Why SVB and Signature Bank failed so quickly and why the US banking crisis is not over yet

Silicon Valley Bank and Signature Bank went bankrupt very quickly, so quickly they could become classic examples of banking crises when too many depositors withdraw their funds at the same time. The SVB and Signature bankruptcies were two of the three largest in US banking history since the Washington Mutual collapse in 2008.

How could this happen when the banking sector has accumulated record levels of reserves, that is, amounts of cash held in excess of what is required by regulators?

While the most common type of risk faced by a commercial bank is the rise in loan defaults, known as credit risk, this is not what is happening here. As a banking economist, I think it comes down to two other big risks that every lender faces: interest rate risk and liquidity risk.

Interest risk

The bank faces interest rate risk when interest rates rise very quickly in a very short period of time.

This is exactly what has been happening in the United States since March 2022. The Federal Reserve is aggressively raising rates – by 4.5 percentage points so far – in an attempt to curb rising inflation. As a result, the yield on debt increased in the same proportion.

1-year US Treasury yields hit their highest level in 17 years (5.25%) in March 2023, down from less than 0.5% in early 2022. And 30-year Treasury yields are up nearly 2 percentage points .

When a security’s yield rises, its price falls. This is why such a rapid increase in rates in such a short time has led to a sharp drop in the market value of previously issued debt – whether corporate bonds or Treasury bills, especially long-term debt.

For example, a 2 percentage point increase in the yield on a 30-year bond could cause its market value to drop by about 32%.

SVB, as the Silicon Valley bank is known, has invested the majority of its assets – 55% – in fixed income securities such as US government bonds.

Of course, the risk that interest rates will cause the market value of a security to fall is not a major problem as long as the owner can hold it to maturity, at which point he can capitalize on its original face value without incurring any loss. . The unrealized loss remains hidden on the bank’s balance sheet and disappears over time.

But if the owner has to sell the security before maturity, at a time when the market value is less than par, the unrealized loss becomes an actual loss.

This is exactly what happened to SVB earlier this year when its clients, faced with a cash shortage, began withdrawing their deposits in anticipation of even higher interest rates.

This brings us to liquidity risk.

Liquidity risk

Liquidity risk is the risk that a bank will not be able to meet its obligations on time without incurring losses.

For example, if someone spends $150,000 of their savings to buy a house and then needs some or all of that money for another emergency, they face the consequences of liquidity risk. Most of his money is now tied to the house, which is not easy to exchange for cash.

SVB customers withdrew their deposits in excess of what the bank could repay using its cash reserves, so to help meet its obligations, the bank decided to sell its $21 billion portfolio of securities for a $1.8 billion loss. The depletion of his own capital prompted him to attempt to raise over $2 billion in new capital.

The request for own funds shocked SVB customers, who lost confidence in the bank and rushed to withdraw cash. Such a banking crisis can bring down even a healthy bank in a matter of days, especially now in the digital age.

This is partly because many of SVB’s customers had deposits well over $250,000 insured by the Federal Deposit Insurance Corporation and therefore knew that their money might not be safe if the bank failed. About 88% of SVB deposits were not insured.

On the other hand, Signature faced a similar problem as the SVB bankruptcy forced many of its clients, concerned about liquidity risk, to withdraw their money. About 90% of their deposits were not insured.

Systemic risk?

Today, all banks face interest rate risk on some of their assets due to the Federal Reserve’s rate hike campaign.

This resulted in $620 billion in unrealized losses on banks’ balance sheets as of December 2022. But most of these banks are unlikely to have significant liquidity risk.

While SVB and Signature were compliant, their asset mix was not in line with the industry average.

Signature had just over 5% of its holdings in cash and SVB 7%, compared to the industry average of 13%. In addition, 55% of SVB’s assets were invested in fixed income securities, compared to the industry average of 24%.

The US government’s decision to back all SVB and Signature deposits, regardless of size, should reduce the likelihood that other banks with less cash and more securities on their books will face a liquidity squeeze due to the sudden panic-driven run-ins.

However, with over $1 trillion in bank deposits currently uninsured, I believe the banking crisis is far from over.

Vidhura S. Tennekoon Associate Professor of Economics at Indiana University

This article was originally published on The Conversation. Read the original.

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