Silicon valley Bank and Signature Bank downfall will go down in history, they failed at such an enormous speed that it is a perfect example of bank runs, in which too many depositors withdraw their funds from a bank at the same time.
US President Joe Biden has vowed to take action against those responsible for the banking crisis in the country, this came in post two of the major US banks collapsed in three days.
Why This Happened?
Well, the reason could be a deeper problem, showcasing the errors in American banking ecosystem focusing on record inflation, shady balance sheet and rising rates.
Martin Gruenberg, the chief of federal Deposit Insurance Corp (FDIC) warned last week about $620 billion risk lurking in the US financial system and by Sunday a major showdown of three banks happened, Silvergate capital Corp being the third to succumb.
Rising Rates Fueling The Showdown
A bank faces interest rates risk when the rates increase rapidly within a shorter time span. This is what is exactly happening in US, the Federal Reserve has been increasing the rates aggressively since March 2022. In a bid to control the inflation, feds has increased the rates by 4.5 percent so far. This has resulted in commensurate rate jump.
As per the AP report, the yield on one-year US government Treasury notes hit a 17-year high of 5.25% in March 2023, up from less than 0.5% at the beginning of 2022. Yields on 30-year Treasurys have climbed almost 2 percent. This starts a chair reason, as the yield on a security goes up, its price starts coming down. Such a rapid rise in rates in a short time causes the market value of previously issued debt whether corporate bonds or government
treasury bills to plunge, especially for longer-dated debt.
For example, a 2 percent gain in a 30-year bond’s yield can cause its market value to plunge by around 32 percent, as per AP explainer report.
In simple term, interest rate risk leading to a drop in market value of a security is not a big problem as long as the owner can hold onto it until maturity, at which point it will be able to collect its original sum without facing any loss. The only losses will stay hidden on the bank’s balance sheet and will disappear with time.
But if the owner has to sell the security before its maturity at the same time when the market value is lower than the original face value, the unrealized loss becomes an actual loss. This is exactly what went wrong with the Silicon valley Bank, dealing with their own cash shortfalls, they began withdrawing their deposit when the interest rates were high, resulting in massive showdown.
This is even raising a big question on regulators that weather their measures are affective enough to protect banks and customers.
Talking About The Liquidity Risk
The showdown happened when the SVB customers started withdrawing their deposits beyond what the bank could pay using its cash reserves, and so to help meet its obligations the bank decided to sell $21billion of its security portfolio at a loss of $1.8billion. This drain on equity led the lender to try raise over $2billion in new capital, as per the AP report.
The call of raise equity sent alarm to SVB’s customers, who were already losing confidence in the bank and rushed to withdraw cash. In this digital age, such a bank run can cause even a healthy individual bank to go bankrupt in matter of days.
Banking Crisis Is Not Over Yet
All banks face interest rate risk today on some of their holdings because of the Fed’s rate-hiking campaign.
The US government’s decision to backstop all deposits of SVB and Signature Bank regardless of their size should make it less likely that bank with less cash and more securities on their books will face a liquidity shortage because of massive withdrawals driven by sudden panic. However, the current US bank data shows that over $1trillion of bank deposits are currently uninsured, which creates a doubt that the US banking crisis is not over yet.
How Will It Impact India?
As per reports by Times of India, Finance ministry officials said that the ‘contagious effects’ of the banking collapse would be limited in India, affecting on Tech start-ups and IT firms. However, if the trouble spreads globally, it may constrict capital flow in India and other emerging markets.