Understanding the Collapse of Silicon Valley Bank and Signature Bank: Lessons Learned
The collapse of Silicon Valley Bank (SVB) and the shutting down of Signature Bank has pushed financial instability concerns onto the front pages once again. The collapse of these banks highlights the risks of liquidity and duration mismatch prevalent in the banking sector. As the Federal Reserve (Fed), the Federal Deposit Insurance Corporation (FDIC), and the Treasury Department rush to douse multiple financial fires, it is necessary to take a step back and consider how we got here in the first place. During 2020-21, the Fed pursued ultra-accommodative monetary policies that held down yields (implying higher bond prices) on Treasuries and mortgage-backed securities. This policy contributed to a massive increase in speculative investments in tech stocks, crypto currencies, NFTs, and other risky assets. The resulting liquidity surge gave rise to an “everything bubble” in 2020-21. Since SVB specialized in servicing both Silicon Valley-based venture capital firms and many of the startups they funded, it experienced an especially strong surge in deposits. Its deposits tripled during the boom period. The Risks of Unrealized Losses Following the spike in client deposits (a liability on the bank balance sheet) in the aftermath of the March 2020 pandemic shock, SVB decided to invest in long-dated Treasury securities and mortgage-backed securities (assets on the bank balance sheet). As long as asset prices remain elevated, bank capital levels will appear strong on paper. However, if asset values fell substantially (while liabilities remained high), the resultant decline in bank capital will raise insolvency fears. Historically, sudden changes in the interest rate environment have wreaked havoc on balance sheets. The Impact of Interest Rate Hikes Having fallen behind the curve, the Fed embarked on a rapid rate-hike path to ease inflationary pressures. Between March 2022 and February 2023, the Fed hiked rates by 450 basis points. Central bankers also signaled to financial markets that interest rates would remain higher for longer. Consequently, yields on mortgage-backed securities and Treasuries surged (implying a sharp drop in their prices). Prophetically, FDIC Chairman Martin Gruenberg recently offered a warning regarding interest rate risks. The Trigger for SVB’s Collapse SVB’s collapse was triggered by the emergence of a bank run that highlighted the classic liquidity/duration mismatch prevalent in the banking sector. In this case, the decline in customer confidence was driven by SVB’s failure to adequately adjust to a rapidly changing interest rate environment. Facing mounting losses on the asset side of its balance sheet (which had a substantial exposure to long-dated government securities that were acquired near peak prices), SVB’s parent company sold some $21 billion worth of securities in early March at a loss of around $1.8 billion and announced plans to raise $2.25 billion worth of equity capital to shore up its balance sheet. Lessons Learned The collapse of Silicon Valley Bank and Signature Bank highlights the importance of managing liquidity and duration risk in the banking sector. Financial institutions must be aware of the risks associated with investing in long-dated securities and ensure that they have sufficient capital to withstand sudden changes in the interest rate environment. Additionally, banks must take steps to reassure customers and prevent bank runs in times of financial stress. In conclusion, the collapse of Silicon Valley Bank (SVB) has raised concerns about financial instability and highlighted the need for greater regulation and oversight of the banking sector. It is a reminder that financial stability is a fragile construct that requires constant attention and vigilance. The Federal Reserve, the Federal Deposit Insurance Corporation, and other regulatory agencies must remain alert to potential risks and take timely and effective action to mitigate them.
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