By Vidhura S. Tennekoon
Silicon Valley Bank and Signature Bank failed with enormous speed – so quickly that they could be textbook cases of classic bank runs, in which too many depositors withdraw their funds from a bank at the same time. The failures at SVB and Signature were two of the three biggest in U.S. banking history, following the collapse of Washington Mutual in 2008.
How could this happen when the banking industry has been sitting on record levels of excess reserves – or the amount of cash held beyond what regulators require?
While the most common type of risk faced by a commercial bank is a jump in loan defaults – known as credit risk – that’s not what is happening here. As an economist who has expertise in banking, I believe it boils down to two other big risks every lender faces: interest rate risk and liquidity risk.
Interest rate risk
A bank faces interest rate risk when the rates increase rapidly within a shorter period.
That’s exactly what has happened in the U.S. since March 2022. The Federal Reserve has been aggressively raising rates – 4.5 percentage points so far – in a bid to tame soaring inflation. As a result, the yield on debt has jumped at a commensurate rate.
The yield on one-year U.S. 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 percentage points.
As yields on a security go up, its price goes down. And so such a rapid rise in rates in so short a time caused 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 percentage point gain in a 30-year bond’s yield can cause its market value to plunge by around 32%.
SVB, as Silicon Valley Bank is known, had a massive share of its assets – 55% – invested in fixed-income securities, such as U.S. government bonds.
Of course, interest rate risk leading to a drop in market value of a security is not a huge problem as long as the owner can hold onto it until maturity, at which point it can collect its original face value without realizing any loss. The unrealized loss stays hidden on the bank’s balance sheet and disappears over time.
But if the owner has to sell the security before its maturity at a time when the market value is lower than face value, the unrealized loss becomes an actual loss.
That’s exactly what SVB had to do earlier this year as its customers, dealing with their own cash shortfalls, began withdrawing their deposits – while even higher interest rates were expected.
This bring us to liquidity risk.
Liquidity risk is the risk that a bank won’t be able to meet its obligations when they come due without incurring losses.
For example, if you spend US$150,000 of your savings to buy a house and down the road you need some or all of that money to deal with another emergency, you’re experiencing a consequence of liquidity risk. A large chunk of your money is now tied up in the house, which is not easily exchangeable for cash.
Customers of SVB were withdrawing their deposits beyond what it could pay using its cash reserves, and 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 drain on equity capital led the lender to try to raise over $2 billion in new capital.
The call to raise equity sent shockwaves to SVB’s customers, who were losing confidence in the bank and rushed to withdraw cash. A bank run like this can cause even a healthy bank to go bankrupt in a matter days, especially now in the digital age.
In part this is because many of SVB’s customers had deposits well above the $250,000 insured by the Federal Deposit Insurance Corp. – and so they knew their money might not be safe if the bank were to fail. Roughly 88% of deposits at SVB were uninsured.
Signature faced a similar problem, as SVB’s collapse prompted many of its customers to withdraw their deposits out of a similar concern over liquidity risk. About 90% of its deposits were uninsured.
All banks face interest rate risk today on some of their holdings because of the Fed’s rate-hiking campaign.
This has resulted in $620 billion in unrealized losses on bank balance sheets as of December 2022.
But most banks are unlikely to have significant liquidity risk.
While SVB and Signature were complying with regulatory requirements, the composition of their assets was not in line with industry averages.
Signature had just over 5% of its assets in cash and SVB had 7%, compared with the industry average of 13%. In addition, SVB’s 55% of assets in fixed-income securities compares with the industry average of 24%.
The U.S. government’s decision to backstop all deposits of SVB and Signature regardless of their size should make it less likely that banks with less cash and more securities on their books will face a liquidity shortfall because of massive withdrawals driven by sudden panic.
However, with over $1 trillion of bank deposits currently uninsured, I believe that the banking crisis is far from over.
Vidhura S. Tennekoon is Assistant Professor of Economics at Indiana University.
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@Vidhura S. Tennekoon
Could you comment on the role of economic moral hazard in this matter?
economic moral hazard
don miller says
what is 1 trillion in uninsured deposits ? big deal. take all the money from the trillions of dollars the Dems passed right after Joe took office that jacked up the inflation plus all the money we gave Ukr and the banks are all backstopped and we are safe. You know what 90% of deposit money uninsured means? That the bank was mostly comprised of big fish clients. Not people like you and me. They got bailed out quick by their politician friends. What you think will happen to people like you and me that owned their stock or bonds in our 401Ks? Right, we will be wiped out. Thanks Joe and Janet. They just secured big fish campaign contributions for 2024. How many did Obama and Joe jail in 2009 for their crookedness. Right, zero. Obama and Joe said they’d go to jail. Now Joe says these will be punished. lol. We are suckers.
Ray W. says
Since don miller often presents inaccurate data points, I decided to fact check his claim about stimulus packages signed by presidents. Per CNN, on March 27, 2020, then-President Trump signed into law a $2 trillion stimulus package. Per the Post, on December 27, 2020, then-President Trump signed into law a $900 billion stimulus package. Thus, President Trump is responsible for some $2.9 trillion of the total of $6 trillion passed in response to the pandemic. There seems to be little dispute among economists that rising inflation rates are a related effect of stimulus spending. Apparently, then-President Trump is on the hook for just under half of the inflation we are experiencing today.
Joe D says
During the TRUMP administration, under the guise of “reduced government regulations,” the prior guidelines of holding more cash on hand to cover a sudden depositor withdrawal “run,” were relaxed from requiring Banks with more that 50 Billion in cash deposits to hold onto ( not invest ) to cover a potential “bank run”, to only affect banks which had 250 Billions in deposits. At the time SVB was one of the “smaller” banks ($250 million banks do….but in the current economy, investors started to withdraw more than the usual amount of money the bank expected, so they decided to sell some other assets, to come up with the cash. However, they sold them at something like $81 billion LOSS. When word got out among the SVB depositors (fueled quickly by social media frenzy)…EVEN MORE investors pulled their money out (“bank run”)… in a 48 hour period…this time the bank couldn’t make up the difference…..so now the bank is taken over by Federal regulators, to ensure that the remaining depositors are not cheated out of their money
The PLAN, released is to have the under $250,000 depositors who lost money, covered by FDIC federal insurance every bank must pay for, the Board of Directors will be replaced by Federal regulators, who are now going to investigate whether the investing tactics of SVB, were just an overly RISKY (stupid) mistake, or whether there is more INTENTIONAL mismanagement by upper level management ( ie. Upper level bank directors pulling their own money out before the bank failed…which would be Illegal INSIDER trading….remember Martha Stewart going to jail?…..and large BONUSES being given out to management and employees just before the bank crashed).
One of the sad effects of this bank closing, is that it provided “Start up” tech companies initial money to grow their businesses, where standard banks might not take the RISK. That investment money source is no longer available to new businesses.
Don’t even get me started on our illustrious probable PRESIDENT WANNABE, state Governor’s comments that the SVB collapsed because they were too concerned with “DIVERSITY.”
What happened to bank stress tests? I know during the Obama years some banks were put under stress to see how they would stand during a financial crisis. Don’t remember that happening during the Trump years or the Biden years. Did the Feds realize this possibility while raising interest rates? Am sure this is the beginning of many bank failures. Hopefully my portfolio will not loose too much.
Joe D says
See my comment above. The TRUMP administration, in an effort to “Reduce BIG Government “ relaxed those rules for back up CASH deposits for banks smaller than $250 Billion in deposits.Prior to that, it had applied to smaller banks with as little as $50 Billion in Deposits. SVB actually testified in the hearings that it “stifled “ Smaller banks to have to keep those cash reserves. However NOW, SVB has (had) assets of approximately $221 Billion in deposits, so even now the TRUMP relaxed rules still wouldn’t have applied to SVB as a “SMALLER “ bank.
Good luck with your investments. Mine dropped 40% during the pandemic and economic shut down. I’m planning to just keep it invested, since NOTHING is doing much better than I’m doing, and hopefully it I can leave it alone, and it will improve over the next 2-5 years. If not, it’s going to be a VERY tight retirement!
@What’s in your wallet?
And who is in your wallet?