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Lessons and Dilemmas from the Silicon Valley Bank Failure


Raising rates rapidly to control inflation induces financial instability, now with long-term bond portfolios losing value

Logo of the Silicon Valley Bank, in Tempe (Arizona). REBECCA NOBLE (AFP)

The bankruptcy of Silicon Valley Bank (SVB) and the contagion to other entities is a reminder of the fragility of banking and the financial system.

A bank can fail not only when it is insolvent, but also due to liquidity problems.

This is what has happened to the SVB due to mismanagement of its balance sheet.

The tech boom greatly increased its deposits, which multiplied by various multiples between 2017 and 2022. The bank did not increase loans in the same proportion and invested in mortgage and US Treasury bonds.

These paid little interest, but deposits were free.

The situation changed when interest rates rose and depositors, mostly companies, demanded remuneration.

This compressed the bank's margins at a time when tech companies needed more liquidity.

Rumors of problems at the bank triggered a panic and SVB was unable to cope with deposit withdrawals (a quarter of the total) due to losses caused by the liquidation of part of the bond portfolio and a failed capital increase.

It should be noted that 96% of the deposits were not insured.

The Fed and Treasury responded with a textbook recipe: resolve the entity, but provide liquidity to insure all deposits against the collateral on par-valued bonds (since regulators can wait for them to mature without incurring loss).

From this episode we can extract some lessons and dilemmas.

More information

The panic continues after the bankruptcy of two banks in the US: what is happening?

In the first place, regarding the necessary diversification of the banking business, both in terms of liabilities and assets.

SVB failed on both sides, and the main damage is suffered by technology companies.

Second, the problems of a non-systemic entity such as SVB may be an indicator of difficulties in a class of entities with similar balance sheets.

More medium-sized banks with little diversification invested a large part of their funds in long-term bonds to find an outlet for the increase in deposits.

A sufficiently large group of non-systemic entities can cause a problem in the system if they have similar strategies and balance sheet structure (as happened in the

savings and loans

crisis of the 1980s).

Third, precisely for this reason it can be dangerous to relax the prudential requirements of small and medium-sized entities to facilitate their compliance.

This is what the Donald Trump Administration did in its review of the Dodd-Frank Act for entities with less than 250,000 million dollars (233,000 million euros) in assets.

Fourth, it must be remembered that lender-of-last-resort central bank interventions, such as insuring all deposits in this case, create moral hazard, as large depositors will have little incentive to monitor bank management.

From now on, implicitly, all deposits in the US will be considered insured above the deposit insurance level.

Fifth, the under-regulation of medium-sized entities can cause the concentration of the sector.

In effect, deposits will now flow to banks that are "too big to fail."

Finally, monetary policy faces a tricky dilemma.

Raising rates rapidly to control inflation induces financial instability, now with long-term bond portfolios losing value.

What happens when the minimum interest rate to control inflation is too high to preserve financial stability?

Xavier Vives

is a professor at the IESE business school

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Source: elparis

All business articles on 2023-03-15

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