The Great Recession seems like an eternity in the past. As an economic scholar, I didn’t even witness the financial meltdown up close but read about the absolute chaos emanating from the noughties in books and academic entries. Over the course of the last decade, I am sure I wasn’t the only one used to the regulatory guardrails introduced in the wake of the economic collapse. It has been somewhat reassuring that the world would not witness such broad-based economic disruption again or that it would be at least relatively deftly handled before it gets out of hand.
The recent collapse of the Silicon Valley Bank (SVB) dares to question that sentiment of reassurance. And the timing could not be more consequential.
The failure of SVB has sent shockwaves through the financial community, with some analysts drawing parallels between the bank’s downfall and the 2008 financial crisis. SVB was a well-capitalized institution seeking to raise funds, but a panic induced by the very venture capital community it served and nurtured ended its 40-year run within 48 hours.
Regulators shuttered SVB last Friday and seized its deposits in the most significant banking failure in the United States since Washington Mutual went bust in 2008 – and the second-largest ever. SVB was ranked the 16th biggest bank in America at the end of last year, with about $209 billion in assets.
The roots of the SVB collapse stem from dislocations spurred by higher rates. As start-up clients withdrew deposits to keep their companies afloat in a chilly environment for IPOs and private fundraising, SVB found itself short on capital.
The downward spiral began late Wednesday when the company surprised investors with the news that it sold a $21 billion bond portfolio, primarily US Treasuries, at a loss of $1.8 billion. The bank’s management further said it would sell an additional $2.25 billion in common equity and preferred convertible stock to shore up its balance sheet. What followed was an unprecedented run that rapidly turned ugly.
The sudden need for fresh capital, coming on the heels of the collapse of crypto-focused Silvergate Bank, sparked another wave of deposit withdrawals Thursday as Venture Capitals instructed their portfolio companies to move funds. By Friday, the collapsing stock price had made its capital raise untenable, and sources said the bank tried to look at other options until regulators stepped in and shut the bank down.
There is no government bailout on the cards. And while SVB Financial, the parent company of SVB, is now looking for buyers in earnest, it seems unlikely that a deal could materialize anytime soon, at least until it files for bankruptcy. On Friday, the S&P Global Ratings expected SVB Financial to enter bankruptcy because of its liabilities.
The fall of SVB rattled investors and customers alike, wiping out more than $100 billion in the market value of banks in the United States within two days, according to Reuters calculations.
The collapse of SVB is surely reminiscent of the financial crisis, spurred by a combination of factors, including excessive risk-taking by banks, a housing market bubble, and the failure of regulators to enforce existing laws and regulations. The crisis had a devastating impact on not only the US but the global economy, leading to widespread job losses, home foreclosures, and a widespread recession.
The ramifications of SVB’s collapse could be far-reaching, with concerns that start-ups may be unable to pay employees in the coming days, venture investors might struggle to raise funds, and an already-battered sector could face a deeper malaise. The collapse of SVB may even pose a contagion risk to the broader financial system if other banks and financial institutions are perceived to be at risk.
The two core factors leading to this blindsiding demise of SVB were high amounts of uninsured deposits and unrealized losses. Ms. Sheila Bair, the former head of the Federal Deposit Insurance Corporation (FDIC), said: “These banks that have large amounts of institutional uninsured money … that’s going to be hot money that runs if there is a sign of trouble.” According to FDIC, the SVB had 89% of its $175 billion in deposits uninsured at the end of the previous fiscal year.
However, the good news is that while the banking system is notoriously complex, opaque, and interconnected, large institutions have more stringent capital requirements and significantly diversified portfolios – courtesy of the regulations imposed after the financial crisis. The SVB mainly tumbled because of its weighted clientele in the start-up sector, which has been under stress due to the damage inflicted by the Fed’s policy tightening. Similar panic is unlikely to percolate through to the overall banking system as it is not rooted predominantly in any particular industry.
Nonetheless, policymakers should apply the lessons learned during the financial crisis to avoid a spread of failure in regional banks across the US that may have the same susceptibility of uninsured deposits threatening a panic run. There is a need for stronger regulation and supervision of smaller banks and other financial institutions to prevent excessive risk-taking and ensure that they have adequate capital and liquidity to weather the storm.
Under the Trump administration, several mainstay provisions of the famous Dodd-Frank Act got rolled back. This act, passed in 2010, introduced a range of regulations aimed at preventing another financial crisis by increasing oversight and accountability of financial institutions. During the Trump era, the threshold for enhanced prudential standards for bank holding companies was raised from $50 billion to $250 billion, meaning that many smaller banks were no longer subject to the same level of regulation as larger banks.
The sudden fall of the SVB also reveals a precarious side of the rate hike regime of the Federal Reserve. As the Fed commits more to its fight against inflation and raises rates beyond prior expectations, it is throttling the availability of cheap money; devaluing massive holdings of securities; and exposing vulnerabilities in markets – primarily the tech sector hinged on high growth over the past decade due to low-cost financing.
As per confidential sources, the regulators are pondering over extraordinary measures to avoid any spillovers from the SVB’s demise that may precipitate systemic risks in the financial system.
The Fed is planning to ease access to its discount window, allowing smaller banks to liquidate their securities holdings without the losses that nudged SVB into turmoil. There is even a prospect of a program designed to backstop uninsured deposits using the Fed’s emergency lending authority. However, while the use and terms of the discount window are well within the scope of the Federal Reserve, enacting the emergency authority would require a vote by the Fed’s board alongside the approval from the Treasury secretary.
The Federal Reserve remains focused on maneuvering a soft landing of the US economy. But persistent inflation and a tight labor market is raising more and more doubts. The fall of the SVB is a reminder that the rate hikes now not only risk a deep recession but could also metastasize a liquidity crisis in the banking sector. And as the panic spreads from regional to institutional to global markets, the Fed’s job isn’t getting any easier with each passing day.