Silicon Valley Bank has turned out to be the latest victim of the end of the era of ultra-low interest rates.
The New York Times explains what’s happened:
Flush with cash from high-flying start-ups, Silicon Valley Bank bought huge amounts of bonds more than a year ago. Like other banks, Silicon Valley Bank kept a small amount of the deposits on hand and invested the rest with the hope of earning a return.
That had worked well until the Federal Reserve began raising interest rates last year to cool inflation. At the same time, start-up funding started to dry up, putting pressure on many of the bank’s clients — who then began to withdraw their money. To pay those requests, Silicon Valley Bank was forced to sell off some of its investments at a time when their value had declined. In its surprise disclosure on Wednesday, the bank said it had lost nearly $2 billion.
When that news started coming out, depositors started pulling their money out, and a bank run was underway. The FDIC has stepped in, effectively taking over the bank, which will reopen as the National Bank of Santa Clara on Monday, but that’s not the end of the matter. Depositors with more than $250,000 (the FDIC deposit insurance limit) with the bank stand to lose much of their money. The bank had about $175 billion in deposits.
And the losses may hit the start-up scene very hard.
The New York Times:
As the start-up ecosystem tries to make sense of Silicon Valley Bank’s implosion, some entrepreneurs whose funds are frozen at the bank are turning to loans to make payroll. Silicon Valley Bank provided banking services to nearly half of venture capital-backed technology and life-science companies, according to its website, and over 2,500 venture capital firms, including Lightspeed, Bain Capital and Insight Partners.
An additional worry is that the run on Silicon Valley Bank may spread. Bank runs are a mix of the rational and the rational. At their core is the mismatch at the heart of banking. Banks tend to borrow short-term (your deposit is a loan to the bank) and lend long. This creates a mismatch, which is generally fine—it’s how the banking system works. But it means that banks will only have a limited amount of funds to hand back to their depositors at any given moment. If enough of a bank’s depositors decide to ask for their money back at once, then the bank can face a liquidity crunch that could bring it down. Under the circumstances, depositors with more than $250,000 with the bank who hear of other depositors pulling out their money out, might decide (even if they believe that the bank is fundamentally sound) that they should get their excess money out—better safe than sorry—and so a bank run spreads.
The New York Times:
Shares of both First Republic Bank, which is based in San Francisco, and Signature Bank in New York were down more than 20 percent on Friday. But shares of some of the nation’s largest banks like JPMorgan, Wells Fargo and Citigroup, nudged higher on Friday after a slump on Thursday.
And as an example of how quickly and how far unease can spread in the modern era, the Daily Telegraph’s Ben Marlow reports this:
As the anxiety escalated on Friday morning, Deutsche Bank tumbled 7pc on German markets, and Societe Generale fell 4.5pc on the Paris stock exchange, leaving the Euro Stoxx Banks index on course for its worst day since June.
In London, trading ended with a 4.7pc loss for HSBC; 4.5pc at Standard Chartered; 3.7pc at Barclays; and 3.3pc at Lloyds; The FTSE 100 index and the more domestically-focused FTSE 250 both closed 1.7pc lower.
The real concern is that what unfolded with lightning speed at SVB is the first crack in the financial system triggered by an unexpectedly prolonged rise in global interest rates.
That’s one way of looking at it, but in reality, the problem is not that rates have risen so high (in real terms they remain negative), but that they had been artificially depressed for so long. Mess with the price of money and trouble will follow.
As Marlow explains, Silicon Valley Bank was a relatively unusual case:
Bonds make up 56pc of SVB’s total assets compared with 25pc at Fifth Third, and 28pc at Bank of America, after a decision to invest more $90bn of deposits into long-dated securities such as mortgage bonds and US Treasuries, according to the Financial Times. Viewed as a safe bet at the time, they are now worth $15bn less as a result of the sudden swing in interest rates.
Even if Treasuries are (debt ceiling crises apart) seen as the ultimate safe asset, the word “safety” refers to the very high likelihood that investors will be repaid at the end of the bond or bill’s term. Between now and then, however, the price at which these bonds or bills trade will largely be driven by interest rates. The general rule is that as interest rates rise, the price of bonds or bills falls. As they fall, the price rises. That can make for alarming volatility, particularly in the case of longer-term dated bonds (the prices of bonds or bills that are due to be repaid within a relatvely short time are less volatile).
Nor do most other banks have such a high proportion of business customers, which means its funding costs climb more quickly than those where deposits are dominated by retail customers. This made it more vulnerable to the recent spike in interest rates, and the corresponding fall in bond yields.
SVB’s other problem was its acute over-exposure to a struggling technology market – as growth has slowed, funding for start-ups from venture capital and the public markets has begun to dry up, which squeezes the deposit base in both directions.
Nevertheless, SVB’s fate has prompted a collapse of confidence in the wider banking sector as investors question whether what went wrong is symptomatic of a much bigger problem.
There seems to be almost universal agreement among analysts that this is not the case, or at least that systemically important banks are not nearly as vulnerable to rate shocks.
The coming days will be decisive. As anyone with even a vague recollection of the financial crash will know, there is always the risk of contagion if investors have already made up their minds.
After a decade of easy money, the chickens are coming home to roost as the fragility of the financial system in the face of rising interest rates is brutally exposed.
Robert Armstrong, writing in the Financial Times:
Other banks’ portfolios of long-term government bonds will be a drag on margins for years to come. That was largely understood by analysts and investors before SVB fell apart, however. Still, its failure may have changed things in the banking system. After SVB’s demise, depositors, their confidence shaken, may demand more interest for their deposits, squeezing banks’ margins. But this is a profitability problem, rather than a threat to solvency in the style of the 2008 crisis.
It has been widely noted that this week’s events were the consequence of years of very low rates. So they were. In a more normal rate environment, banks would not have extended the duration of their bond portfolios in a search for yield. If banks now have to become more conservative to protect their balance sheets, that will have consequences for credit creation and the economy.
The risk of contagion within the banking system appears to be limited. But at the end of every central bank rate-increase cycle, there comes a phase where things in the financial system begin to break. These breakages, minor or major, erode the confidence of investors and consumers, increasing the odds of recessions. The failure of SVB does not herald another 2008, but it does mark the beginning of the breakage phase.
That seems right. But more to come.