The world of finance can be a wild ride, with its ups and downs, twists and turns, and sudden drops that leave even the most experienced banks clutching their seats. And when it comes to the banking system, it's not just about making money - it's about stability, soundness, and the health of the entire economy. But recently, we've seen a troubling trend that threatens to undermine the very foundation of the banking system: rising interest rates. 

The problem is simple: banks make their money by lending out the funds they receive from depositors. But when interest rates rise, borrowing becomes more expensive, and people and businesses are less likely to take out loans. This means less money flowing into the economy, which can slow growth and harm businesses. And for banks, it means reduced profits, higher funding costs, and increased risk of failure. 

We've seen this happen before, most recently with the collapse of several regional US banks that had focused their lending activities in a specific industry. And it's not just a problem in the US - European banks like Credit Suisse are also feeling the pinch. So what can be done to prevent a full-blown banking crisis? 

The answer lies in effective risk management practices and robust governance frameworks. Banks must be able to identify and manage potential risks, diversify their lending activities, and maintain strong liquidity positions. And they must do so while navigating the ever-changing landscape of the financial world, where even the best-laid plans can be upended by unforeseen circumstances. 

Just look at the cases of Silicon Valley Bank and Washington Mutual. Both were well-managed banks with different markets and specializations, yet both failed due to a common risk: a high concentration in a particular sector. Their demise serves as a stark reminder that even the best-laid plans can go awry, and effective risk management and governance are crucial for sustained success.

A closer look at what led to SVB's collapse:

We now have a basic understanding of what caused the collapse of SVB. Essentially, the bank failed due to a liquidity crisis - a scenario where there are insufficient cash inflows to support operations during a period of significant cash outflows.

To put it into perspective, think about having a leak in your house - a small leak that starts to drip and won't stop. You try to catch the water in a bucket, but it fills up quickly and overflows. You realize that the leak is getting worse, and you need to fix it before it causes serious damage to your home. This is similar to a liquidity crisis, where a bank like SVB faced a massive outflow of cash that it couldn't catch up to. Just like a leak that can turn into a flood, a liquidity crisis can quickly escalate and cause major problems for a bank and the wider economy.

The downfall of SVB was caused by a liquidity crisis that arose due to inadequate preparation for the rapid and significant withdrawals of funds by depositors following the news of the bank's cash burn and capital raising requirements. The situation was worsened by losses incurred from the sale of investment securities in the available-for-sale section of the balance sheet. This announcement caused concern among investors and triggered a sharp drop in the bank's stock price, resulting in the biggest bank run in history.

The company made a series of risk management mistakes, starting with the decision to make significant investments in treasury bonds during a period of low interest rates. Banks typically categorize their balance sheets into two groups: assets available-for-sale (AFS) and held-to-maturity (HTM) assets. HTM assets are held for long-term investment and valued at their original cost, while AFS assets are revalued based on current market conditions and expected to be sold within a certain time frame.

SVB's financial reports showed that by the end of 2022, the company held $120 billion in investment securities, which made up 55% of its assets, more than double the industry average for U.S. banks. Furthermore, the majority of its assets portfolio, accounting for 75%, consisted of held-to-maturity (HTM) securities, mostly in the form of U.S. Treasuries and mortgage-backed securities. Although Treasuries and mortgage-backed securities (MBS) are generally considered safe investments in terms of credit risk, but they do present significant interest rate risk.

The downfall of SVB was attributed to its substantial investment in long-term US government bonds, including those backed by mortgages, which were perceived to be very secure. However, bonds are negatively impacted by rising interest rates, leading to a decrease in bond prices. Thus, when the Federal Reserve implemented a significant interest rate hike to counter inflation, SVB's bond portfolio began to suffer substantial losses. In 2022, when interest rates spiked rapidly, the value of the bank's investment portfolio plummeted as bond yields and prices move in opposite directions. As a result, the bank had to take measures to prevent further losses, as the unrealized losses impacted the balance sheet, particularly in equities, through the accumulated other comprehensive income or loss (AOCI).

SVB's regulatory capital was not affected by the unrealized losses reported under accumulated other comprehensive income or loss (AOCI), but the losses did impact the bank's non-regulatory total common equity (TCE) ratio. As a result of the significant unrealized losses, SVB's TCE ratio was severely impacted, prompting the bank to sell its available-for-sale (AFS) assets at a loss. This move triggered a rush of deposit withdrawals once news of the losses became public.

SVB claims it has strong risk management procedures, including advanced market risk analysis and interest rate risk hedging. However, the bank had only implemented minimal interest rate hedging compared to its large AFS investment portfolio. As a result, SVB failed to anticipate the combined impact of interest rate and liquidity risk shocks, highlighting the inadequacy of its risk modeling and risk management practices.

In normal circumstances, banks can avoid any significant negative effects of market fluctuations on their bond investments if they hold onto them until maturity and the borrower returns the principal. During a period of low interest rates, some banks opted to purchase longer-dated bonds as they offered higher yields than shorter-dated debt securities. However, the Federal Reserve's aggressive rate hikes caused many of these banks to suffer losses on their longer-dated bond holdings. This highlights the potential risks of investing in longer-dated bonds, particularly during times of increasing interest rates, which can lead to significant losses.

How does the current banking crisis affect the broader economy?

Several US and European banks have experienced financial troubles recently, with some collapsing and others needing bailouts to stay afloat. The US government has guaranteed deposits over $250,000 and provided a cheap lending facility, while The Swiss National Bank has taken measures to restore confidence and support the banking sector.

A weakening of the banking sector could have various impacts on the broader economy, including:

1. Credit Contraction: A banking crisis can lead to banks being unable or unwilling to lend money, resulting in a credit crunch. This can make it difficult for businesses and individuals to obtain loans, reducing investment, consumer spending, and economic growth. This can have a significant impact on the overall economy, as economic activity slows down, and recovery becomes more challenging.

 2. International Contagion: A banking crisis in one country can have far-reaching consequences, affecting other countries and regions. This is known as international contagion. For instance, the 2008 financial crisis, which started in the US, had significant impacts worldwide, causing economic contraction and financial instability in Asia, Europe, and other regions. The spread of a banking crisis across borders can result in a global recession and a prolonged period of economic instability.

 3. Economic Recession: A banking crisis can lead to an economic recession. The collapse of banks and financial institutions can have a domino effect that leads to a decline in asset prices, reduced demand, and lower economic output. The 2008 financial crisis is an example of this, where the collapse of the housing market and financial institutions led to a recession. A recession resulting from a banking crisis can have a severe impact on the overall economy, causing job losses, reduced consumer spending, and prolonged economic instability.

 4. Government Intervention: Governments may need to intervene during a banking crisis to rescue failing banks, which can lead to a significant increase in public debt levels and even nationalization of banks. These actions can have long-term fiscal consequences and limit growth by reducing private sector investment and competition. Therefore, government intervention must balance the immediate need to stabilize the financial system with long-term consequences.

 5. Confidence and Trust: A banking crisis can erode public trust in the financial system, making it difficult for banks to raise capital and businesses to obtain financing. This can lead to a prolonged period of economic stagnation, impacting consumer spending and reducing investment, growth, and stability in the broader economy.

Impacts of the banking crisis on central banks

The banking crisis has led to potential risks to financial stability, and this may cause central banks to adopt a cautious approach towards interest rate hikes in the short term. Although inflation remains high in major economies, the impact of the banking sector issues on financial conditions and lending standards may dampen economic growth and contribute to downward pressure on inflation.

A banking crisis can have several impacts on central banks, including the need to adjust monetary policy, act as a lender of last resort, expand their balance sheet, and face reputational damage. These consequences can arise due to the central bank's responsibility for regulating and overseeing the financial system, and the need to maintain stability during a crisis. As a result, central banks must navigate these challenges to promote economic growth and restore public confidence in the financial system.

The Bottom Line

Have you ever thought about what would happen if your bank suddenly failed? It's a nightmare scenario that nobody wants to experience. This nightmare scenario is precisely what happened to depositors of Silicon Valley Bank (SVB), whose lack of preparedness for significant withdrawals by depositors led to its collapse. The bank's failure highlights the importance of effective governance and risk management in ensuring the sustainability of financial institutions.

The consequences of a banking crisis can be catastrophic, including credit contraction, international contagion, economic recession, government intervention, and a loss of confidence and trust in the financial system. These impacts can result in prolonged periods of economic instability, job losses, reduced consumer spending, and a lack of private sector investment and competition. Nobody wants to be caught up in such a financial catastrophe.

To prevent banking crises and ensure financial stability, it is essential to implement effective risk management practices and governance frameworks that can withstand market volatility and changing economic conditions. This includes maintaining sufficient liquidity, diversifying investments, and regularly monitoring and assessing risks to identify potential weaknesses and take corrective action. By doing so, financial institutions can avoid the disastrous consequences of a banking crisis and maintain the stability needed for sustainable economic growth. After all, it's not just about the numbers on the balance sheet; it's about the trust and confidence you have in your bank to keep your money safe and secure.