By Alex Gloy*
On Friday March 10, California-based Silicon Valley Bank (SVB) was forced to close. SVB was one of the Top 20 US Banks by assets. Its collapse was the second biggest bank failure in the history of the United States. Who could have caused the collapse of SVB?
Let’s examine the potential culprits one by one.
The Federal Reserve
In a interview With the Blockworks Macro YouTube channel, Chris Whalen, investment banker and author, puts the blame for SVB’s failure on the trail of the Federal Reserve, the US central bank. He argues that long periods of near-zero interest rates have forced management to venture into longer-dated securities to find acceptable returns without compromising asset quality. The speed of subsequent rate increases, the the fastest of the past six cycles, has led to heavy losses on longer duration bonds.
While this is certainly true, a central bank is unlikely to need to consider individual positioning when deciding monetary policy. Unfortunately, rising interest rates usually take their toll, especially after long periods of low interest rates. Should the fight against inflation, which affects every individual, take precedence over the desire to protect certain institutions against financial damage?
Whalen predicted the Federal Reserve would cut interest rates in an emergency meeting before financial markets open Monday morning or face the risk of contagion. Whether that happens or not, it looks like Whalen isn’t quite right in blaming the Fed for SVB’s collapse.
Over the past ten years, customer funds at SVB increased almost tenfold, from $38 billion in 2012 to $375 billion in 2022. Inflows in 2021 alone were $137 billion. From a bank’s perspective, customer inflows represent an increase in liabilities. The bank must make a corresponding transaction on the asset side of its balance sheet, preferably earning a higher rate of interest than that due to its customers.
During the period of the largest inflows, the returns of securities considered risk-free, such as 3-month Treasury bills, varied between 0.02% and 0.16%. Management could have chosen to relax loan approval standards in order to increase loans to customers. This would have been a recipe for increased credit losses in the future. Low interest rates have forced management to venture into longer dated bonds in order to earn acceptable returns on their assets.
Despite these pressures, the management does not seem to be able to escape completely unscathed.Moody’s severely downgraded SVB, citing “significant interest rate and asset liability management risks and weak governance”. In hindsight, buying hedges against rising interest rates would have been beneficial. However, these hedges would have eaten away at the margins more. Management could be forgiven for dismissing the need to hedge after a decade of interest rates below 2.5%. Still, it is worth investigating the gaps in governance.
Social media abounds with comments demanding ‘no taxpayer bailouts for wealthy clients’ or accusing clients of not being aware of the Federal Deposit Insurance Fund’s (FDIC) $250,000 insurance limit per account. Many of SVB’s clients were start-ups in the technology and healthcare sectors. Their deposits at the SVB often consisted of capital raised from venture capitalists – money intended to see them through the first years of loss. These funds are needed for payroll, rent and other living expenses. Losing them would most likely cause the start-up to shut down and all employees to be fired.
A bank’s client should not be required to study the bank’s balance sheet or familiarize themselves with the implications of monetary policy decisions on duration risk. During the financial crisis of 2008-09, the FDIC managed to protect all depositors of nearly 500 bankrupt banks without using a single taxpayer dollar. The same is expected at SVB, especially as the losses incurred appear manageable relative to its assets.
Rating agencies and regulators
A press article by Reuters titled “Silicon Valley Bank’s Demise Began With a Downgrade Threat” describes how an impending credit ratings downgrade by Moody’s derailed a plan by SVB to raise $1.75 billion in fresh capital. For legal reasons, investors should be informed of material developments when purchasing newly issued securities. While news of an impending downgrade certainly spooked potential investors, it would be unfair to blame rating agencies for the bank’s demise.
Following the 2008-09 crisis, banking supervision tightened. Bankers regularlycomplain how tight regulation hampers their operations. “Where were the regulators when SVB crashed” asked THE The Wall Street Journal. The article raises some valid questions, but it’s important to note that regulations require banks to hold a certain percentage of assets in “high-quality liquid assets.” These can be quickly turned into cash should depositors wish to withdraw funds, which is exactly what SVB has done. Its losses came not from bad credit or investments in poor quality assets, but from unrealized losses on high quality bonds.
Regulations cannot anticipate every business decision a bank might make. The banking sector is already one of the most regulated sectors and more regulation does not seem to be the solution.
The Crypto Bros and Short Sellers
Bitcoin advocates were quick to celebrate SVB’s demise as a sign that the current system of fiat money was about to collapse. Meanwhile, Circle Internet Financial, the issuer of USDC stablecoin, confirmed to have $3.3 billion out of $40 billion of its stranded reserves at SVB. This revelation caused a stir in the stablecoin market, with USDC breaks its $1 peg. It is not without irony that crypto is still dependent on traditional banking – the system it seeks to free its followers from – only to get caught with funds in said system, leading to a bank run on its stablecoin.
Stablecoin reserves are difficult to manage as a withdrawal might be required in a short period of time. Many banks refuse deposits from stablecoin operators for this reason, aside from legal considerations.
As usual, short sellers are accused of driving down the stock price of a bankrupt company. However, short sellers analyze companies thoroughly and are knowledgeable. Rising short interest (number of stocks sold short) is often an indication of trouble brewing. According to an online service, as of February 15, approximately 6% of SVB shares outstandings were sold short. This is only a slightly high number. If the short sellers had had an impact on SVB’s share price, it would have been relatively minor.
SVB was Unique
The bank’s business model is to borrow short term (at low rates) and lend long term (at higher rates). Otherwise, there is no way to take deposits and make a profit. Net interest margins are slim. It would make no sense to run a bank without leverage. The business model has inherent risks, but these risks should not be borne by depositors. Depositors themselves pose a risk if they decide to withdraw funds all at once. This is discouraged via FDIC deposit insurance, which has worked very well in the past.
The combination of rapid deposit growth during a period of low yield, a lack of lending opportunities, a high share of uninsured deposits and rapidly rising interest rates has led to a unfortunate lack of risk-bearing capital. Calls on start-ups to to withdraw their funds were individually rational, but they led, overall, to a bank run and the irrational result of the bank closing.
It is important to contain the contagion: share prices of other regional banks have suffered. Investors are now also worried about unrealized losses on long-term bonds of other institutions. In order to prevent growing distrust from becoming a self-fulfilling prophecy, the Federal Reserve may be forced to prevent the fire from spreading by lowering rates or lending against collateral. The fight against inflation may have to take a back seat.
The opinions expressed in this article are those of the author and do not necessarily reflect the editorial policy of Fair Observer.
*About the author: Alexander Gloy is an independent investment professional with over 35 years of experience in the financial markets. He worked in Equity Research and Sales, both in Investment and Private Banking for Deutsche Bank, Credit Suisse, Sal. Oppenheim and Lombard Odier Darier Hentsch. It focuses on macroeconomic research, analyzing the impact of global debt and derivatives on the stability of our monetary system. His interest in cryptocurrencies from a monetary theory perspective led him to become a member of the Central Bank Digital Currency Think Tank. He has taught at colleges and universities.
Source: This article was published by Fair Observer