-backed securities.” These were sold off as far more valuable than the mortgages of which they were composed.

We all know how that ended. Yet because of the bailout, no banks failed. The perps walked away from the train wreck they had caused.

The mortgage lenders 15 years ago clearly did not fear the discipline of the market. Neither did the decision makers at Silicon Valley Bank (SVB), which has also failed due to unwise risk-taking.

SVB occupied a desirable niche, serving the local venture capitalists and tech startups. The fed pumped trillions of dollars into the economy while interest rates were held near zero, making us all feel rich. The stock market, especially tech investments, soared.

Times were good. Deposits in SVB tripled in the three years after 2019. SVB could offer generous loan terms to favored borrowers and above market returns on deposits.

But the music had to stop eventually and so it did. The feds finally raised interest rates in response to roaring inflation. SVB was forced to raise capital and sell some assets at a loss, sparking a run by depositors, which SVB was unable to withstand. The bank collapsed.

SVB had been warned. It lacked the liquidity to respond to stress because the present market value of its held-to-maturity bonds was $15.9 billion less than face value at maturity, which was the number on the balance sheets. The cash wasn’t there when needed.

Most commentators deemed this a regulatory failure. But does a banker really need a regulator to tell him not to count on zero-interest rates indefinitely? That loans to shaky borrowers might default? That bond values fall when interest rates rise?

Of course they knew. They just didn’t care – enough. If they believed their losses would be borne by others, then charging ahead through all the yellow lights to maximize gain actually made sense.

SVB, its depositors, and associated banks have all been bailed out to “stop the contagion.” That’s politically astute, even though the demise of Lehman Brothers 15 years ago hardly fazed financial markets.

But relying on government regulation, rather than market forces, to discipline bank behavior has produced a chronically unstable financial sector which lurches from crisis to crisis.

Let them fail.

Dr. Thomas Patterson, former Chairman of the Goldwater Institute, is a retired emergency physician. He served as an Arizona State senator for 10 years in the 1990s, and as Majority Leader from 93-96. He is the author of Arizona’s original charter schools bill.