One of the biggest challenges to the financial sector occurred on March 11 when Silicon valley bank (SVB) declared bankruptcy, followed by the collapse of the Signature Bank. The two bank failures represent the second and third largest bank failures in U.S. history. Another big bank, First Republican bank of California with more than two-thirds of its deposits being uninsured, was also on the brink of collapse. The SVB is the 16th largest bank in the USA with assets of $252 billion. A majority of these banks’ clients are high-tech and startup firms. The sudden collapses of few regional big banks sent a shock wave throughout the global financial markets as a large scale fear erupted as to whether the other small banks would also experience a run on their deposits.
The government acted promptly by backing the uninsured deposits of the failed SVB and the Signature Bank. A group of its rival banks offered First Republic bank with a rescue package. With the prompt action by the government and other banks, the bleeding may have been stopped for now.
The common characteristic of the failed banks was that large banks were catering to a niche group of customers. When some Silicon Valley banks became public few years ago, they were flooded with cash which found their way to SVB and other regional big banks. According to a survey reported in a recent issue of the Wall Street Journal, about 3,000 companies are engaged in business with SVB. About 400 of them have exposure to the meltdown and 300 firms said they could not make payrolls for the next three days.
So what went wrong? Many years of low interest and inflation rates created an environment of complacency among the bankers. Some regional big banks loaded up on long-term bonds on the assumption that the interest rate would remain low forever. SVB had most of its assets held in long-term government-backed, mortgage-based securities and treasury securities, normally low-risk investments. As long as interest rates stay low, yields on long term bonds are higher, relative to short-term bonds. So banks were making good amounts of profits from higher interest rate margins by holding long term bonds. However, when the Fed started applying a tight monetary policy by raising the interest rate in successive phases, trouble began.
There is an inverse relationship between the price of a bond and the interest rate. When the interest rate rises, the present value of the future interest payments and maturity value falls. So as the Fed was raising interest to control inflation, the price of long-term bonds fell more than those of short-run bonds. The longer the term of the bond, the bigger is the decline in the price of bonds with a given change in interest. So even though the value of the liability side of a bank declined with an increase in the interest rate, the value of the asset side consisting mostly of long term treasury bonds declined even more, causing a mismatch between the assets and liability side. Effective liability management is about careful balancing of interest sensitive assets against interest sensitive liabilities and fixed rate liabilities against fixed rate assets. Unfortunately, the sharp increase in the interest rate exposed the regional, big Silicon banks to a higher risk of insolvency, the news of which, thanks to Twitter and other social media, spread fast. The fear of insolvency led to the liquidity problems as depositors rushed to their banks for withdrawals.
The persistent increase in the interest rate may have worked in the moderation of inflation in recent months. But the side effect of a high interest rate policy was that banks were ending up with unrealized losses. The losses would have disappeared if banks could wait until these long-term bonds would mature. But faced with higher interest and the slowdown in the tech economy, depositors turned to their banks for deposits, causing a severe liquidity problem even though banks were technically solvent based on book values. Banks found themselves in the unenviable position to be forced to sell their long-term bonds at a fire sale price causing the insolvency problem to get worse.
The Wall Street Journal reported that at the end of 2022, banks had unrealized losses of $620 billion, which is one-third of the capital cushion banks need. In addition to the effect of interest rate on the asset and the liability side differently, banks didn’t use their profit from the low interest rate judiciously. Instead of building up the cushion to face large withdrawals, bank executives used a large chunk profits on bonuses, severance pays and other lavish expenditures by the executives of these banks, exemplifying the so-called principal-agent problem that management does not always work in the best interests of the company. The SVB “put unusual pressure on borrowers to keep the majority of their cash at SVB” rather than diversify them among other banks, according to an article in the Wall Street Journal.
Though a rise in the interest rate made all banks vulnerable with a risk of bank runs, not all depositors behaved like those of the troubled banks, thanks to the massive aid provided by other regional big banks, and the Fed’s continued assurance that banks in general are not facing any crisis and the Fed is ready to cover any deposit losses by any bank. Depositors in small regional banks continued to have confidence in the stability of their banks and didn’t rush to them for withdrawals. These bank failures also expose an underlying weakness of the fractional reserve system that banks, in order to maximize their profits, normally do not keep enough reserves to meet withdrawals by all its depositors at any given time.
In terms of the monetary policy, the Fed is using the interest rate policy believing that a rise in the interest will reduce the appetite for various types of expenditures, which will then cure or soften the inflation problem. The problem with a high interest policy is that it can have punitive effects on the sectors of the economy that are already struggling in a post-COVID-19 economy, particularly at a time when the economy is ridden with severe supply side bottlenecks from the pandemic-era and the Russia-Ukrainian war.
Syed Ahmed is professor of Economics and Director of Bill Burgess Jr. Business Research Center, Department of Business, at Cameron University.