Never ignore the fragility of the bank, even if the lender involved is not traditional. The shutdown of Silicon Valley Bank (SVB) has already caused a contagion, wiping out tens of billions of value from banks in New York and around the world.
The Great Financial Crisis began with the collapse of broker Bear Stearns in the US and mortgage lender Northern Rock here in the UK.
The paradox of the current jolt is that it can be attributed to the aggressive effort of the Federal Reserve, the US central bank, to defeat inflation through aggressive interest rate hikes. Higher borrowing costs are seen as a good thing for retail banks.
During the recent 2022 earnings season, the majority of High Street lenders increased their gross lending margin, which is the difference between what they pay savers and what they charge borrowers.
In almost all cases, this produced “windfall” profits, allowing banks to strengthen their balance sheets, increase dividends and pay ungodly bonuses to bosses.
Fragility: The shutdown of Silicon Valley Bank has already caused a contagion, wiping out tens of billions of value from banks in New York and around the world
There is another side to the rate talk, as we saw in the UK, when Truss’ “moronic premium” distorted markets in the fall of 2022. Concerns over the untested mini-budget of the United Kingdom led the markets to dump sterling and government bonds.
The sharp drop in the value of gilts has wreaked havoc on liability-driven investing (LDI), the derivatives at the heart of the pension system. Without the intervention of the Bank of England, the insolvencies could have passed through the markets.
SVB is intimately tied to American West Coast technology. During Covid-19, there was a speculative bubble with venture capitalists and other financial groups shoveling money from entrepreneurs and start-ups.
So much money was coming in that the technicians couldn’t spend it fast enough and were placing the surpluses on deposit with SVB – Silicon Valley’s darling bank. The bank invested much of that excess cash in long-term US government bonds, which, like UK gilts, are considered the safest asset class. As market interest rates soared, the underlying value of bonds fell.
Fixed interest rate instruments work like seesaws. When rates move, the value of the underlying bonds moves in the opposite direction. As market rates rose, commercial depositors, such as technology companies, expected a better return. While most NatWest or Barclays consumers have left their savings where they are, the companies are looking to maximize returns by shifting cash deposits to higher-yielding venues.
At SVB there was an effective run on deposits, so the bank sought to solve the problem by selling $21bn (£17.5bn) of long-term bonds. He replaced them with short term but higher yielding assets, which left him with a big hole in his balance sheet.
The SVB model, as was the case at Northern Rock in 2007, is aberrant. Northern Rock was the only lender to offer 110% mortgages and to fund nearly all of its loans by converting long-term deposits into short-term repackaged securities. This seemed like an exception, but, as we learned later, nearly every UK and US bank had loaded its balance sheets with repackaged, high yield securities based on rotten sub-prime mortgages.
The latest big sell-off in bank stocks on both sides of the Atlantic is not just a knee-jerk reaction. The bonds have the imprimatur of sovereign governments and, with the exception of serial defaulters like Argentina, are considered solid.
It is undeniable that since the financial crisis, regulators have required banks around the world to maintain large volumes of bonds as a cushion of capital.
Rapidly rising general interest rates in the United States rattled bond markets and left US banks sitting on gigantic unrealized losses.
It won’t be a full-blown crisis unless wholesale and retail depositors get scared and withdraw funds, forcing banks to return their bond holdings at a loss.
SVB may have been behind the rout, but it is far from the only bank experiencing similar difficulties. As always with financial contagion, you never really know where it will end. Shares in London cited Molten Fund, which owns a stake in fintech firm Revolut, capsized in the latest trades.
In the US, start-ups are warned not to hold more than $250,000 (£208,000) in cash at any one institution. It doesn’t look like 2008, but anyone who lived through the last banking disaster will recognize how quickly stability can crumble.
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