The demise of Silicon Valley Bank (SVB) appears to have awakened the age-old question: “Should government institutions be allowed to bail out private businesses to prevent them from failing due to less-than-ideal business practices or poor risk management procedures?”

There has been two main schools of thought, even before the SVB nightmare, with a few moderate views in-between.

The first, arguing that bailouts generally only apply to the rich and encourage extremely risky behaviour from the directors of private institutions, insists that bail outs are bad and should not be done under most circumstances.

They argue that executives at private corporations are incentivised to take excessive risk, including unrestricted use of leverage. Think of leverage or debt as an amplifier of outcomes – whether positive or negative outcomes (simplistically, when a company applies debt to a project or asset base and generates returns that are higher than the cost of debt, the returns to equity holders are magnified – shareholders get the positive returns from investing their equity as well as the excess returns from debt after paying the cost of debt. Likewise, when the company makes a loss, the negative returns to equity holders are also magnified because, despite the losses made by the assets, the cost of borrowing would  still need to be paid to the lender). 

Because of the impact of leverage on returns, financial institutions and investment managers are expected to be mindful of the proportion of their total assets that is financed by debt and the characteristics of the assets that they hold (i.e., liquidity, duration, etc., basically, how easy it is to convert these assets to cash without having to sell them at a material discount). In fact, in many sectors, including banking, most regulators have laid down specific principles on the debt ratio / capital reserves and the characteristics of assets that these organisations are allowed to hold.

The anti-bail out school of thought is supported by the argument that if private businesses (such as banks) expect governments to bail them out, the balanced nature of consequences is reduced to a one-sided game in favour of the directors and shareholders of these organisations. In essence, sticking with the example of an institution applying leverage excessively, when reckless or bad decisions result in positive returns (yes, bad decisions can sometimes lead to good outcomes, and vice versa), the returns are amplified, making the shareholders and directors wealthier through dividends and fat bonuses, but when the results are negative, the government simply bails them out. Hence, there are no negative consequences for bad decisions or outrightly illegal activities.

Another common anti-bail out argument is that bail outs are commonly financed by tax payers ultimately, i.e., when the government bails out a private business, they are simply transferring the losses / cost of the bail out to law-abiding, tax-paying individuals and corporations, whereas the profits made by these bailed out private businesses were kept private for their shareholders. Capitalism when profitable, but socialism when it gets inconvenient – private profits, socialised losses.

On the other side of the bail out debate, is the school of thought that is generally in favour of bailing out failing organisations, particularly when they are deemed to provide essential services, to be of national interest or a source of national pride, or simply to protect consumers, the industry or markets in general.

The pro-bail-out school, in the case of SVB, believes that to protect customers and to prevent a total collapse in the banking sector in the US, it is necessary to prevent SVB from failing. In particular, all customers of the bank who may be unable to recover 100% of their deposits (i.e., since the realised value from the sale of the banks assets are unlikely to be sufficient to cover all of their liabilities – mainly customer deposits) should be made whole.

What do I think? To quote a certain former US President, there are “very fine people (points) on both sides”.

According to most media outlets, only about 2.7% of SVB’s deposits are insured by the Federal Deposit Insurance Commission (should the amounts recovered from selling the bank’s assets be insufficient to cover all deposits, only 2.7% of depositors would get back 100% of their deposits. The other depositors will be repaid in order of priority as unsecured creditors. Given the nature of SVB’s clientele, this could have a catastrophic impact on the start-up / tech ecosystem and eventually, the overall economy due to contagion. Do these depositors deserve to suffer the negative consequences from poor risk and interest rate management by SVB and its directors?

What impact will allowing SVB fail and allowing the customers suffer losses have on the overall US economy, and in particular, on the sustainability of capital markets? Is the US Federal Reserve and the US Government ready to take a chance and find out?

In the case of SVB, should making customers whole even be considered a bail out, if the shareholders do not get any amounts in excess of the cash surplus that is left after settling all other creditors with the proceeds from liquidating their assets, if any?

On the other hand, will saving customers / making customers whole have the intended consequences on capital market sustainability? Will a decision to make all customers whole (despite them not being covered by the FDIC insurance limit) be viewed as the Government propagating the “private profits, socialised losses phenomenon”, thereby leading to a deterioration in the level of trust that market participants place in capital markets and in the ability of regulatory agencies to regulate?

I guess we will find out soon!