Financial Crises 101
Posted March 16, 2023
In today’s economy, this is money.
Many believe it’s the only form of money. In reality, it’s just a small part of money in the modern financial system.
Without understanding this simple fact…
The big banking crises in the 21st century -- like 2008, March 2020, and Silicon Valley Bank -- just don’t make sense.
Today, I'm going to sum up the first 40 pages of a book called Central Banking 101 by former Fed insider Joseph Wang.
If there’s anything about modern banking that confuses you, this book probably won’t make you less confused. But it will help you understand how it all works.
Four Types of “Dollars”
According to the Federal Reserve, there are four types of money. This is another way of saying that there are four ways to hold dollars:
→ Fiat currency (cash)
→ Bank deposits
→ Central bank reserves
→ Treasury bonds
But wait. Aren’t fiat currency and bank deposits the same thing?
In normal times, bank deposits can be converted into government-issued fiat currencies, but they’re not the same.
Let's look at all the differences:
Fiat currency is non-interest-bearing debt issued by the Federal Reserve to fund its portfolio of assets. Mostly Treasuries.
A bank deposit is interest-bearing debt issued by a bank to fund its portfolio of assets. In other words, it’s an “IOU” that can become worthless if the issuing bank goes bankrupt. (Which is why the FDIC insures deposits up to $250,000.)
Central bank reserves are a type of interest-bearing debt issued (or “printed”) by the Fed that only commercial banks can hold. It’s also used to fund the Fed’s portfolio of assets. Again, mostly Treasuries.
For example, when the Fed buys $1 billion in Treasuries, it creates $1 billion in central bank reserves to pay for them.
Commercial banks use central bank reserves to send back and forth to one another and they can convert them into bank deposits or fiat.
Treasuries are a type of interest-bearing debt issued (or “printed”) by the US government that anyone can hold.
Treasuries can be converted into bank deposits by selling them in the market or using them as collateral for a loan. Commercial banks can also convert them into central bank reserves.
When functioning normally, all forms of money are freely convertible.
But when that conversion breaks down, it creates big problems in the financial system.
Let’s take two big examples first: March 2020 and 2008.
In March 2020, people all over the world got spooked and wanted to hold dollars.
It was a dollar-buying frenzy.
Investors pulled out of their investments en masse, demanding dollars. Foreigners did the same with their home currencies, also demanding dollars.
To keep up with demand, investment funds and foreign banks started spilling their investments into the markets, also demanding dollars.
But since everyone was rushing all at once, they couldn’t sell their portfolios except at a massive loss. In some cases, they couldn’t sell them at all. Even Treasuries were locked up.
That’s not supposed to happen. Especially not with Treasuries.
Again, when convertibility between all types of money breaks down, that’s a crisis.
And it spreads into the entire economy rapidly. Some get hurt more than others. For example, many investors took massive losses on Treasury futures and mortgage REITs, to name a couple.
Why did this happen? Well, that in part goes back to 2008.
In 2008, there was a run on dealers at the same time investors were too afraid to lend to them due to their prior thirst for securitized loans.
In March 2008, for example, Bear Stearns failed when its subprime mortgage investments went sour. Investors got spooked and refused to renew their loans.
Stearns was forced to liquidate their positions at fire sale prices to pay back their existing loans, causing panic.
Once again, convertibility between the different types of money broke.
In response to 2008, regulators made it more difficult for dealers to hold loads of securities and especially risky securities, even putting a cap on Treasuries.
As usual, such sweeping rules had unintended consequences.
Over a decade later, in March 2020, these rules handicapped the dealers’ ability to buy securities from their clients. They quickly reached their limit and couldn’t buy any more. Not even the super safe Treasuries.
When everyone realized they couldn’t even sell their “risk-free” Treasuries at par, they panicked.
That’s doomsday stuff.
So the Fed stepped in.
Among other things, the Fed purchased about $2 trillion in Treasuries -- creating that money out of thin air (AKA, “quantitative easing”) -- in order to stabilize the markets.
The government solved a problem (2008) by creating the conditions necessary for another one (March 2020).
And, as it happens, the solution for 2020 created the conditions necessary for Silicon Valley Bank’s collapse.
So it goes.
More on that tomorrow in Part Two.