In recent weeks, the state of the global banking system once again made headlines due to a spate of high-profile bankruptcies and bailouts. The collapse of California-based tech-lender Silicon Valley Bank (SVB) in early March is the largest bank failure in the United States since the financial crisis of 2008-2009, while the emergency takeover of Credit Suisse by its rival UBS was orchestrated by the Swiss government to prevent a global banking meltdown.

There is a general belief that banks operate as the intermediary between people that save money and those that want it, either to invest or to consume. It is also believed that the profits of a bank equal the difference between the interest rate that they pay to depositors (passive rate) and the one they charge to debtors (active rate).

For others, such as the American writer and humourist Mark Twain: “A banker is a fellow who lends you his umbrella when the sun is shining but wants it back the minute it begins to rain.” However, not many people understand some of the pivotal issues that constitute the banking system and how they relate to employment, wages and economic growth.

Banks receive deposits, and they are allowed to lend money to the public, as long as they keep a share of those deposits, which are called legal reserves, in their own safe or at the central bank (CB), depending on local regulations. The remaining amount can be lent to the public. These reserves are intended to ensure that banks have sufficient liquidity (cash) to meet their obligations and to prevent excessive lending that could lead to financial instability if all deposits are simultaneously withdrawn from the institution, or if the loans are not repaid. Deposits minus reserves constitute the ‘lending capacity’ of the bank. But this can’t be calculated statically. This is a dynamic process that repeats over and over, depending on the amount determined by the CB to be held in legal reserves.

Loans, which can be allocated to the corporate sector and firms, or to households for consumption or the purchase of durable goods such as cars and homes, take the form of new deposits in the current accounts of those awarded with a loan, in a similar fashion to new deposits. As such, it is also possible to create new loans. Think of this system as a double entry book, where every loan automatically constitutes a new equivalent deposit. It is as if the borrower brings fresh cash to the institution.

How do banks create money and how much can they lend?

As explained, the legal reserves refer to the minimum amount of funds that a bank is required to hold in available money by its national CB. The rest constitute loans, as many times until the lending capacity is extinguished. This lending capacity depends on the percentage of the legal reserves. As an example: if the legal reserves are 10 per cent, this means that the bank can make loans for 10 times that amount, but if they are 5 per cent this so-called ‘bank multiplier’ can reach 20 times, and at 1 per cent, an astonishing 100 times. Hence, the lower the legal reserves, the more money a bank can create. From this we could argue that banks don’t need money to lend money – or at least, they don’t need too many deposits to make loans. This fact reduces the assumption that banks are just intermediaries to mobilise people’s savings towards those that would like to invest.

In the past, the amounts held in reserves tended to be quite homogeneous across the system, but ever since the introduction of worldwide banking deregulation in the 1980s and 1990s, these requirements were dropped. As a result, the system has become more complex. The global financial crisis of 2008-2009 brought the mandatory reserves down significantly, as a way of adding liquidity to the system.

In reality, banks can lend as much as they want, and the main restriction, due to the extremely low legal requirements in terms of reserves, is the perception that they will make money with those loans, in aversion to risk behaviour.

Banks can lend the maximum that they feel will be paid back, because they have the almost unlimited capacity to create money.

There are two main ways by which a bank may fail:

1. Bad investments or by lending money that is not repaid
2. A lack of confidence by depositors or by being pressured by the public to return their money

Of course, there are many forms that the first point may take, such as bad investments in activities that don’t perform, lending money to people or corporations that don’t pay it back, and bad collateral in order to protect the money lent. This was the cause of the ‘subprime mortgages’ at the root of the global financial crisis in 2008-2009.

In the case of point two, it is straightforward and the result of a ‘run’ against the bank or banks, and this would constitute a systemic lack of trust in the sector, or just an idiosyncratic, one-of-a-kind event.

These two effects tend to be linked. If the loans are not serviced or repaid, depositors tend to run to claim their money. There is a similar outcome when the news around bad investments by an institution start to spread.

In general, banks don’t face the same problem as a traditional business, which would be to sell something at a price that doesn’t cover the costs of production. Costs in the banking sector are quite controlled. Mainly guaranteed by fixed charges and other items that guarantee that income. Even when they pay enormous amounts to CEOs and others, since they are mainly in shares or options, the operating costs are under control.

What is happening with the recent bank crashes?

The first crisis was the Silicon Valley Bank collapse, which constitutes the second-largest failure in US financial history. SVB was among the 20 largest US banks and had assets of US$209 billion, but its deterioration was so fast, that in less than 48 hours the regulators had to intervene to avoid contagion. It went down when customers started to withdraw their deposits and SVB was unable to pay them. Something similar happened to Bear Sterns, the first bank collapse to trigger the global financial crisis, in 2008.

In Europe, the collapse of Credit Suisse shows just how a 167-year-old institution can go down and how governments can act quickly to prevent anything similar from happening elsewhere.

It is a powerful example of the underlying logic of capitalism that a bank can be bailed out in a matter of hours but during the Covid-19 pandemic it took most governments several months before deciding to intervene to support workers and households.

So, what is similar and what is different in the cases of these two banks? Well, they both suffered a withdrawal of deposits from their clients, meaning, a lack of confidence in the health of the banks’ finances. And the speed at which the lack of confidence impacts the numbers is much quicker now, with electronic banking and automatic transfers, compared to a time when all transactions had to be performed by a bank clerk.

However, the differences are also significant. SVB received a large number of deposits from the tech startups that developed during the pandemic and drove up the shares of these companies. The bank did what all banks do: kept a fraction as reserves, gave some loans, and invested the rest into long dated US treasury bonds that promised good returns since the interest rate was close to zero. When the Fed raised the interest rate to more than 4.5 per cent, the value of the bonds plummeted, since new ones offered higher rates of interest.

As the interest rate went up, the venture capital diverted from risky startups, and those companies that were flooded with cash in 2021, now started to face losses and require the money deposited in SVB to meet their payrolls and other expenses. However, SVB didn’t have enough money since the bulk of it was in supposedly risk-free treasury bonds that would have to be sold at a huge loss.

Lessons learned

There are several lessons that we can learn from these events:

1. Severe and sudden increases in the interest rate are not without cost to banks and the overall economy. Interest rates not only affect the ‘price of money’, but also something more complex with ripple and backward effects that should be considered by financial regulators.
2. Keep an eye on those banks that seem to be solid, because they are invested in low-risk sovereign bonds, even if these are from the US Treasury, the European Central Bank, or other governments rated as AAA by the three major agencies.
3. There is an over-capacity by banks to create money, which makes, in turn, the ratio of loans to deposits extremely high. At the same time, in times of crisis, such as the US subprime mortgage crisis of 2008-2009, it is more convenient to save the debtors, which are many times more, than the depositors, that are fewer and can be more effectively covered by the bank’s assets.
4. Banks that are leading with relatively unknown instruments such as crypto, NFTs and new technologies, should be required to have larger reserves.

How have these events affected workers and employment?

In principle, these recent bank failures don’t seem to have any linkages with the labour market, other than the employment generated by the banks involved, but the issue is that many of the loans provided by SVB financed the activities of startups, which in general are devoted to workers and computing power. The latter is provided by tech giants such as Microsoft, Amazon and Google, and involves a large number of workers. Unsurprisingly, the recent layoff announcement by these companies involved many jobs.

The other problem that these tech companies will face is that with the nosedive in the prices of their stocks, their capacity to get bank loans is reduced. Banks receive shares as collateral of the loans, and if the value of those shares decline, then loan recipients either have to increase the collateral (which in general is not accepted as more shares) or return the loans.

The combination of increased interest rates and the failure of these banks in the last month reduces the financing of productive activities, both because they are more expensive, but mainly, because banks become much more conservative, avoiding risks since the rate of return that firms that they finance would need to be much higher, and companies with very high profit rates tend to be risky, suspicious, or one of a handful of corporate monopolies.

In general, the main operating cost of enterprises, especially small- and medium-sized, are the salaries paid to workers, because the rest is either deferred (taxes) or financed by suppliers (materials and inputs), but wages have to be paid every week or month, whatever the case may be. In current accounts, banks provide the cash needed to fulfil those needs.

If the financing is no longer there, the employment expectations of the entrepreneur have to be reduced. And this can become difficult if the general perception is that from the demand side of the equation, clients are going to be constrained by the lack of financial support due to these restrictions.

“In” a nutshell, it could be argued that it is the banks that validate – or not – the employment expectations and requirements by producers of goods and services, and among the banks, the CB is the ‘employer of last resort’, or at least the one which has the last word on how many people to employ. While the SVB and Credit Suisse crises seem to be isolated events, the causes are deeply rooted in the aforementioned underlying logic of capitalism, as well as the erosion of the regulatory power of governments in defending employment as one of the main goals of monetary policy – all in the name of the ‘independence of central banks’, a new kind of fetishism.