Silicon Valley Bank logo in Tempe, Arizona REBECCA NOBLE (AFP)
The failure of the Silicon Valley Bank (SVB) and the contagion of other companies is a reminder of the fragility of the banking and financial system. A bank can fail not only because of insolvency, but also because of liquidity problems. This is exactly what happened to SVB due to mismanagement of their balance sheet. The tech boom greatly increased its deposits, which multiplied by various multiples between 2017 and 2022. The bank did not increase credit at the same rate and invested in mortgage and US Treasury bonds. These paid little interest, but deposits were free.
The situation changed as interest rates rose and depositors, mostly corporations, demanded compensation. This squeezed the bank’s margins at a time when tech companies needed more liquidity. Rumors of problems at the bank sparked panic and SVB was unable to absorb deposit withdrawals (a quarter of the total) due to losses from liquidating part of the bond portfolio and a failed capital raise. It should be noted that 96% of deposits were uninsured.
The Fed and Treasury responded with a textbook recipe: liquidate the company but provide liquidity to insure all deposits against the collateral on par-value bonds (since regulators can wait until they mature without incurring losses). From this episode we can extract some lessons and dilemmas.
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In the first place with regard to the necessary diversification of the banking business, both on the liabilities side and on the assets side. The SVB has failed on both sides, and the tech companies have suffered the most.
Second, the troubles of a non-essential company like SVB can be an indicator of trouble in a class of companies with similar balance sheets. Rather medium-sized banks with little diversification invested a large part of their funds in long-dated bonds in order to find an outlet for the accumulation of deposits. A large enough group of non-systemically important firms can cause a problem in the system if they have similar strategies and balance sheet structures (as in the 1980s savings and credit crisis).
Third, for precisely this reason, it can be dangerous to relax the prudential requirements of small and medium-sized enterprises in order to facilitate their compliance. This is what the Donald Trump Administration did in its review of the Dodd-Frank Act for companies with assets under $250,000 million.
Fourth, it must be remembered that central bank interventions as lenders of last resort, such as insuring all deposits in this case, pose a moral hazard since large depositors will have little incentive to oversee bank management. From now on, all US deposits are implicitly insured above the deposit insurance level.
Fifth, the under-regulation of medium-sized companies can lead to the concentration of the sector. In fact, deposits are now flowing to banks that are “too big to fail”. Finally, monetary policy faces a tricky dilemma. Raising interest rates quickly to control inflation creates financial instability, causing long-term bond portfolios to lose value. What happens if the minimum interest rate to control inflation is too high to preserve financial stability?
Xavier Vives He is a professor at the IESE Business School.
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