The entire banking concept is based on the assumption that depositors will not want to withdraw their money at the same time. But what happens when this assumption fails? The answer lies in the mismatch of banks' assets and liabilities, which can have disastrous consequences for the financial system in general.
Silicon Valley Bank (SVB), one of the leading banks for startups and venture capital firms in the United States, went bankrupt due to a liquidity crisis that has reverberated throughout the startup ecosystem. Silicon Valley Bank's struggles shed light on the many risks inherent in banking, including mismanagement of equity economic value (EVE), failure to hedge interest rate risk, and a sudden outflow of deposits (risk of financing). The risk arises when a bank's assets and liabilities are not properly aligned (in terms of maturity or interest rate sensitivity), creating a mismatch that can cause significant losses if interest rates change.
Failure to hedge interest rate risk leaves banks vulnerable to market changes that can erode profitability. Funding risk occurs when a bank is unable to meet its obligations due to an unexpected outflow of funds, such as a run on deposits. In the case of SVB, these risks combined to create a perfect storm that threatened the bank's survival.
Related: Silicon Valley Bank was the tip of a banking iceberg
SVB recently made strategic decisions to restructure its balance sheet, with the aim of taking advantage of potential higher interest rates in the short term and protecting net interest income (NII) and net interest margin (NIM), all with the aim of maximize profitability.
The NII is a fundamental financial metric used to assess a bank's potential profitability and represents the difference between interest earned on assets (loans) and interest paid on liabilities (deposits) over a specified period, assuming the balance does not change. On the other hand, EVE is a vital tool that provides a comprehensive perspective of the underlying value of the bank and how it responds to various market conditions, for example, changes in interest rates.
Excess capital and financing in recent years created a situation in which startups had excess funds to deposit but little inclination to borrow. As of the end of March 2022, SVB had $198 billion in deposits, compared to $74 billion in June 2020. As banks generate revenue by obtaining a higher interest rate from borrowers than what they pay to depositors, SVB chose to allocate the majority of the funds in bonds, mainly mortgage-backed securities of federal agencies (a common choice) to offset the imbalance caused by large corporate deposits, which carry minimal credit risk but may be exposed to significant interest rate risk.
However, in 2022, when interest rates rose sharply and the bond market declined significantly, Silicon Valley Bank's bond portfolio took a hit. At the end of the year, the bank had a portfolio of securities worth $117 billion, which made up a substantial part of its total assets of $211 billion. Consequently, SVB was forced to liquidate a part of its portfolio, which was available for sale, in order to raise cash, incurring a loss of $1.8 billion. Unfortunately, the loss had a direct impact on the bank's capital ratio, making it necessary for SVB to raise additional capital to maintain solvency.
In addition, SVB found itself in a โtoo big to failโ scenario, in which its financial difficulties threatened to destabilize the entire financial system, similar to the situation faced by banks during the Global financial crisis of 2007-2008 (GFC). However, Silicon Valley Bank failed to raise additional capital or secure a government bailout similar to that of Lehman Brothers, which filed for bankruptcy in 2008.
Related: Why doesn't the Federal Reserve require banks to hold depositors' cash?
Despite ruling out the idea of โโa bailout, the government extended "find a buyer" support to Silicon Valley Bank to ensure depositors have access to their funds. Furthermore, the collapse of SVB resulted in such imminent contagion that regulators decided to dissolve Signature Bank, which had a risky client base. cryptocurrency companies This illustrates a typical practice in conventional finance, in which regulators intervene to prevent a spillover effect.
It's worth noting that many banks experienced an asset-liability mismatch during the GFC because they funded long-term assets with short-term liabilities, leading to a funding gap as depositors withdrew their funds en masse. For example, in September 2007, an old-fashioned bank run occurred in Northern Rock, UK, as customers queued outside branches to withdraw their money. Northern Rock was also heavily reliant on non-retail funding like SVB.
Continuing with the Silicon Valley Bank case, it is clear that Silicon Valley Bank's exclusive focus on NII and NIM led to a neglect of the broader issue of EVE risk, which exposed it to changes in interest rates and underlying EVE risk. .
In addition, SVB's liquidity problems stemmed largely from its inability to hedge interest rate risk (despite its large portfolio of fixed-rate assets), which caused EVE and earnings to fall as that interest rates rose. In addition, the bank faced funding risk resulting from reliance on volatile non-retail deposits, which is an internal management decision similar to those discussed above.
Therefore, if the Fed's supervisory measures were not relaxed, SVB and Signature Bank would have been better equipped to handle financial shocks with tighter capital and liquidity requirements and regular stress tests. However, due to the absence of these requirements, SVB collapsed, leading to a traditional bank run and the subsequent collapse of Signature Bank.
Furthermore, it would be inaccurate to blame the entire cryptocurrency industry for the failure of a bank that coincidentally included some cryptocurrency companies in its portfolio. It is also unfair to criticize the crypto industry when the underlying problem is that traditional banks (and their regulators) have done a poor job of assessing and managing the risks involved in serving their clientele.
Banks need to start taking the necessary precautions and follow robust risk management procedures. They can't simply rely on Federal Deposit Insurance Corporation deposit insurance as a safety net. While cryptocurrencies can present particular risks, it is crucial to understand that they have not been the direct cause of any bank failure to date.
Guneet Kaur she joined Cointelegraph as an editor in 2021. She holds an MS in FinTech from the University of Stirling and an MBA from India's Guru Nanak Dev University.
This article is for general information purposes and is not intended to be and should not be taken as legal or investment advice. The views, thoughts and opinions expressed herein are those of the author alone and do not necessarily reflect or represent the views and opinions of Cointelegraph.
