The specter of another financial crisis is haunting the world

The scene is familiar. A somewhat obscure financial institution goes into crisis. Authorities urge people to stay calm. Central banks step in. Investors seek refuge elsewhere. Stocks fall. Bonds go up. So does gold. It smells, in short, of a financial crisis. The depth of this crisis and how much this episode, marked above all by the collapse of Silicon Valley Bank, will affect the real economy is still unknown. But the effects are already palpable in the markets, in the expectations of new interest rate hikes and even in the political rhetoric.

The echoes of 2008 resonate in the messages that have followed the Silicon Valley Bank (SVB) crisis. Just 15 years ago it was also claimed that Bear Stearns (and some other canaries in the mine that died even earlier) was an isolated case and that the risk of contagion was limited; that was right before the collapse of Lehman Brothers marked the official starting point of the Great Recession. Will history repeat itself or is it different this time? The central scenario remains one of limited impact, but in financial crises, like in bank runs, there is something of a self-fulfilling prophecy involved. And the plunge in market value of US regional banks this Monday was bad enough to make one’s hair stand on end.

The Federal Deposit Insurance Corporation (FDIC), the Federal Reserve and the Treasury have guaranteed the deposits of all SVB clients, which amounts to some $175 billion, as well as those of Signature Bank for about $100 billion. Despite the moral risk involved in covering all deposits (and not just those of up to $250,000 per depositor, as regulations stipulate), authorities are aware that not guaranteeing them would have caused an immediate contagion effect, dragging down other regional financial entities and triggering a major crisis of confidence in the country’s banking system.

“Americans can rest assured that our banking system is safe. Your deposits are safe,” said US President Joe Biden on Monday. Authorities said they will do “whatever is needed,” using words reminiscent of former European Central Bank president Mario Draghi’s famous “whatever it takes” as he stepped up to defend the euro on July 26, 2012, in the middle of Europe’s sovereign debt crisis.

While promising to do whatever it takes, Biden has also insisted that no losses will be borne by the taxpayers: instead, the money will come from the fees that banks pay into the FDIC. That’s the first big difference with the 2008-style bailouts, which were paid for with public money. The other is that although depositors are being helped out, there will be no bailout for the banks’ investors: “They knowingly took a risk and when the risk didn’t pay off, investors lose their money. That’s how capitalism works,” Biden insisted on Monday.

It’s not only SVB investors who have lost their money. Last week saw the collapse of Silvergate, a small bank focused on cryptocurrencies, and Signature Bank, a New York-based entity that is also linked to the crypto world and was dragged down over the weekend. Authorities may have prevented a run on deposits, but they have not stemmed investor flight.

The market is now placing bets on who will be the next victim. The top candidates are those that most resemble SVB: regional banks, especially in California, where the SVB crisis is also a reflection of a somewhat broader change of cycle for technology companies. The shares of America’s 14th largest lender, the San Francisco-based First Republic Bank, plunged more than 60% on Monday despite its assurances of abundant liquidity. Shares of other regional banks such as Western Alliance (Arizona), PacWest (California) and Zions (Utah) fell between 25% and 50%. Even the veteran Charles Schwab, with about $350 billion in deposits, tumbled more than 11%.

Around the world, banks, especially those perceived to be weaker, were also battered by investors on Monday. Crisis reports came in from all financial corners of the planet, from a Swedish pension fund to an Australian technology company to a Japanese investment firm.

The fall of SVB

Silicon Valley Bank was a peculiar entity. Founded in 1983 and headquartered in Santa Clara, California, in the heart of Silicon Valley, it grew to become the 16th largest bank in the United States by assets. Living up to its name, it played an important role in the tech sector. It was a benchmark bank for startups, which traditional entities were more reluctant to lend money to. The paradox is that it was not the risk inherent to the tech sector that sunk the bank, quite the opposite.

The business of a bank is to take deposits from those who have money and lend it to those who need it, but the tech companies were swimming in abundant liquidity in 2021 and early 2022. Low interest rates, financing rounds, IPOs, capital increases and other financing channels meant that startups did not request as many loans from SVB, but instead deposited multimillion-dollar amounts with the entity. So SVB decided to invest those short-term deposits for which it did not pay interest in safe, long-term, fixed-income securities with some remuneration.

It seemed like a good deal, but then interest rates began to rise. Normally, for a bank, an interest rate increase is a good thing. Most of its loans to companies are at variable interest rates, so that a rise in rates will increase revenue for the bank, which will typically drag its feet when it comes to raising the interest it pays on deposits. In the case of SVB, rather than short-term, variable-rate corporate loans, there were long-term Treasury bonds and other fixed-rate securities. The value of these securities moves in the opposite direction to interest rates. If rates go up, securities are worth less. In theory, these are only unrealized losses as long as the bank keeps the securities in its portfolio, but if it sells them, the losses materialize.

At the same time, the rise in rates drained funding sources for tech companies, which began to withdraw their money from the bank. In order to repay these deposits, SVB was forced to sell securities and those losses on paper became real ones. This further deteriorated its indicators. The appalling way in which the situation was handled and communicated by management last Wednesday, coupled with a failed operation to increase capital, led to widespread mistrust and more depositors demanded their money back, fueling a vicious circle of deposit flight that no entity can withstand. The bank run thus brought down a lender that had actually invested in safe assets.

The contagion effect

The problems spilled over to Signature Bank. What both had in common is that they had grown very strongly in deposits, most of which were uninsured. And while SVB had startups as its clients, Signature held deposits from cryptocurrency firms, and experienced its own bank run.

To ward off the specter of a more serious financial crisis, US authorities have not only guaranteed deposits: the Federal Reserve has also created a new liquidity mechanism for entities affected by customer deposit withdrawals. They will be able to request funds from the central bank using their public debt securities at nominal value as collateral and thus will not have to sell them at a loss. The idea behind this type of mechanism is that it will act as a deterrent: its mere existence will prevent a run on deposits and make its use unnecessary.

But the fear of contagion can be felt in the market, as Citi analysts explained this weekend: “Prior to SVB, we were already in a fragile environment with concerns in the market for the banks about funding pressures, large unrealized losses on securities, and potential credit quality concerns in areas such as commercial real estate […] so the failure of SVB just feeds the narrative,” they said. “While we believe the nature of the SVB business model is unique, we understand concerns about contagion risk in this fragile environment for smaller banks, especially those with large uninsured deposit bases […] which is why a resolution is important to restore confidence. This becomes more about psychology as bank business models are dependent on trust, and, as the SVB story shows, once that goes, it can become very problematic.”

On Sunday the FDIC tried unsuccessfully to find a buyer for Silicon Valley Bank, a solution that would have been cleaner and more surgical than a blanket deposit insurance. Efforts to sell the fallen bank to another entity that will answer for the deposits continued this Monday without materializing, and the option of breaking it up was becoming more likely.

Experts at Oxford Economics also support the limited risk thesis: “There were specific factors behind the SVB collapse that suggest it is not necessarily an indication of broader financial stability risks, but it is clear that risks are increasing. SVB’s client base was dominated by venture capitalists and related start-up companies. And it was uniquely ill-prepared to survive the Federal Reserve’s aggressive rate increases. They held a particularly large proportion of their liquid assets in longer-duration hold-to-maturity securities.”

Large losses

Although the SVB case was extreme, it was not unique. Martin Gruenberg, chairman of the FDIC, warned on March 6 at a conference in Washington at the Institute of International Bankers that “the current interest rate environment has had dramatic effects on the profitability and risk profile of banks’ funding and investment strategies.”

As a result of rising interest rates, assets with longer maturities bought by banks when rates were lower are now worth less than face value, he explained. “The total of these unrealized losses, including securities that are available for sale or held to maturity, was about $620 billion at yearend 2022.”

Although Gruenberg argued that banks are generally in a strong position, and a long way from the solvency problems of 2008, part of his speech was prescient: “Unrealized losses weaken a bank’s future ability to meet unexpected liquidity needs. That is because the securities will generate less cash when sold than was originally anticipated, and because the sale often causes a reduction of regulatory capital.”

In the 2008 financial crisis, more than 450 banks failed over the course of four years, from very small banks to large firms like Lehman Brothers and Washington Mutual.

A pause on rate hikes

To fight inflation, the Federal Reserve has undertaken the most aggressive rate hikes in four decades. There’s a saying on Wall Street that the Fed raises rates until it breaks something. And it seems that it has already broken something. For this reason, analysts who believed that there would be a 0.5 point rate hike at next week’s meeting are now inclined to think that it will be 0.25 or that there will be no rise whatsoever. Goldman expects a pause “in light of the recent tensions in the banking system.” Previous cycles of rising official rates led to the subprime mortgage crisis of 2007, the collapse of the LGTM fund in 1998 and the devaluation of the Mexican peso in 1994.

As for the most recent financial crisis, the rate hike by the European Central Bank in July 2008 is still remembered as the biggest mistake under the presidency of Jean-Claude Trichet. Now, it is unclear to what extent a hypothetical pause in monetary policy tightening would spill over to Europe.

Both the cryptocurrency and venture capital booms, especially in the tech sector, have been fueled by the ultra-cheap money available since the previous financial crisis. Now, those same sectors have become victims of the rise in rates.

Regulatory errors

The collapse of the SVB has also opened the debate on the apparent regulatory errors that have allowed the situation to deteriorate to this point. The Federal Reserve has announced a review of the supervision and regulation of Silicon Valley Bank, the result of which will be published by May 1. “The events surrounding Silicon Valley Bank demand a thorough, transparent, and swift review by the Federal Reserve,” said Chair Jerome H. Powell in a statement.

“We need to have humility, and conduct a careful and thorough review of how we supervised and regulated this firm, and what we should learn from this experience,” added Vice President of Supervision Michael S. Barr, who will lead the review.

President Biden himself alluded to possible regulatory deficiencies in his address to undescore that deposits are guaranteed. “We must get the full accounting of what happened and why those responsible can be held accountable,” he said.

The president also introduced a political angle, noting that “during the Obama-Biden administration, we put in place tough requirements on banks like Silicon Valley Bank and Signature Bank, including the Dodd-Frank Law, to make sure the crisis we saw in 2008 would not happen again. Unfortunately, the last administration rolled back some of these requirements.”

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