March 9, 2023 Bank of Silicon Valley (SVB) is being closed by US regulators. Its UK subsidiary is being sold by HSBC for £1, protecting the interests of British savers. The second bank to fail was Signature Bank. OUR First Republic The bank bailed out with $30 billion. In Europe Credit Suisse The bank, despite assistance of 50 billion Swiss francs from the Swiss National Bank, could not be saved. The Swiss government has approached UBS, another Swiss investment bank, to buy Credit Suisse for $3.25 billion. Meanwhile in Germany, shares of Deutsche Bank, the leading bank in Europe’s largest economy, fell 14%.

The collapse of these institutions is alarming. The reasons are related to the new environment of high interest rates. An extended period of low interest rates in previous years provided banks with affordable funding. However, this changed dramatically after COVID-19 when central banks around the world (for example, the Federal Reserve, the Bank of England, the European Central Bank and the Bank of Japan) began a series of interest rate hikes to counter inflationary pressures. Since the beginning of 2022, the cost of borrowing has risen from almost zero to around 5%, representing the fastest rise in interest rates in recent history.

For banksThis development had two consequences. First, they have to take on more risk to maintain profitability. However, this possibility may be limited by applicable law. Second, they can maintain constant risk, but with a concomitant loss of profitability. So this is definitely a dangerous situation.

The banks’ predicament was exacerbated by another factor: the expectation that higher interest rates would be passed on to savers. Thus, an alternative funding method for banks, i.e. deposits are also becoming more expensive. In some countries, such as the UK, deposit rates have kept pace with rising borrowing costs, and many banks have offered depositors a 5 percent return.

Conversely, in countries such as Greece, banks are reluctant to raise deposit rates, dealing with both public discontent and advice from the government and the Bank of Greece. This entails the risk of bank runs and contagion, which can happen quickly, leading to a crisis.

The collapse of the SVB

So how did this change in interest rates cause a banking institution like Silicon Valley Bank (SVB), the 16th largest depository bank in the US, to become the second-largest bankrupt in the history of the country after the collapse of Washington Mutual in 2008? The reason was “interest rate risk”. Interest rate risk describes the possibility of a decline in the value of an asset due to unpredictable changes in interest rates and is primarily associated with fixed income investments.

Rising interest rates tightened financial conditions, making it difficult for banks to obtain funding and lowering their asset values.

In addition, there was a risk associated with the difference between short-term and long-term interest rates. During COVID-19, SVB, whose clientele was mainly technology companies, received large deposits. As demand for loans was low, the bank invested most of these deposits in long-term bonds such as mortgage-backed securities (MBS) and US Treasuries. This is mainly due to the use of short-term deposits to finance long-term investments.

However, the increase in interest rates implemented by the Federal Reserve has resulted in short-term interest rates exceeding returns on long-term investments. The decline in the purchase price of securities would not be a big problem if the bank could hold them to maturity and get their true value. However, the loss is realized if the bank is forced to sell the security early when its purchase price is lower than the actual cost, as was the case with SVB. Her clients started withdrawing their deposits.

By the end of 2022, the bank lost 8% of its deposits and this accelerated in January and February of the following year. To adjust to the withdrawal of deposits, the bank was forced to sell some of its long-term bonds at a loss of $1.8 billion.

News of the sale triggered further withdrawals of deposits, exposing the bank to liquidity risk. The fact that about 88% of SVB deposits were over $250,000 and therefore not covered by the Federal Deposit Insurance Corporation (FDIC) further complicated the situation.

How could all this have been avoided? Surprisingly at first, even though the bank was vulnerable to interest rate risk, it did not take any action to hedge the interest rate risk. Hedging of interest rate risk is widely carried out by financial institutions. Second, SVB failed to diversify its deposit base.

Most of his deposits were wholesale, coming from Silicon Valley startups and their founders. These clients withdrew their deposits faster when they could earn higher returns elsewhere than retail clients.

Messages

The current banking crisis in the US and Europe is reminiscent of the 2008 financial crisis. Despite assurances from central banks, savers are wondering if other banks are vulnerable. There are indeed some similarities between the 2008 crisis and the current economic situation. Liquidity was a major issue in 2008 as banks were reluctant to lend to each other due to their unknown exposure to toxic financial products. Then the lack of liquidity formed the term “credit crunch”. Regulatory changes have been made to address this problem, such as Basel III, which recognized the importance of monitoring liquidity as a significant risk. However, the problem today is not so much liquidity as interest rate risk.

There are mixed messages after the collapse of SVB and Credit Suisse. If interest rates continue to rise to cope with inflationary pressures, financial stability could be in jeopardy as more banks could face similar problems. But in a controversial move in terms of their inflation control goals, central banks around the world, including the Federal Reserve, the Bank of England, the European Central Bank and the Bank of Japan, have pledged to boost market liquidity to keep the financial system stable.

Evidence of this is the support provided by the US Central Bank to SVB to safeguard all deposits, including over $250,000, as well as initial assistance provided by the Swiss central bank Credit Suisse, followed by a forced merger with UBS. and writing off $17 billion of private debt.

Central banks are trying to cope with inflationary pressures without compromising financial stability. While SVB and Signature Bank are not major players in the financial system and their collapse is not likely to trigger a wider financial crisis, it is important to be aware of the systemic risks that their collapse has exposed. “When the Fed raises interest rates from 1% to 5% a year, we shouldn’t be surprised that it causes problems in the system,” said Douglas Diamond, 2022 Nobel Prize winner in economics.

Historically, episodes of rising interest rates have usually been followed by recessions. And since short-term interest rates are higher than long-term ones, as they are now, a recession seems likely.

Dr. Vassilios Pappas is Associate Professor of Finance at the Kent Business School, University of Kent. Dr. Athina Petropooulou is a Research Fellow at the Center for Global Finance at SOAS University London.