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SVB Failure and the Risk of Contagion

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SVB Failure and the Risk of Contagion

Last week, there was upheaval in the US banking sector when Silicon Valley Bank (SVB), a US-based bank whose primary customers were cash-burning start-ups with millions of dollars raised from the venture capital community, collapsed, leaving depositors anxious about the safety of their deposits.

This was hot on the heels of another bank failure, Silvergate Bank, a banker to crypto exchanges, which announced on 08 March 2023 that it planned to wind down operations and voluntarily liquidate after posting significant losses following the collapse of the crypto exchange FTX.


Why did SVB fail?

Banks take deposits from their customers in their normal course of business and lend at a significantly higher interest rate than they pay depositors, thus making a healthy profit in between.

The main reason for bank failures is when banks lend too much money to companies unable to repay their loans. This was not the case with SVB, which had too much money from its cash-rich start-up customers and few customers to lend to. The options available to make a healthy profit were few because of the low rates of return available in the market before 2022, so it turned to the long-dated bond markets that offered the best yields at the time, thus investing its short-term deposits in long-term bonds.

In the last 12 months, interest rates have risen sharply in the US, rising from 0.25% to 4.75%. The rise had a big impact on the value of the long-dated bonds held by SBV. There is an inverse relationship between interest rates and bond values, so as rates rose, the value of the bond held by SVB started to fall dramatically.

In normal times, this wouldn’t have been a problem, however, the recent fall in valuations of tech stocks led to these customers needing to withdraw their money and because the banks had invested in long-term assets, their liquidity ratio (a measure of their ability to repay the short-term debt) started to fall. Demand for cash withdrawals gathered pace when major venture capital firms started asking companies in their portfolio to withdraw their money from SVB. This led to a run on the bank as more companies headed for the door, causing the bank to collapse.


Could this spread to other institutions?

To put this into perspective, the SVB failure is the second largest in US banking history, with $209bn in assets at the time of the collapse. If this were an isolated incident, then we would be tempted to say that it wouldn’t have any impact beyond SVB. However, SVB is the second of three bank failures in the past week.

US regulators abruptly shut down Signature bank on 14 March citing systemic risk as the reason for the closure. Both Sivergate and Signature banks had exposure to crypto exchanges and as the fallout from the failure of FTX and the loss of confidence in cryptos gathered pace, their business models became unsustainable.

These banks have links to techs, crypto, and other businesses and relationships with other banks, all of which could face financial ruin, and could in turn, lead to a wider bank run on other banking institutions with stronger balance sheets.

Fortunately, the US government stepped in early in the week to provide a liquidity back-stop and assurances that depositors would not lose their money, but will it be enough?

Three bank failures within a week in the US is very concerning. These banks failed because their customers, mainly corporates, tried to withdraw their money simultaneously, leading to a liquidity crisis. How many other banks have similar balance sheets to SVB? We could be witnessing the start of another global crisis in the financial markets.

What happens in 3 to 6 months’ time matters. If the spate of bank failure continues, it would indicate that some form of a financial crisis is unfolding. The rapid increase in interest rates will have impacted the value of long-dated assets that banks have invested in. In addition, the slowdown in the global economy in the last six months and the overall drop in confidence could spread very quickly. When combined, there is a very real possibility that we have not seen the last of the bank failures and could be witnessing the start of another global financial crisis.

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