The financial wizards who set the rules for our financial markets have inadvertently created a two tier system. They have designated a few very large financial institutions as “Systemically Important” or in the vernacular “too big to fail”. They have made it very clear the institutions to which they are referring. That seems smart as a way to say these banks, insurance and investment companies are large and if they fail it will have significant negative impacts for the country. It therefore also establishes a second group of financial institutions, those which are allowed to fail.

This would be okay, but for the existence of the FDIC and insurance for depositors. For every federally licensed financial institution the FDIC provides insurance to depositors, generally $250,000 per account. There are some exceptions that allow for a higher amount but for this discussion $250k works. In the recent Silicon Valley Bank (SVB) failure and the run on First Republic (FRC) the $250,000 dollar limit created much of the angst for those institutions. SVB and First Republic had fallen into the classic banking trap. They had made a lot of loans that had a term in years, and were generally fixed rate. These loans were funded by depositor accounts which 18 months ago were paid very little in interest. Great deal for the banks. Loan money for 3.5% and pay the depositors .25%. The difference between what banks pay depositors and the rate on loans they make is their “net interest margin”. When the expense side of the equation changes it can become precarious for the bank.

Over the last year or so the Federal Reserve has been trying to fight inflation by raising interest rates in the market. One impact is that banks now have to pay their depositors more interest or those deposits will be withdrawn. If those deposit funds were tied up in long term low interest loans the bank has a problem. The loans may be good loans and likely to be paid off, but it doesn’t matter. The bank needs cash to repay depositors who are withdrawing funds. As people start withdrawing funds the bank has a cash flow squeeze. When people realize the bank is squeezed they try to take their money out as soon as they can. All of them. At once. The result is that the bank cannot repay its’ depositors and is effectively bankrupt regardless of the quality of the assets it owns. They can potentially sell some of those assets but loans that earn less than the market rate of interest are not worth their face value. The result is large losses and the taxpayer stepping up to bail out the banks. Or at least the first $250,000 per depositor. Then the political cat fight starts. Big depositors caught short or asleep immediately start screaming for relief in the form of an expanded deposit guarantee. This happened in 2008 and again last month with SVB. Big depositors are typically politically connected. You will be stunned to hear that the government stepped in to guarantee all of the deposits and save the bacon of a bunch of tech companies and their financial backers. Right or wrong it happened.

So who is next? The government cannot afford to fight inflation and guarantee all of the deposits of the banking system. Doing so would give the banks no incentive to make good loans that would be repaid rather they would simply make as many loans as they could to allow the banksters to collect big bonuses, consequences be damned. The Treasury Department personified by one Janet Yellen, a Berkeley Finance type distinguished mostly by being wrong a lot, starts trying to simultaneously calm fears of a bank run and deny that deposit insurance will be increased beyond the current limits. Despite what happened last month for the SVB depositors and now for First Republic. That was different because shut up.

Here is where it gets ugly. Regional and local banks tend to make the majority of the small business and commercial real estate loans in the country. Those banks have the misfortune of not belonging to the club of “Too Big to Fail”, which means the Treasury department is saying “we can allow this this bank to fail”. That implies that the deposit limits are in place for the smaller banks and more importantly their depositors, but not for the depositors of the Wells Fargo, Bank of America and JP Morgans of the financial world. I could add Prudential, Pimco and Blackrock to that list as well but you get the picture. No rational depositor will keep more than $250,000 in any single account in any of the smaller, “Not Too Big to Fail” banks. You would be stupid to do so when you have the Federal Government effectively saying that they will backstop 100% of the deposits in the Systemically Important Banks.

Most people do not have deposits in excess of $250,000. But a lot of those who do, local businesses, retirees and the like want to support their local bank but simply cannot justify the risk. The local bank now has a hard time growing their deposit base no matter how secure. With limited deposits the local bank’s ability to make loans to the local community business, or real estate development is severely constrained. No problem, this means that the Big Banks will just step in and make those loans. Right. Not a chance. Big banks try not to make small loans or loans that are based on knowing their customers. They are heavily incentivized to make “safe” loans or buy government bonds as an investment. Convenient for the government and the big banks which have a locked in source of cheap capital. Lousy for the regional and community banks and the customers who depend on them for credit.

Over the next 18 to 24 months credit available to small and medium sized businesses will gradually dry up. As borrowing costs increase fewer investments make business sense. This will result in lots of companies being starved for capital or simply closing. Business may be doing fine for the big companies as credit is still available to help them take market share from smaller competitors. The result is small business job loss, and more economic hardship for the suburbs and rural areas. I suspect we will see more bank failures as well. Congress created this mess. I am certain they will quickly pass more laws resulting in more bank regulation, but will not improve credit conditions for the people most squeezed. Be sure to thank your representatives when you see them.