SVB, SPDIs, and the Future of Banking

by Tanner C. Dowdy, Notes and Comments Editor, University of Cincinnati Law Review Vol. 91

I. Introduction

The collapse of Silicon Valley Bank (“SVB”) was the largest bank failure since the Financial Crisis of 2008.1Rachel Louise Ensign et al., Silcon Valley Bank Closed by Regulators, FDIC Takes Control, Wall St. J. (Mar. 10, 2023), https://www.wsj.com/articles/svb-financial-pulls-capital-raise-explores-alternatives-including-possible-sale-sources-say-11de7522. In many ways, SVB’s collapse is a reminder to retail depositors that, thanks to fractional reserve lending, banking is an inherently fragile business.2See generally Michael S. Barr et al., Financial Regulation: Law and Policy 8-12 (3d ed. 2021). That is to say, banks are, technically speaking, on the brink of illiquidity and insolvency at all times: If all depositors demanded their money at once, the bank would not meet its obligations.3Id.

Since SVB failed, more banks have suffered a similar fate, including Signature Bank, First Republic Bank, and Credit Suisse.4Luc Olinga, Four Banks Collapsed. Worries About Two Others Persist. Will They Fall?, TheStreet (Mar. 24, 2023), https://www.thestreet.com/banking/four-banks-collapsed-worries-persist-around-two-others-will-they-fall. Though there are differences in the details underlying each of these failures, it is widely accepted that together, the failures indicate financial contagion is afoot.5Id. And given the speed at which information and money is exchanged today, there are those who are beginning to explore how to exit the fractional reserve banking system altogether (or at least hedge their exposure).6See Abha Bhattarai, Bye, Banks: Recent Turmoil Is Spurring Many to Move Their Money, Wash. Post (Mar. 24, 2023), https://www.washingtonpost.com/business/2023/03/24/bank-deposits-withdrawals-money-markets/. As it turns out, those holding existential fears about the current banking system should find solace in a new bank charter being proposed in numerous jurisdictions: the Special Purpose Depository Institution (“SPDI”). 

This article highlights why SPDIs are a unique solution for those who are increasingly wary about the safety of holding dollars in the commercial banking system in the United States. Part II explains why commercial banking is inherently risky; detailing what happens when a bank accepts your deposits for lending. Part III describes how bank charter statutes and deposit insurance mitigate the risk of fractional reserve lending.  Part IV details new risks that banks face today; and Part V introduces a novel solution to the risks of modern commercial banking—full reserve banking under an SPDI charter.

II. The Risks in Fractional Reserve Lending

Banks never hold enough cash money to satisfy all of their depositors.7Barr, supra note 2, at 10. That is because when a bank accepts cash deposits (or an interbank payment), it takes those funds and commits them to a process known as maturity transformation.8Id. What that means is that banks loan in excess of the amount of reserves they hold—whether their reserves are held in a cash vault or on account at the Federal Reserve.9Id. Crucially, each time a bank makes a loan, it creates another deposit.10Id. Banks also invest funds they hold in safe securities that generate returns.11Id. In other words, banks borrow short (by accepting demand deposits) and lend long (by making loans or investing in, hopefully, safe securities).12Id. Banks generate profit from the spread between the interest expense they incur on deposits and the interest revenue they collect on loans and investments.13Id. at 148.

Properly managed, maturity transformation promotes credit creation and economic growth to those in the real economy who wish to finance their operations.14Id. at 10-12. But of course, the tradeoff is that, at all times, banks have less on hand than they owe.15Id. As a result, they face liquidity and solvency risk, operating on the assumption that a certain number of withdrawal demands will not commence at once.16Id. If that were to happen, a “run” on the bank would commence, and depositors would not be made whole.17Id. 

Banks, by creating loans and corresponding deposits, create money from nothing.18Joseph Wang, Central Banking 101 19-21 (2020). Further, this process—loaning more than what is held in reserve—could, in theory, go on forever.19Id. If this practice sounds risky, that is because it is. Accordingly, regulators have a created a bevy of tools to mitigate the risk fractional reserve banking presents to retail depositors. Those tools include bank chartering and deposit insurance.  

III. Mitigating Risk: Bank Chartering & Deposit Insurance

A. Bank Charters

Before a bank can begin taking deposits and making loans, it must be granted a charter.20Barr, supra note 2, at 167. Charters are meant to gatekeep who may enter the business of banking.21Id. The following excerpt succinctly captures the function of charter statutes in financial regulation:

Starting a bank involves a long organization process that could take a year or more, and [in the United States] permission from at least two regulatory authorities. Extensive information about the organizer(s), the business plan, senior management team, finances, capital adequacy, risk management infrastructure, and other relevant factors must be provided to the appropriate authorities.22Id.

In the United States, banks may choose to be chartered at the state or federal level.23Id. at 175. Which type of charter a bank pursues determines the prudential regulator that oversees its operations.24Id. If a bank elects to be federally chartered (“National Bank”), its prudential regulator is the Office of the Comptroller of the Currency (“OCC”).25Id. And, because all National Banks are required to be members of the Federal Reserve system, National Banks are regulated by the Federal Reserve (“Fed”).  Federal law also requires that National Banks have federal deposit insurance; accordingly, the Federal Deposit Insurance Corporation (“FDIC”) acts as a third regulator for National Banks.26Id.

If a bank elects to pursue a state charter (“State Bank”), its prudential regulator is the state regulatory agency tasked with overseeing commercial banks.27Id. State Banks are allowed to choose whether they wish to become a member of the Fed.28Id. If not, the State Bank will not have access to the Fed’s payment rails—a serious limitation.29Id. Importantly, State Banks have no optionality with regard to deposit insurance: “all state laws require that a [State Bank] obtain FDIC insurance.”30Id. In practice, “the vast majority of [National Banks] and [State Banks] are wholly owned by holding companies that are regulated by the Federal Reserve . . . .”31Id.

The charter system allows regulators to assess and screen risks at the beginning of the bank’s life.32Id. at 167. Additionally, charter statutes prevent those who receive charters from engaging in certain activities that pose risks to the business of banking, such as investing a portion of deposits in risky assets like equity stocks.33Id. at 219. By gatekeeping the business of banking, charters help retail depositors feel more confident that the institutions they entrust with their money are acting responsibly.34Id. at 167. Further, the federal charter system helps promote regulatory uniformity among the largest banks (since most of the largest banks are National Banks), which helps mitigate market instabilities associated with excessive regulatory arbitrage.35Id. at 174-75.

B. Deposit Insurance

The prevalence of bank failures following the Great Depression led regulators to enact the Banking Act of 1933, which created the FDIC.36Id. at 53. In addition to supervising banks, the FDIC levies a fee on National and State Banks that contributes to an insurance fund.37Id. at 261. The FDIC insurance fund guarantees deposits up to a certain amount.38Id. at 260. Currently, the number is $250,000.39Id. The insurance fund administered by the FDIC should, in theory, help depositors feel safe that in the event of a bank run, they will be able to recover any money lost.40Id.

The success of the FDIC fund rests on two core assumptions: (1) that bank failures will never be so widespread that the fund is overwhelmed; and (2) the $250,000 cap on insurance reflects a reasonable amount for how deposits are situated across the banking system. The fall of SVB and other banks may challenge whether either of these assumptions can still be defended. Of particular concern are some practical realities of the world today that present serious risks to its stability.

IV. Modern Day Risks: Faster Payment Rails; Interest Rate Risk; Information Flow

Today, banks face acute risks stemming from (A) faster payment technology; (B) centrally controlled interest rate risk and inflation; and (C) faster information flow.  Each of these risks are presented below.

A. Faster Payment Technology

Banks that are members of the Fed have access to FedWire.41See Fedwire Funds Service, Fed. Rsrv., https://www.frbservices.org/financial-services/wires/ (last visited Apr. 8, 2023). However, in the summer of 2023, member banks will have access to a faster payment system: FedNow.42See FedNow℠ Service, Bd. of Governors of the Fed. Rsrv. System, https://www.federalreserve.gov/paymentsystems/fednow_about.htm (last visited Apr. 8, 2023). FedNow is a step towards real time settlement for interbank wires and transactions.43Id. On the one hand, FedNow will promote faster payments, reduce transaction costs, reduce counterparty risk, and promote liquidity.44Id. But, on the other hand, FedNow introduces more risk with regard to depositor flight: Imagine how much quicker SVB would have collapsed if FedNow had been online.

B. Interest Rate Risk and Inflation

As a result of massive fiscal stimulus and monetary intervention from the Fed, the money supply exponentially increased during 2020-2021.45See M2 [M2SL], Bd. of Governors of the Fed. Rsrv. Sys., FRED, Fed. Rsrv. Bank of St. Louis (Mar. 28, 2023), https://fred.stlouisfed.org/series/M2SL. Right or wrong, the deficit spending and money printing led to price inflation in the real economy.46See Gabriel T. Rubin, U.S. Inflation Hits New Four-Decade High of 9.1%, Wall Street J. (July 13, 2022, 7:07 PM), https://www.wsj.com/articles/us-inflation-june-2022-consumer-price-index-11657664129. And, because the Fed has a mandate to fight inflation, it has, since 2021, resorted to abnormally fast rate hikes.47Ensign et al., supra note 1. Rate hikes restrict lending and access to credit in the banking system.48See Wang, supra note 16, at 105-120. In such an environment, depositors, especially those such as venture capitalists who need their funds for operating expenses, are encouraged to withdraw at higher rates; which is exacerbated by the desire to exit deposit accounts as inflation causes dollars to lose their purchasing power.49See generally Ensign, supra note 1.  

Aside from increased expenses and cost of capital, rate hikes present another, more hidden threat to banks: unrealized losses on securities investments.50Ensign et al., supra note 1. Recall that banks often take depositor funds and reinvest them in assets—such as treasuries and mortgage backed securities—that offer a safe return.51Barr, supra note 2, at 10. This model is safe insofar as only those assets do not experience a sharp decline in value.52Ensign et al., supra note 1. And unfortunately, as the Fed raised rates, a loss in value is exactly what has happened. Because new treasury and bond issuances are offering higher returns, prior issued securities that banks bought at lower rates have suffered losses.53Id. Crucially, those losses have not been reflected in the market until now, as banks have started selling securities to meet withdrawal demands from depositors.54Id.

C. Faster Information Flow

Information speed was a centerpiece in the collapse of SVB, which occurred over the course of forty-eight hours.55Ramishah Maruf & Allison Morrow, How Does a Bank Collapse in 48 Hours? A Timeline of the SVB Fall, CNN Bus. (Mar. 13, 2023), https://www.cnn.com/2023/03/11/business/svb-bank-collapse-explainer-timeline/index.html. Put simply, as depositors at SVB began panicking, they began to sound the alarm by leveraging social media platforms and cell phones. Like a hive, the venture capitalists with large accounts rushed the bank.56Alex Conrad, Silicon Valley Bank’s Abrupt Closure Leaves Venture Capitalists And Founders Scrambling, Forbes (Mar. 10, 2023), https://www.forbes.com/sites/alexkonrad/2023/03/10/silicon-valley-bank-closure-vc-startups-reaction/?sh=3e162644eda4.

The speed at which SVB faced demands proves just how much “information speed” risk banks face today. Unfortunately, this risk is hard to fight against. Phone alerts, decentralized applications, news feeds, and social media may not increase the length of a line at the bank door, but they surely help to accelerate the speed at which the line develops. Because bank runs are fundamentally a liquidity issue, banks have an interest in reducing the speed at which depositors ask for their funds: if they can buy some time, they may be able to liquidate just enough assets to make depositors hold and stave off panic. SVB was not so lucky.

In theory, one would assume that facing this confluence of risks, more banks would begin to hold pure cash in reserve on the fear that bank runs could happen quicker today than they could have even twenty years ago. Unfortunately, this assumption would not be correct. Though post financial crisis regulations increased the amount of required capital banks must hold, those regulations may no longer instill confidence for depositors: data demonstrates that banks continue to be highly leveraged and exposed to depositor flight risk at the middle market and regional level.57Nicole Goodkind, US Banks Sitting on Unrealized Losses of $620 Billion, CNN Bus. (Mar. 12, 2023), https://www.cnn.com/2023/03/12/investing/stocks-week-ahead/index.html. The good news is that certain jurisdictions may be offering an answer to the increased risks traditional banks face: the SPDI charter.

V. Special Purpose Depository Institutions

Long before the collapse of SVB, SPDI legislation and SPDI charters were being pushed.58See Patrick J. Boot & Marysia Laskowski, Wyoming Issues Second Crypto Bank Charter, Nat’l L. Rev. (Nov. 10, 2020), https://www.natlawreview.com/article/wyoming-issues-second-crypto-bank-charter. SPDI legislation creates what is known as an SPDI charter, which would allow chartered entities to practice full reserve banking (meaning banks would have to hold an amount of reserves equal to 100% of the amount in claims that depositors are entitled to).59See Carla Napolitano, H.B. 585, Bill Analysis, Ohio Legis. Serv. Comm’n 1 (Mar. 25, 2022), https://www.legislature.ohio.gov/download?key=18718&format=pdf. The primary way such a bank would make money is through transaction fees and contractual arrangements with its depositors.60Id. More than any other state, Wyoming led the way in adopting such legislation.61Boot & Laskowski, supra note 56. 

It is not just Wyoming that is experimenting with SPDI charters. Ohio, for example, recently proposed House Bill 585 which, if passed, would permit SPDIs to perform “nonlending banking business with depositors, conduct activity incidental to the business of banking, and provide custodial services for digital assets . . . .”62Napolitano, supra note 57, at 1. The bill would allow SPDIs to apply to become a member of the Fed.63Id. at 7. But, unlike all other depository institutions, SPDIs would not be required to hold FDIC insurance. That said, the point of the charter, of course, is to remove the need for FDIC insurance by mandating full reserve banking. The bill states that “an SPDI must, at all times, maintain unencumbered liquid assets valued at not less than 100% of its depository liabilities.”64Id. at 9. “Liquid assets” means any of the following: (1) U.S. currency held on the premises; (2) reserve accounts of the SPDI at a federal reserve bank (assuming the SPDI applies and is accepted to be a member of the Fed); (3) deposit accounts of the SPDI at a FDIC insured bank; or (4) highly liquid investments such as treasuries or other agency debt.65Id.  

So long as an SPDI met the requirement regarding full reserves, it would be permitted to “[exercise] custody [over client assets], [oversee] asset servicing, [provide] fiduciary asset management, and [conduct other] related activities.”66Id. at 7. And that’s not all, SPDIs would also be permitted to provide payment services, receive notes, and purchase and sell silver and gold bullion.67Id. That said, the bill does impose several restrictions. First, any entity banking with an SPDI would need to meet a deposit minimum of $5,000. Further, the SPDI, rather than pursue FDIC insurance, would be required to collect payments from depositors for pooling into a contingency fund for a potential liquidity event.68Id. at 1.

One important limitation of Ohio House Bill 585 is that it would restrict depositors to legal entities.69Id. at 1. That means no natural person could bank with an Ohio SPDI.70Id. In addition to this limitation, the legislation specifies that prior to receiving a charter, an SPDI applicant must have $10,000,0000 in capital stock and demonstrate a reserve fund that could sustain the institution’s operating expenses for three years.71Id. at 2.

An important note regarding the future of SPDIs is their status under the Fed. Though House Bill 585 allows SPDIs to apply for Fed membership, that does not mean the Fed will accept SPDIs with open arms. In fact, there is already evidence that the Fed is hostile towards SPDIs: The Fed recently rejected an application for membership from Custodia Bank, a Wyoming SPDI chartered with full reserves.72See Federal Reserve Board Announces Denial of Application by Custodia Bank, Inc. to Become a Member of the Federal Reserve System, Bd. of Governors of the Fed. Rsrv. Sys. (Jan. 27, 2023), https://www.federalreserve.gov/newsevents/pressreleases/orders20230127a.htm. One has to wonder why the Fed would reject such banks that, in theory, are far more liquid and safer than the rest of its members. Perhaps it has to do with the permissiveness SPDI legislation shows towards exercising custody over digital assets, which would include virtual currencies such as Bitcoin.

VI. Are SPDIs the Solution to Meet the Demand for Full Reserve Banking?

A lot could be said about the SPDI model. Though it is true that SPDIs would, in theory, give depositors more security, there is the possibility that widespread use of SPDIs would reduce capital investment through credit contraction throughout the economy. What can certainly be said is that SPDIs would offer a state blessed custodial solution and banking option for those in the digital assets ecosystem. One could argue that, if the use of virtual currency grows, then the security that SPDIs provide would serve as an affront to the traditional banking system and its payment rails. 

With regard to Ohio House Bill 585, the legal entity requirement does restrict SPDIs from personal banking. That said, it is not a stretch to imagine that individuals desperate to access full reserve banking at an SPDI could use an LLC or S-Corp to open an account. Though such a scheme would implicate concerns under the recently passed Corporate Transparency Act, incorporating as an entity to access SPDI services may be the best option for individuals absent an amendment that allows them to personally bank with SPDIs. Another option is for depositors to hedge their exposure to the traditional banking system. This could be done, for example, by holding $250,000 in a FDIC institution, and the rest in an SPDI account under a legal entity. Regardless of what the future holds, as the fight against the banking contagion continues, legislators, regulators, and depositors should research the utility of SPDIs—they may become integral to the future of banking. 

Cover Photo by Expect Best on Pexels

Author

  • Tanner Dowdy is a Kentuckian born and raised. Before law school, Tanner attended the University of Kentucky where he majored in Finance and Political Science. It was at UK, fusing together these majors, where Tanner became passionate about the interplay between law and capital markets. His contributions to the law review reflect that passion. After law school, Tanner plans to practice in the securities law space. In his free time, you can find Tanner outdoors, collecting vintage records, running, lifting, or visiting new coffeeshops and breweries with friends!

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