The Silicon Valley Bank: How Interest Rates Contributed to Its Collapse and What Central Banks Should Do Now

Former British Prime Minister Harold Wilson is famous for noting that a week in politics is a long time. But in the world of finance, it seems like everything can change in just two days.

It took just 48 hours between the March 8 announcement by the US-based Silicon Valley Bank (SVB) that it was trying to raise $2.5 billion (£2 billion) to patch a hole in its balance sheet and the announcement by the US regulator. The Federal Deposit Insurance Corporation reported that the bank had collapsed.

At its peak in 2021, SVB was worth $44 billion and managed over $200 billion in assets. Just a week ago, he was the 16th largest depository in the US, and now he has become the second largest bankrupt in the history of the country. Only the collapse of Washington Mutual during the 2008 global financial crisis was more massive.

While SVB has been in trouble for some time now, the speed of its collapse has taken nearly all commentators by surprise, as well as its customers, mostly in the tech sector. Tech companies around the world locked their money in SVB deposits and worried about how they were going to pay their workers and bills until US government support was announced, as well as HSBC’s deal to buy SVB’s UK subsidiary.

And it seems that the panic against the SVB, which announced its collapse – by some measures, the fastest in history – is spreading to other institutions with similar characteristics. On March 12, two days after SVB went bankrupt, New York City regulators closed Signature Bank, citing systemic risk.

But what happened to the SVB was unpredictable and inevitable? My research shows no. My latest book on the history of financial crises, Calming Storms: The Carry Trade, Banking School, and British Financial Crises since 1825.was published coincidentally the day before the bankruptcy of SVB and describes three situations in which a banking crisis can be triggered.

Why SVB collapsed

One possible reason is that changes in interest rates between countries cause capital flows to suddenly start or stop as investors seek better rates. This affects the availability of funding. This is exactly what happened during the 2007 credit crunch, which preceded the global financial crisis but was not behind the SVB bankruptcy.

The SVB bankruptcy is related to two other situations that I describe in my book.

First, when interest rates rise rapidly. The reason may be the reaction of the central bank to a surge in inflation, war or tension in the labor market. In fact, the Federal Reserve, along with other central banks, have raised rates from the 0.25-0.5% range to 4.5-4.75% over the past 12 months.

Higher rates tighten lending conditions. This makes it difficult for financial institutions to finance, while hurting the value of your existing loans and assets.

The second occurs when short-term interest rates exceed long-term rates, as has happened in the United States in recent months. During the pandemic, tech startups with money left over from funding rounds in the easy money world placed their deposits in SVB. Given the low demand for loans in this sector, SVB has invested most of the money in long-term bonds, mainly mortgage-backed securities and US Treasuries.

In short, the SVB took deposited funds mostly for the short term and linked them to long-term investments. Thus, in recent months, short-term rates have risen more than long-term bond yields (see chart below). This is because interest rates have risen sharply thanks to the Federal Reserve’s rate hike.

The evolution of interest rates in the US

As funding rounds become harder to come by in a high interest rate environment, tech companies have begun withdrawing and spending their deposits. At the same time, these higher rates led to a fall in the prices of the bonds in which SVB invested. This reduced SVB’s profit margin and left its balance sheet in a delicate position.

The situation worsened as SVB had to sell some of its long-term bonds at a loss to fund the deposits its clients were withdrawing from the bank. News of the sales forced savers to withdraw more funds that were supposed to be funded by additional sales. A vicious circle has formed.

The March 8 announcement that SVB was seeking to raise $2.5 billion to close the hole in its balance sheet left by these asset sales sparked a bank run that killed it.

Concerns about systemic risk

How worried should we be about SVB going bankrupt? It is not a major player in the global financial system. It is also unique to modern banking in terms of its dependence on one sector for its customer base and its balance sheet exposure to interest rate spikes.

But even if the collapse of the SVB does not trigger a wider financial crisis, it should serve as an important warning. The rapid rise in interest rates in the past year has weakened the global economy.

The world’s central bankers are on a narrow path, trying to fight inflation without harming financial stability. Central banks need to manage interest rates more carefully, while regulators should prevent the financial sector from borrowing short to extend long loans without sufficient coverage of the risks that this entails.

It is also important for central banks to monitor the impact of interest rate differentials and cross-border capital flows on credit available to both banks and companies. Even if the failures of SVB and Signature turn out to be nothing more than “minor local difficulties” (to quote another former British Prime Minister Harold Macmillan), the systemic risks that their collapse revealed can no longer be ignored.

Charles Reed, Fellow in Economics and History at Corpus Christi College, University of Cambridge

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

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