If You Think SVB Was Undiversified, Just Look at America's First 150 Years

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5 MIN READ - The Cautious Optimism Correspondent for Economic Affairs and Other Egghead Stuff compares Silicon Valley Bank’s now-heavily criticized lack of asset and depositor diversification with that of regulated unit banks during America’s past.

Now that multiple postmortems have been performed on the failure of SVB a consensus has emerged that its collapse was, in the words of Federal Reserve Vice Chair of Supervision Michael Barr, a “textbook case of mismanagement.”

Citing examples of SVB management’s failures, Barr and others have pointed to its overreliance on long-term U.S Treasury and mortgage securities in a zero-interest rate environment and a lack of depositor diversification.

Of course even with those mistakes SVB still wouldn’t have failed were it not for the Fed's fifteen years of near-zero interest rate policy running head-on into a twelve month, 500 basis point rate hike wall. But that’s another story.

But back to diversification, it’s been thoroughly reported by now that SVB loaned heavily to high-tech and healthcare companies and that its deposit base was also heavy in those same sectors.

In fact, according to the company’s website its clients included a full 44% of all venture-backed technology and health care initial public offerings in 2022.

According to Ernst and Young there were 328 technology IPO’s that year and another 168 in healthcare.

The Correspondent doesn’t know exactly how many of those 496 IPO’s were “venture-backed,” but given the nature of IPO’s in those two fields he’d wager “majority” is a conservative call.

Add IPO clients from years before 2022, corporate accounts from other industries, and high net worth individuals and the Economics Correspondent can confidently estimate SVB’s large depositor base at many hundreds of accounts if not in the thousands. After all, in its last SEC-10-K filing SVB reported $186 billion in deposits so even a high estimate of one thousand large accounts would still average a whopping $186 million each (excluding small accounts). 

UNIT BANKING RULES EARLY AMERICA

Now let’s go back in time to the early 20th century.

Cautious Rockers may recall the Economics Correspondent wrote in detail last year about American “unit banking” laws that, for most of U.S. history, heavily restricted the right of banks to open branch offices.

Most states forbade banks from branching at all. Legislatures literally specified “one building” in their statutory language to define chartered banks, and 100% of states forbade branching into other states.

The result? In 1914 the United States had about 27,000 banks of which 95% were tiny and had no branches. Even the remaining 5% of banks that were allowed to branch averaged only five branches each (Calomiris & Haber, 2014)

The political rationale behind these restrictions was complicated and involved stuffing state government coffers with rent-seeking monopoly unit bank profits. Links to the Correspondent’s articles containing more of those details can be found in the comments section.

However the predictable result was—you guessed it—a protracted lack of diversification in America’s entire banking system that was far worse than SVB which looks like a multinational money center bank by comparison.

The nearly 26,000 U.S. banks with no branches were usually one building in a small rural town. Granted a monopoly to operate in that township, the unit bank was heavily reliant on the price of a single regional crop. And a few miles down the road in the next town would be another monopoly unit bank, also heavily dependent on just one local crop.

And depositor bases were nearly as narrow. In a town of a few hundred people, a handful of the wealthiest locals could constitute the majority of the unit bank’s entire deposit base. Just one or two wealthy customers getting nervous and cashing out in times of trouble could bring down a unit bank.

This “unit banking” structure goes all the way back to 1784 when America’s first two banks still in operation today—the Bank of Massachusetts and the Bank of New York—were granted local monopolies alongside their new charters.

The result was nearly 150 years of massive financial instability for the entire country. Falling prices in just one or a few different crops could bring down hundreds or even thousands of unit banks whose loans were dependent entirely on local agriculture or on loans to consumers and small businesses whose fortunes were also tied directly to local agriculture.

As one example informs us, food prices fell globally in the 1920s, the aftermath of World War I and European soldiers returning from the battlefield to farm again. During that decade over 5,000 American banks failed.

And this all happened before the Great Depression had even started. In the early 1930’s over 9,000 more banks failed.

Note: Canada never had any restrictions on bank branching so even as it weathered the Great Depression alongside the United States, zero Canadian banks failed. Canadian banks were larger, better-capitalized, typically had several hundred nationwide branches, and diversified their loans across the country’s entire economy with literally hundreds of thousands or even millions of depositors.

AND THEY SAY SVB WASN’T DIVERSIFIED?

So what’s the point of going back to the early 20th century?

Well if the press and regulators are now declaring:

“Of course SVB was mismanaged: it relied on only a thousand-plus large depositors, loans heavily focused on tech and healthcare companies, and Treasury and mortgage-backed securities”

…all which is true, what do they have to say about U.S. banks a hundred years ago that were forced by law to rely on just a single crop and couldn’t expand outside a town of a few hundred people?

If SVB’s business model was a recipe for collapse and failure, then much more draconian unit banking regulations were a prescription for waves of nationwide bank failures and systemic crisis. 

And that’s exactly what happened—over and over again.

From 1792 to 1933 the United States was rocked by fifteen systemic banking panics while Canada experienced zero.

Unit bank laws were a primary driver of these repeated crises although, if you can believe it, they weren’t even the only bad regulations.

Adding fuel to the fire were the missteps of America’s three central banks—the Bank of the United States (1791-1811), the Second Bank of the United States (1816-1836), and the Federal Reserve System (1914-present)—alongside yet more complicated regulatory restrictions that undermined bank stability during the National Banking System era of 1863-1914.

So if we look at the level of undiversified risk at SVB—which the press and regulators are all calling “textbook mismanagement”—and compare it to the far worse lack of diversification at America’s 19th and early 20th century banks, one can see how financial crises were triggered so easily for 150-plus years.

Only unlike SVB, the lack of unit bank diversification wasn’t by choice. Rather it was mandated by Congress and state legislatures.

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Postscript: Just a moment ago the Economics Correspondent asked rhetorically: “What do they [regulators, the press, and let’s throw in academia] have to say about U.S. banks a hundred years ago that were forced by law” to stay unbranched and far more undiversified than SVB?

Well here's a few responses: 

1) “For most of the 19th century and into the 20th century, laissez-faire attitudes and minimal state regulations led to a succession of financial panics.”

-Jon Talton, Seattle Times

2) “Andrew Jackson had famously allowed the charter of the Second Bank of the United States to expire in the 1830s. With only loose regulation, the financial system was decentralized and rudderless… …so the industrializing United States suffered a continual spate of financial panics, bank runs, money shortages and, indeed, full-blown depressions.” 

–Daniel Gross, Washington Post

3) “History tells us that banking is subject to occasional destructive “panics” that can wreak havoc with the economy… …Gilded Age America — a land with minimal government and no Fed — was subject to panics roughly once every six years.”

-Paul Krugman, (New York Times)

4) “An unregulated banking system in the nineteenth century contributed to a string of severe money panics. A short play in this lesson plan helps students understand why this happened and how today’s Federal Reserve System protects against panics.”

-National Council on Economic Education, New York

5) "With the failure to recharter the First Bank of the United States in 1811, regulatory influence over state banks ceased. Credit-friendly Republicans—entrepreneurs, bankers, farmers—adapted laissez-faire financial principles to the precepts of Jeffersonian political libertarianism."

-Wikipedia article on the Panic of 1819