The inflation-is-tamed narrative takes its first scalp
Silicon Valley Bank failure is a text-book case of an asset liability mismatch. It’s roots are in poor risk management practices that zero interest rate decade in the US triggered.
Like an episode of a fast-paced crime thriller, the story of the 16th largest bank of America, Silicon Valley Bank (SVB), moved from a fifth-year-in-a-row Forbes best bank award to bank failure — all in the space of a month. Over the weekend of March 11 and 12, it looked as if the failure of SVB would spread to other banks, cause a global contagion and trigger another financial crisis. Signature Bank (SB) of New York was the next to be shut down on March 12. But the Sunday evening action by the US Treasury, Fed and Federal Deposit Insurance Corporation (FDIC) to protect SVB and SB depositors addressed the current panic attack. In fact, the expectation that the Fed will now have to reduce or pause its rate hike programme, might perversely give markets a breather.
SVB was a banker to the Silicon Valley venture capitalists and start-ups — a tight niche business that it served well. The first sign of trouble was when Moody’s downgraded the bank on March 8, 2023, citing a deterioration of its funding, liquidity and profitability. SVB then tried to raise funds by selling investments worth $21 billion. But two things happened to derail the bank. One, its client base was very concentrated with the top VCs banking with it, and these hyper-active suits lit a shuck out of the bank. In a flight to safety, more than $42 billion in deposits were wired out over the next day, a Thursday. Two, the “social media risk” kicked in with the news going viral that there was a run on the bank. This prompted the California Department of Financial Protection and Innovation to shut down SVB on March 10.
Bank deposits up to $250,000 are insured by FDIC, and the average American holds $5,300 in their accounts, removing the risk of a run on a bank. But again, the niche nature of SVB came in the way of stemming the panic. Over 80% of deposits were not covered by the insurance cover since the deposits ran into millions of dollars of VC money and start-up money to pay vendors, payroll and other expenses. If there was no back-stop for these deposits, the fear was that the contagion would spread — to start-ups, their vendors and clients, and other banks and the world.
But this did not happen, as a March 12 joint statement by the Treasury, Fed and FDIC assured depositors that their money was safe and the taxpayers that they were not going to bail out the bank. The hit would be on the shareholders of the banks and their management. Most likely the banks will be sold to some of the big banks in the US. The crisis seems to be over for the moment, but what happened? Why this sudden crash from a viable bank to a possible global contagion event?
SVB is the visible damage of a narrative built up in the US over the past decade — that inflation had been tamed. The 2008 financial crisis saw a similar end to the credit-risk-has-been-tamed narrative built by Wall Street. The inflation-is-tamed narrative meant that people believed that interest rates would remain low. This expectation got baked into business plans and risk-management strategies. But when inflation shot up in 2021 and peaked in mid-2022 at 9.1% from a near-zero level in 2020, the Fed carried out a brutal 450 basis point rate hike in 12 months.
There is an inverse relation of interest rates with bond prices — when rates rise bond prices fall as investors sell the older lower-interest bonds to buy the newer higher-interest bonds. Investors holding the low-interest bonds saw the bond price fall sharply. However, US regulation allows smaller banks to not mark the bond portfolios to market, but to value them as if they are held to maturity. This strategy works if the bonds are held to maturity or interest rates fall (the bond prices will rise, giving a profit if these bonds are sold).
SVB was not holding dodgy assets or crypto coins that went bust — it simply used short-term money to buy long-dated US Treasuries in the expectation that interest rates will remain low. The sharp Fed rate hikes should have alerted the bank to take risk mitigation steps that it did not take earlier in the year. What happened with SVB was a textbook case of poor risk management leading to an asset-liability mismatch. The value of the assets fell so much that it could not cover its liabilities. In a bank, this is sure death.
Can this happen in India? Both the Reserve Bank of India (RBI) and the Securities and Exchange Board of India (Sebi) have been pushing banks and mutual funds to mark their portfolios to market — which means that if there are unrealised losses due to a change in the bond price, these need to be accounted for. This means that banks today will be sitting on mark-to-market losses on account of their bond portfolios as RBI has been raising rates, but it also means that a sudden event will not catch them off guard and cause a sudden deterioration of their asset values. Sebi has progressively made rules tougher for debt funds.
Most of the 16 debt fund categories have been created, keeping the holding period of the investor in mind. For example, a money market fund must keep the average maturity of bonds in the portfolio at one year. This means that investors in this category of funds will not be facing a huge interest rate risk — or the risk of interest rate hikes causing portfolio losses. The SVB story, the reaction of Silicon Valley VCs, usually dismissive of the government, screaming for a deposit guarantee from the Fed, makes me think of this famous line: Sharp suits want capitalism on the way up, but socialism on the way down.
Monika Halan is the author of the bestselling book Let’s Talk MoneyThe views expressed are personal