Banks Might Be About to Ruin the Economy Again

For the second time in the 21st century, mistakes in the financial sector could topple the economy.

Just about anyone whose job it is to pay attention to financial news should have known that interest rates would go up over the course of the last year.

A year ago, when the Federal Reserve raised interest rates for the first time in three years to combat inflation, it said that the banking industry should expect “ongoing increases,” and by September, the Fed projected that it wouldn’t stop heightening rates until they topped 4.5%—from near zero in early 2022. The Fed did what was largely predicted March 22, when it announced it would raise interest rates by 25 basis points, pushing them to the range of 4.75% to 5%.
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The people running Silicon Valley Bank (SVB) did not understand that this was coming, since the bank stowed its deposits in U.S. government bonds. The value of older government bonds plummets as the Fed raises interest rates, because new bonds pay out more as interest rates grow. But SVB kept its deposits in government bonds, despite warnings from the Federal Reserve that it might not be able to come up with enough cash in a crisis.

Fast-moving news about SVB’s liquidity problems prompted a run on the bank, which subsequently failed, and which prompted bank runs at other small and mid-sized banks, including Signature Bank, which also failed. Other dominoes have fallen since: First Republic Bank is still in need of rescue and Credit Suisse was sold to UBS in a contentious deal that may face lawsuits from bondholders.

Now, forecasters are warning of a potential recession from this extremely avoidable banking crisis.

The idea that banking mistakes could plunge the U.S. economy into a recession is familiar—the Great Recession that began in 2007 was caused when banks made risky home loans and then sold to lenders who did not understand exactly what they were buying. Indeed, the current banking crisis has some parallels to 2008, says Neil Fligstein, a sociologist at the University of California, Berkeley who has extensively studied the financial crisis.

“Banks are finding themselves with investments that are losing big money, and when depositors come in, they can’t turn them into something liquid fast enough to pay back people who want their deposits,” he says. “That’s what happened in 2008—people had all these mortgage-backed securities and no one knew what they were worth.”

Of course, there is still time to contain this bank contagion and even if it does lead to a recession, analysts don’t think it would be as long lasting as the Great Recession.

But it’s curious that the beginning of the 21st century may be marked by two recessions created by the banking sector—especially since consumers had been driving economic growth until now. If you forget the SVB bank panic, things have been looking pretty good in the overall U.S. economy this year. Employers added 311,000 jobs in February, more than analysts had expected; existing home sales jumped 14.5% in February, the largest increase since July 2020, and consumer spending has remained resilient despite high inflation. Regular people and businesses are doing what they’re supposed to be doing to keep the economy going—buying stuff, expanding their businesses, and investing in that great wealth generator, property, even though mortgage rates are about double what they were two years ago.

That relatively firm economic footing makes it even more frustrating that banking mistakes could tip the U.S. into a recession. But it didn’t have to be that way. Fligstein says that there was a long stretch of time in the U.S. where the banks weren’t causing financial panics every decade. Between the Great Depression and around 1980, the government separated banking businesses into different silos like savings-and-loan, commercial, and investment banks. Thanks largely to the Glass-Steagall Act of 1933 and other laws passed in 1934, the government could regulate these parts of the financial industry differently, and thus was able to control risk-taking.

But the high inflation and slow economic growth of the 1970s and 1980s undermined the banking business model, and both the savings-and-loan institutions and the commercial banks were deregulated. The banking industry embraced financial innovation, coming up with new products and complicated ways to make money, including packaging mortgages into securities. The finance industry lobbied Congress to repeal Glass-Steagall for over a decade, finally succeeding in 1999, and profits flowed. By the early 2000s, the financial services sector was making more than 30% of total domestic profits in the U.S. economy, despite employing 7% of workers. The risk-taking that emerged in this period was part of what created the 2008 financial crisis. The financialization of America didn’t benefit everyday Americans, but it did hurt many of them in the Great Recession.

The Dodd-Frank Act, passed in 2010, imposed stricter regulations on banks to prevent this kind of a crisis in the future, but parts of it were rolled back in 2018, allowing smaller banks to escape some of the more intense federal supervision that big banks still face today.

The economy has been on a slow recovery from the crisis of the Great Recession ever since 2010, but it’s been a long slog. Until recently, wages for low-income workers were not keeping up with inflation, and economic growth was more sluggish than usual after recessions. That’s partly why the sustained good news about consumer spending, the housing market, and unemployment has been so unusual. Some economists had worried that something had fundamentally broken in the 21st century, and that some Americans were never going to get back to financial stability. The last year or two has made things seem rosier for even the Americans with the lowest levels of education and income. Workers in the lowest-income quintile saw the fastest earnings growth of all income groups during the pandemic, according to research by the Federal Reserve Bank of Dallas, and their earnings outpaced inflation.

But the quick pace of news about the problems at Silicon Valley Bank, Signature Bank, and others, puts all of that in jeopardy. Though the large banks still seem stable, thanks to Dodd-Frank, small and mid-sized banks are still facing significant risk. One recent study estimated that 190 banks are at risk of failing in a similar way to Silicon Valley Bank. The economic stability gained by some everyday Americans since the last banking crisis may well be toppled. Some banks will go under because of this, but worse, some Americans may too—even though they did everything right.