Article Summary: Riskless Capital by Raghuram Rajan and Luigi Zingales

Recommendation

In early March 2023, US regulators placed Silicon Valley Bank into Federal Deposit Insurance Corporation (FDIC) receivership after a bank run had caused the financial institution to fail. In an effort to mitigate financial contagion, regulators extended federal protection to all deposits, not only to those under the FDIC’s usual limit of $250,000. While providing much-needed stability and calming stakeholders, this action may have unleashed moral hazard into the marketplace. Professors Raghuram Rajan and Luigi Zingales explore the potential consequences of “riskless capitalism” in this astute essay.

Take-Aways

• To avert a banking crisis, the US government insured all deposits at the struggling Silicon Valley Bank.
• The decision to backstop all deposits highlights how politicized economic decisions undercut free market capitalism.
• Officials should work to restore “pro-market capitalism.”

Summary

To avert a banking crisis, the US government insured all deposits at the struggling Silicon Valley Bank.

The demise of Silicon Valley Bank (SVB) in March 2023 sent shockwaves through the banking system and financial markets. SVB’s swift demise placed the system at risk of contagion, so the Federal Deposit Insurance Corporation (FDIC) placed the entity into receivership. The federal government chose to guarantee that all depositors – not only those maintaining the FDIC limit of $250,000 or less in the bank – would have full access to their funds.

“A government that repeatedly shows its willingness to bail out has little credibility when it says next time will be different.”

What the US Treasury won in short-term financial stability could be lost through long-term systemic fragility. Specifically, the guarantee of deposits with values greater than $250,000 may have unleashed financial moral hazard that promotes “riskless capitalism.”

As documented in the Federal Reserve’s report on the collapse of SVB, the institution’s risk management was shoddy, particularly in regard to the bank’s portfolio exposure to rising interest rates. Depositors with holdings greater than $250,000 – such as the corporation Roku, which kept $450 million at SVB – had to know that the FDIC would not typically insure their deposits. The government’s action protected these depositors, despite their own undisciplined risk management.

The decision to backstop all deposits highlights how politicized economic decisions undercut free market capitalism.

SVB stakeholders, many of whom were part of the Silicon Valley technology and venture capital communities, pressed state and federal politicians for a bailout. The government’s backstop of uninsured deposits raises questions about the fundamental nature of free market capitalism.

“While shareholders in SVB were deservedly wiped out and management let go, large depositors enjoyed riskless capitalism as the government changed the rules to benefit them.”

The SVB debacle and the blanket insurance on all deposits indicates that business and political actors engaged in “cronyism” to cover their positions. In 2019, powerful business interests collaborated with politicians to cut regulations on SVB and other banks. This allowed financial entities to operate with less transparency and fewer concerns about government oversight.

Officials should work to restore “pro-market capitalism.”

Fixing this dynamic of crony capitalism and focusing on pro-market capitalism requires significant changes to the current system. Society should ensure that businesses not amass too much commercial and political power. Policy makers should work to encourage a robust competitive balance. Competition by its nature produces winners and losers, so the government should put in place a safety net for workers displaced by failing ventures.

“Free enterprise capitalism, then, is not the final stage of a deterministic process of evolution. ‘It is better thought of as a delicate plant, which needs nurturing against constant attack by the weeds of vested interests’.”

Officials should support international corporate dynamism across industries. Government and business need to vest in the promise, virtue and advantages of free market capitalism, not in big business and big government entanglements. By mitigating political influence, markets can function more efficiently and provide greater economic value to all Americans.

About the Authors

Raghuram Rajan and Luigi Zingales are finance professors at the University of Chicago’s Booth School of Business.