A brief response to a common question after the takeover of Silicon Valley Bank and Signature Bank by the regulators.


by Richard Werner


To consider the question whether banks should be allowed to fail, we have to be aware that bank failures have a significant adverse impact on the economy.

Firstly, there is the impact on the economy, on economic growth and employment. We saw this in the 1930s, when the US Federal Reserve oversee the bankruptcy of ca. 10,000 small banks, this had a devastating impact on the economy. Banks create credit and this is our money supply, because we use Bank Digital Currency. If the banks collapse, the money supply collapses, and thus economic growth declines, unemployment rises and we experience a recession. Of course, the impact is larger, the more banks go bust.

That leads me to the second point: Banks are network businesses and we experience the problem of ‘contagion’ quickly: As one bank fails, this will have ripple-on effects on other banks. Quickly another bank can fail, and another one etc.

Thirdly, there is the reputation effect: bank failures result in loss of faith in the financial system. As a result, people will revert to gold or use foreign or private cryptocurrencies. This makes it harder for the central bank to maintain control over the economy and will weaken the efficacy of monetary policy.

Fourthly, there is the issue of equity and justice. Many ordinary people do not have the time or knowledge to understand the differences between different banks, while everyone mostly still needs a bank account. They can hardly be expected to make an informed assessment of which bank is riskier than another.

Fifthly, the banking system has one inherent flaw: it is possible for a perfectly good bank with sound assets to get into trouble and to fail, if only a large amount of depositors demand that their deposit claims on the bank are transferred out of the bank. This is why in the US Congress agreed to establish the Federal Reserve: it would step in and lend, as a lender of last resort, to banks hit by a run on deposits. Some of these problems were modified by the introduction of the deposit insurance scheme, but they remain the main five reasons why generally regulators try to avoid bank failures.

What about the argument that rescuing banks means we don’t really have free market capitalism? Well, one could say that in the US free markets were given up with the introduction of the Federal Reserve (and some would argue, the simultaneous introduction of the income tax). As soon as a central bank is introduced, central planning and top-down manipulation of markets have a foothold. According to the Theory of Bureaucracy, what we can next expect is for the bureaucracy to grow, like cancer, and take over ever greater parts of society. Mind you, for much of its history, the US did not have a central bank. Economic growth was higher then…

Diversity in banking seems to be key. Sadly, the central planners have been reducing the number of banks, and this is the sixth reason why it’s not usually a good idea to let banks fail or even to let them merge: it reduces the number of banks in the economy and with it increases concentration of the banking system. Fewer and bigger banks will lend less and less to small firms, which tends to mean that productive credit creation the produces jobs, prosperity and no inflation, also declines, and credit creation for asset purchases, causing asset bubbles, or credit creation for consumption, causing inflation, become more dominant.

Ultimately the central planners maximise their power by introducing CBDCs. And that’s where a conflict of interest becomes apparent: Shouldn’t the regulators, as umpires, keep out of the business of banking? Shouldn’t they be prevented from competing against the banks which they regulate? If the umpire in a soccer game suddenly starts to score goals, using the yellow and red card liberally in the process, few would think this was a fair game. Likewise, the central banks should not at the same time be bank regulators and prepare to compete against them via central bank digital currencies.

It is concerning that for the past decade or so central banks have steadily been working towards the introduction of CBDCs, while at the same time adopting policies that have killed thousands of small banks. In the eurozone, more than 5,000 banks have disappeared since the ECB started business a little over two decades ago. Once CBDCs are introduced, it just takes a bit of bank run, such as in the case of Silicon Valley Bank, and all deposits will be shifted to the central bank, driving banks out of business. Then we will have arrived at the most centralised form of banking: A Soviet-style economy with only one bank. While that may be the dream of any central planner, it is inefficient, does not work, as we have seen in the Soviet Union, and it also crushes the human spirit: Central planners get too much wrong, which is at the very least demotivating and frustrating, but is quickly much worse than that – it easily turns into totalitarianism.

Considering the collapse of Silicon Valley Bank and also Signature Bank on 10 March 2023, what concerns me most is that the bank seems to have been solvent and that Federal Reserve did not seem to have provided the short-term liquidity that a solvent bank should receive from the central bank when there is a bank run. The depositors were largely companies and institutions and not covered by the deposit insurance, which means that a classic bank run could occur. Almost $50bn left in one day on Thursday 9 March 2023, thanks to efficient digital bank technology with which we transfer BDC (bank digital currency), proving once again that there is no problem with the digital money that we have been using for decades. But why did the Fed only provide such liquidity after the Federal Deposit Insurance Corporation had stepped in and closed the bank? Over the weekend, the regulators set up a new bank that took over. Just like in the 1930s, the promised lender of last resort function, on the back of which a reluctant Congress was persuaded to adopt the Federal Reserve Act in 1913 (and a very badly attended Congress, as the vote had barely been announced and was held on 23 December, when most had left for Christmas), was once again not forthcoming in time. The result: An ever more concentrated banking system. And ever more power for the central planners.

China’s success started when Deng Xiaoping came to power in 1978 and immediately demanded that ideology and politics should be de-emphasised, and economic policies should be adopted that had a record of working well. So he ditched the Soviet-style monobanking system and created thousands of banks, mostly small local banks, lending to small firms.

Decentralised structures are more resilient and more successful than centralised ones, for one, because central planning crushes the human spirit. Central planners also can never get things right in detail. Decentralised forms of organisation improve motivation and boost creativity. Since money is at the heart of the economy, and banks create it, we need to ensure we have a decentralised banking system consisting of many small banks.