Explained: Why Silicon Valley Bank and Signature Bank failed so fast

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 US 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? Also Read: How the collapse of Silicon Valley Bank caused chaos and can it be contained? 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 US 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 US government Treasury notes hit a 17-year high of 5.25 per cent in March 2023 , up from less than 0.5 per cent at the beginning of 2022. Yields on 30-year Treasurys have climbed almost two percentage points . [caption id=“attachment_12287742” align=“alignnone” width=“640”] Bob who has been a customer of SVB for 25 years and came to the bank to withdraw his money speaks with press after exiting Silicon Valley Bank’s headquarters in Santa Clara, California. AP[/caption] 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 two percentage point gain in a 30-year bond’s yield can cause its market value to plunge by around 32 per cent . SVB, as Silicon Valley Bank is known, had a massive share of its assets — 55 per cent — invested in fixed-income securities , such as US 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 realising any loss. The unrealised loss stays hidden on the bank’s balance sheet and disappears over time. Also Read: Silicon Valley Bank collapse: What we learnt from the bank’s failure 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 unrealised 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 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 $150,000 (Rs 1.23 crore) 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. [caption id=“attachment_12287722” align=“alignnone” width=“640”] While SVB and Signature were complying with regulatory requirements, the composition of their assets was not in line with industry averages. AP[/caption] 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 (Rs 1.72 lakh crore) of its securities portfolio at a loss of $1.8 billion (Rs 0.14 lakh crore) The drain on equity capital led the lender to try to raise over $2 billion (Rs 0.16 lakh crore) 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. Also Read: Why did the Silicon Valley Bank collapse? Will this lead to a repeat of 2008? In part this is because many of SVB’s customers had deposits well above the $250,000 (Rs 2 crore) 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 per cent 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 per cent of its deposits were uninsured. Systemic risk? 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 (Rs 51.07 lakh crore) in unrealised 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 five per cent of its assets in cash and SVB had seven per cent, compared with the industry average of 13 per cent . In addition, SVB’s 55 per cent of assets in fixed-income securities compares with the industry average of 24 per cent . The US 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 (Rs 8 lakh crore) of bank deposits currently uninsured, I believe that the banking crisis is far from over. This article is republished from The Conversation under a Creative Commons license. Read the original article . Read all the Latest News , Trending News , Cricket News , Bollywood News , India News and Entertainment News here. Follow us on Facebook , Twitter and Instagram .