What triggered Silicon Valley Bank’s collapse?
SVB’s collapse was triggered by the emergence of a bank run that highlighted the classic liquidity/duration mismatch prevalent in the banking sector.
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The collapse of Silicon Valley Bank (SVB) and the shutting down of Signature Bank has pushed financial instability concerns onto the front pages once again. As the Federal Reserve (Fed), the Federal Deposit Insurance Corporation (FDIC) and the Treasury Department rush to douse multiple financial fires, it is necessary to take a step back and consider how we got here in the first place.
During 2020-21, the Fed pursued ultra-accommodative monetary policies that held down yields (implying higher bond prices) on Treasuries and mortgage-backed securities. After lowering short-term policy rates to near-zero levels in March 2020, the Fed instituted a massive round of quantitative easing (QE) that resulted in the purchase of around $4.6 trillion worth of long-dated Treasuries and mortgage-backed securities over the following two years. (The Fed ended its asset purchase program in March 2022.)
The resultant liquidity surge gave rise to an “everything bubble” in 2020-21 as the Fed’s easy money policy contributed to a massive increase in speculative investments in tech stocks, crypto currencies, NFTs and other risky assets. During this period, venture capitalists, flush with easily accessible capital, were throwing money around and there was a surge in startup activity. Since SVB specialized in servicing both Silicon Valley-based venture capital firms and many of the startups they funded, it experienced an especially strong surge in deposits. (Its deposits tripled during the boom period.)
Following the spike in client deposits (a liability on the bank balance sheet) in the aftermath of the March 2020 pandemic shock, SVB decided to invest in long-dated Treasury securities and mortgage-backed securities (assets on the bank balance sheet). The difference between assets and liabilities is referred to as bank capital (or owner’s/shareholders equity).
As long as asset prices remain elevated, bank capital levels will appear strong on paper. However, if asset values fell substantially (while liabilities remained high), the resultant decline in bank capital will raise insolvency fears. Historically, sudden changes in the interest rate environment have wreaked havoc on balance sheets.
Having fallen behind the curve, the Fed embarked on a rapid rate-hike path to ease inflationary pressures. Between March 2022 and February 2023, the Fed hiked rates by 450 basis points. Central bankers also signaled to financial markets that interest rates would remain higher for longer. Consequently, yields on mortgage-backed securities and Treasuries surged (implying a sharp drop in their prices).
Prophetically, FDIC Chairman Martin Gruenberg recently offered the following warning regarding interest rate risks: “First, as a result of the higher interest rates, longer term maturity assets acquired by banks when interest rates were lower are now worth less than their face values. The result is that most banks have some amount of unrealized losses on securities. … Unrealized losses on securities have meaningfully reduced the reported equity capital of the banking industry. The good news about this issue is that banks are generally in a strong financial condition, and have not been forced to realize losses by selling depreciated securities. On the other hand, unrealized losses weaken a bank’s future ability to meet unexpected liquidity needs. That is because the securities will generate less cash when sold than was originally anticipated, and because the sale often causes a reduction of regulatory capital.”
SVB’s collapse was triggered by the emergence of a bank run that highlighted the classic liquidity/duration mismatch prevalent in the banking sector. In this case, the decline in customer confidence was driven by SVB’s failure to adequately adjust to a rapidly changing interest rate environment. Facing mounting losses on the asset side of its balance sheet (which had a substantial exposure to long-dated government securities that were acquired near peak prices), SVB’s parent company sold some $21 billion worth of securities in early March at a loss of around $1.8 billion and announced plans to raise $2.25 billion worth of equity capital to shore up its balance sheet.
This raised concerns among several clients, which began to withdraw their deposits from SVB. The situation was compounded by the fact that over 90 percent of SVB’s deposits were uninsured, reflecting a largely corporate customer base. The FDIC’s standard insurance covers only up to $250,000 per depositor account. Even prior to the recent turmoil, many startups and venture capital funds were yanking funds from low-yielding bank deposits as they sought more attractive returns in money markets (yields on some Treasury bills approached 5 percent in recent weeks). Given that short-term liabilities (deposits) were covered by long-dated assets (mortgage-backed securities and Treasuries) that had suffered significant paper losses, SVB was caught in a bind.
As more and more depositors withdrew funds, SVB was facing massive losses from a forced liquidation of its asset holdings at substantial losses. In many ways, bank runs reflect self-fulfilling prophecies. As more and more depositors rush for the exit, the financial institution teeters towards insolvency, and, when a critical mass of client withdrawals is reached, a forced shutdown becomes inevitable.
Bank failures are not exactly uncommon in the U.S. However, the size and nature of recent failures suggest a need to reexamine risks associated with ultra-loose monetary policies and poorly-designed regulations. The rise and collapse of the tech and crypto bubbles contributed to the problems faced by SVB, Signature Bank and Silvergate Capital.
It is high time that Congress forced the Fed to explicitly incorporate a financial stability mandate alongside a price stability mandate. The current dual mandate, focused on attaining full employment and price stability, may need to be reconsidered.
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