What has happened to this bank? How is it possible that an entity with 40 years of history, 30 of them without giving losses, has had to be rescued?
First of all, we must remember how the balance sheet of a bank works. On the assets side, in addition to its buildings and offices, it shows the loans it grants to customers, its investments and its liquidity. On the liabilities side, in addition to capital and reserves, it shows customer deposits and current accounts.
We have to know that when we deposit money in an account or place a fixed-term money we are lending money to the bank and for the entity it is a liability, an obligation. In a very simplified but real way (source Federal Reserve), SVB’s balance sheet on December 31, 2022 was like this:
A little history
We must go back to 2021. During that year, given the euphoria of investments and cheap money post-covid, the bank took customer deposits and they rose from $102 billion to $189 billion, according to the Fed’s own data.
This increase in liabilities (recall a bank’s balance sheet) was offset by an investment on the asset side of about half in long-term mortgage bonds, in the expectation that interest rates would not rise as much.
But inflationary pressures caused the Federal Reserve to undertake the fastest interest rate hikes in 40 years. These hikes produced, specifically for the SVB, two lethal effects:
Depositors compared and preferred to invest in risk-free 4.5% Treasury bills rather than in a lower-yielding, higher-risk bank deposit, and withdrew their SVB deposits at unprecedented speed.
When market interest rates rise, long-term bonds lose value, and they lose more value the faster rates rise and the more long-term the bond is. In this case, for SVB these rate hikes have resulted in losses in its portfolio of billions of dollars. Losses that were not realized (at the time), but have been booked.
Thus, depositors began to withdraw large amounts from their accounts (liabilities). Faced with this flight of deposits, the bank, unable to ask for its money from the customers to whom it had lent money at fixed terms, was forced to sell, to meet its customers’ demand for cash, the bonds (assets) it had bought as investments, but it has to sell them at a huge loss. These latent losses materialize, accelerate and the bank is in danger of running out of liquidity.
The Federal Reserve has intervened, bailing out account holders and depositors, insuring all their money (beyond the $250,000 guaranteed by the FDIC) but shareholders and those who held bank bonds will not be bailed out.
At this point, it should be emphasized that when a bank is bailed out, its deposit and account customers are bailed out. Its shareholders, its owners, are not rescued and lose everything, as is logical. Likewise, neither are those who invested in bonds issued by the SVB. The managers have been replaced and we still do not know at this stage whether the rapid intervention of the Fed will succeed in tackling the problem. But we can already draw several conclusions:
Apparently, the mistake of the managers has been to finance with short term money (the deposits) long term investments (the bonds).
The banking business is based on trust. What the bank does with our money is to lend it and invest it. When we deposit money in a bank we are lending it to it and the bank, in part, lends it or invests it. That is its function. I have peace of mind as long as I trust that my money is safe.
A rate hike this fast and of this magnitude always has consequences.
The era of free or almost free money that we have lived through has been a huge distorter of reality and of the risk/return binomial.
At the time of writing this article the Fed’s intervention has apparently calmed the markets, but the situation is volatile to say the least.
Álvaro Bañón Irujo, Professor of Financial and Investment Management, University of Navarra, Spain
This article was originally published in The Conversation. Read the original.
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