Silicon Valley Bank and Signature Bank failed with enormous speed, so quickly that they could be textbook cases of classic banking crises, in which too many depositors withdraw their funds at the same time. The failures of SVB and Signature were two of the three largest in U.S. banking history, following the collapse of Washington Mutual in 2008.
How could this have happened when the banking industry has been accumulating record levels of reserves, i.e., the amount of cash held above what is required by regulators?
While the most common type of risk a commercial bank faces is an increase in loan defaults – known as credit risk – that is not what is happening here. As a banking economist, I think it comes down to two other major risks that every lender faces: interest rate risk and liquidity risk.
Interest rate risk
A bank faces interest rate risk when rates rise very rapidly over a very short period.
That is exactly what has been happening in the United States since March 2022. The Fed has been raising rates aggressively-4.5 percentage points so far-in an attempt to control rising inflation. As a result, bond yields have risen in the same proportion.
The yield on one-year U.S. Treasury bonds reached a 17-year high (5.25%) in March 2023, up from less than 0.5% in early 2022. And yields on 30-year Treasury bonds have risen almost 2 percentage points.
When a security’s yield goes up its price goes down. So such a rapid rise in rates in such a short time has caused the market value of previously issued debt – whether corporate bonds or Treasury bills – to plummet, especially in the case of longer-term debt.
For example, a 2 percentage point increase in the yield on a 30-year bond can cause its market value to plummet by about 32%.
SVB, as Silicon Valley Bank is known, had a majority of its assets – 55 % – invested in fixed-income securities, such as U.S. government bonds.
Of course, the risk of interest rates causing a drop in the market value of a security is not a big problem as long as the owner can hold it to maturity, at which point he can collect his original face value without realizing 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 the face value, the unrealized loss becomes an actual loss.
That is exactly what happened to SVB earlier this year when its customers, facing their own cash shortfalls, began withdrawing their deposits while expecting 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 when due without incurring losses.
For example, if someone spends $150,000 of his savings to buy a house and later needs some or all of that money to meet another emergency, he is experiencing a consequence of liquidity risk. A large portion of their money is now tied up in the house, which is not easily redeemable for cash.
SVB’s customers withdrew deposits in excess of what the bank could pay out using its cash reserves, so to help meet its obligations, the bank decided to sell $21 billion of its securities portfolio at a loss of $1.8 billion. The depletion of equity capital led the bank to attempt to raise more than $2 billion in new capital.
The call for equity shocked SVB’s customers, who lost confidence in the bank and rushed to withdraw cash. Such a banking crisis can cause even a healthy bank to fail in a matter of days, especially now, in the digital age.
This is partly because many of SVB’s customers had deposits well above the $250,000 insured by the Federal Deposit Insurance Corp. and therefore knew that their money might not be safe if the bank failed. Approximately 88% of SVB’s deposits were uninsured.
On the other hand, Signature faced a similar problem, as SVB’s failure led many of its customers, concerned about liquidity risk, to withdraw their money. About 90% of its deposits were uninsured.
Systemic risk?
All banks face interest rate risk today on some of their holdings due to the Fed’s rate hike campaign.
This has resulted in $620 billion in unrealized losses on December 2022 bank balance sheets. But most of these banks are unlikely to have significant liquidity risk.
Although SVB and Signature met regulatory requirements, the composition of their assets was not in line with the industry average.
Signature had just over 5% of its assets in cash and SVB had 7%, compared to the industry average of 13%. In addition, SVB had 55% of its assets in fixed income securities while the industry average is 24%.
The U.S. Government’s decision to back all SVB and Signature deposits, regardless of size, should make it less likely that other banks, with less cash and more securities on their books, will face a liquidity shortfall due to mass withdrawals triggered by a sudden panic.
However, with over $1 trillion of bank deposits currently uninsured, I believe the banking crisis is far from over.
Vidhura S. Tennekoon, Assistant Professor of Economics, Indiana University
This article was originally published in The Conversation. Read the original.
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