US bank regulators closed Silicon Valley Bank (SVB) on March 10 2023, after it suffered US$42 billion (£35 billion) of deposit withdrawals in a 24-hour period. This was the largest bank failure since the 2008 global financial crisis and was not supposed to happen again.
Since the 2008 crisis, international bank regulations have been greatly tightened and, among other measures, banks now have more capital to absorb losses and protect themselves from insolvency. Yet, even though SVB’s capital was above the minimum level required by regulators, this was not enough to keep it alive.
The SVB debacle has caused new concern about the safety of banks across the developed world, raising the likelihood of a run on deposits in any bank that has been showing signs of weakness. This sense of alarm was heightened by the collapse of Credit Suisse and its subsequent takeover by UBS just ten days after SVB’s failure. The Dow Jones index of US bank shares fell by 22% in the two weeks from March 6.
Even though central banks have been providing “lender of last resort” facilities to assist banks with their cash flows, the major worry is that vulnerable banks may need capital injections from government to avoid failure.
This is what happened in 2008, but post-crisis banking regulation was supposed to prevent the need for such assistance. And so SVB’s troubles are a reminder that the current rules on capital have been designed to cushion banks against losses on defaulting loans. While this was the predominant cause of bank failures after the 2008 financial crisis, default risk was not a major issue for SVB. Its troubles stemmed from falling asset values as interest rates rose. This is known as interest rate risk.
SVB’s interest rate risk
As a specialist bank to the technology industry, deposits at SVB grew from US$62 billion to US$189 billion during 2020 and 2021, but demand for loans from tech companies grew at a slower pace. In order to achieve a return on these funds, SVB invested in long-term bonds, mainly “agency” mortgage-backed securities (MBS), which are effectively government-guaranteed.
Silicon Valley Bank: how interest rates helped trigger its collapse and what central bankers should do next
At the end of 2022, 47% of SVB’s US$212 billion asset portfolio comprised this kind of long-term debt. But the value of all fixed interest debt such as MBS falls as interest rates rise. As the US Federal Reserve raised its official interest rate during 2022 to combat inflation, long-term rates also rose and the market value of SVB’s holdings fell by US$15 billion.
But this drop was not recorded as a loss by SVB because it had classified nearly all of this MBS debt as “held to maturity” (HTM). Under standard accounting rules, this means they are valued according to their purchase price not the price SVB would have received for selling at that time (the market value). If these assets had been placed in the alternative accounting category – “available for sale” (AFS) – they would have been recorded at their market value and the resulting US$15 billion loss would have wiped out most of SVB’s capital. Instead of being well-capitalised, it would have been nearly bankrupt.
How bonds work and why everyone is talking about them right now: a finance expert explains
Meanwhile, as the tech boom came to an end, the inflow of deposits turned into an outflow during 2022 as investment dried up and depositors needed their cash. By early 2023, SVB was running short of liquid assets to pay out to depositors that were making withdrawals. It attempted to borrow extra cash for this purpose on March 9 but failed. This shone a light on the bank’s weakness and the outflow of deposits became a flood. The fact that most of SVB’s deposits were greater than US$250,000, and therefore not insured by the US government, no doubt made this flood worse.
SVB could have raised cash by selling some of its HTM assets at a loss but that would only have confirmed its poor condition. Instead, the Federal Reserve stepped in with a guarantee for all of SVB’s accounts.
Why not change the regulations?
SVB is not alone in this situation. Although other banks are generally not as exposed as SVB, holders of long-term US dollar debt were collectively sitting on some US$600 billion of unrealised losses at the end of 2022.
Why have US banks not been required to carry enough capital to take account of interest rate risk? For a start, it would be hard to design suitable rigid rules or to amend the accounting conventions. Another likely reason is that this would raise costs for all issuers of long-term debt, and the largest such issuer in all countries is the government.
Another likely reason is complacency. Interest rate risk was never such a serious problem during the four-decade general decline in rates before the rapid rise that began in mid-2020.
Falling long-term US interest rates
In the absence of a regulatory remedy for interest rate risk, the concern is that central banks will face greater pressure to reduce the chance of that risk materialising. This could cause them to soft-pedal on the interest rate rises needed to curb inflation.
This is dangerous. If central banks are perceived to be hesitating in their resolve to tackle inflation for fear of exacerbating financial instability, they risk their credibility. This could mean that even higher interest rates are necessary in the future to bring inflation under control.
by : John Whittaker, Senior Teaching Fellow in Economics, Lancaster University