On March 11th, Silicon Valley Bank, one of the top 20 banks in the US with over $200 billion in assets, suddenly announced its bankruptcy. This was the largest bank failure since the 2008 financial crisis, and the entire collapse occurred within just 48 hours. Subsequently, the earthquake hit the US stock market. The Dow Jones Industrial Average fell by 345.22 points, the S&P 500 index fell by 56.73 points, and the technology stock index Nasdaq fell by 199.46 points. The impact then spread to the European and Asian stock markets and even the cryptocurrency market. The stablecoin USDC and the US dollar were almost decoupled. What exactly happened? How could a bank collapse so suddenly? And what does it have to do with me? Let me help you understand by starting from 2020.
Interest-Free Debt
Do you recall the well-known statement by the Federal Reserve, "We will do whatever it takes"? In early 2020, the global economy suffered severe consequences due to the outbreak of the COVID-19 pandemic. On March 3rd of the same year, the Federal Reserve declared an "emergency rate cut" of 0.5% with the intention to stimulate the economy. Only 12 days later, on March 15th, they issued another "emergency rate cut," where the rate was directly reduced to 0-0.25%, effectively achieving "zero interest rates."
Now, what does this have to do with Silicon Valley Bank?
During this time, Silicon Valley Bank obtained a substantial amount of almost interest-free savings, amounting to over $190 billion, up from $76 billion between June 2020 and December 2021. For customers, these funds represented deposits, while for Silicon Valley Bank, they constituted liabilities, specifically interest-free liabilities.
At first glance, not paying interest on borrowed funds appears to be an excellent situation. However, the pertinent question is, what did the bank do with this money?
Holding to Maturity Bonds
As a bank located in Silicon Valley, one may assume that Silicon Valley Bank primarily invests in local startups. However, despite a decrease in demand for loans from Silicon Valley startups over the past year, the bank has diversified its investment strategy. To generate returns, Silicon Valley Bank has purchased a significant amount of 1-5 year government bonds, which are considered relatively low-risk investments. Although the interest rates for these bonds are relatively low at 1%, the bank incurs no cost and pays the face value. This investment strategy has proven successful, with positive returns generated.
However, it is important to note that many of these government bonds are classified as "held to maturity" (HTM), which means that the principal and interest can only be redeemed upon maturity. Early redemption would result in the loss of both interest and principal, which poses a risk known as short-term borrowing for long-term investment. Despite this risk, the bank has carefully evaluated and managed its investment portfolio to ensure long-term financial stability.
What is "short-term borrowing for long-term investment"?
A demand deposit, or a checking account, is a short-term debt. A 5-year government bond, on the other hand, is a long-term investment. The reason why a demand deposit is called a demand deposit is that it can be withdrawn at any time. If all depositors suddenly come to withdraw their money, but the bank's investments cannot be recouped until five years later, there may be a situation where the bank cannot pay its debts. This is the risk of "short-term borrowing for long-term investment". However, "short-term borrowing for long-term investment" is almost inevitable in banks. In theory, all depositors may withdraw their money one day later. But loans made by banks cannot be repaid after just one day. Loan terms are always longer than deposit terms. So what can be done about it?
Deposit Reserve Requirements
Let us discuss the deposit reserve requirements and their significance in maintaining financial stability. While it may seem unlikely that all depositors will withdraw their savings simultaneously, it is vital to maintain a certain level of cash reserve to meet most withdrawal demands. Therefore, many central banks worldwide have implemented a "deposit reserve" system that mandates banks to keep a portion of their funds with the central bank and restricts them from using it for lending purposes. The New Zealand Reserve, for instance, amounts to NZ$14,899 million. However, in the United States, the current deposit reserve ratio is 0% as a measure to stimulate the economy. But what if depositors initiate a run on the bank and the bank lacks the funds? In such a scenario, the bank is solely responsible for handling it. Nevertheless, deposit insurance is still available to mitigate depositors' losses.
Deposit Insurance
Deposit insurance is a mechanism that provides protection to depositors in the event that a bank becomes insolvent. Historically, there was a perception that banks were unlikely to fail, but this view has been challenged in recent years. For instance, in 2006, China introduced the Enterprise Bankruptcy Law, which demonstrated that banks are also susceptible to bankruptcy.
In the event of bank insolvency, the safety of deposits becomes a major concern for depositors. In China, deposit insurance covers up to ￥500,000 per depositor. To mitigate risk, some individuals have suggested spreading their deposits across multiple banks, with each bank holding no more than ￥500,000. However, for large deposits made by businesses, such a strategy may not be feasible.
The deposit insurance limit in the United States is $250,000 per depositor. Interestingly, a significant proportion of Silicon Valley Bank's deposits, 90%, exceed this threshold. In New Zealand, the Depositor Compensation Scheme provides insurance coverage up to $100,000, with plans to go live in late 2024.
While deposit insurance provides a measure of protection for depositors, extreme situations can still occur. For example, the combination of the Federal Reserve raising interest rates and a cold winter in the tech industry has caused disruption in the past. Nevertheless, it is important to remain vigilant and take steps to mitigate risk where possible.
Federal Reserve's Interest Rate Hike
In 2020, the Federal Reserve implemented a zero-interest rate policy, whereas, in 2022, the Fed increased interest rates seven times consecutively. While a single hike in interest rates can provide a sense of satisfaction, a continued rise in interest rates can generate even greater gratification. As of February this year, the current interest rate reached 4.5% to 4.75%.
The Federal Reserve modifies interest rates periodically to either encourage economic growth or mitigate inflation, depending on the current economic climate.
Nevertheless, do you recall that Silicon Valley Bank's risk-free government bond has a yearly yield of merely 1%? If the cost of funds surpasses 4%, but the returns on funds are only 1%, wouldn't this result in a loss?
Undoubtedly, this would lead to a loss. However, this loss would not become evident immediately. It would only become apparent upon selling the bond. This type of loss is termed an unrealized loss.
Regrettably, misfortune seldom comes alone. Presently, the United States is also experiencing a cold winter in the technology sector.
Tech Winter
Starting in the latter half of 2022, a significant number of tech companies in the United States began implementing layoffs, including notable firms such as Tesla, Facebook, Microsoft, Twitter, and others. The tech industry was experiencing an unparalleled downturn. This phenomenon was not only limited to the US, but was also occurring globally, with numerous tech firms halting their hiring and drastically reducing their budget for 2023.
Furthermore, the US venture capital industry exhibited a generally pessimistic outlook regarding the US economy. Sequoia Capital, a prominent investment firm, advised all of its invested companies to adopt a cost-cutting strategy and prioritize cash flow management. Startups that were once able to effortlessly secure funding were no longer able to do so.
Although the aforementioned developments are understandable, their relevance to Silicon Valley Bank stems from the fact that it is primarily a "Silicon Valley" bank, with most of its depositors comprising US tech firms.
Liquidity Crisis
As the financing environment for tech companies worsened, they increasingly relied on their own savings in the bank. While this was understandable, it had negative implications for Silicon Valley Bank as it meant that the bank's cost-free funds were continuously being depleted. As withdrawals by tech companies intensified, Silicon Valley Bank encountered a significant liquidity crisis, prompting it to sell some of its assets to obtain funds. However, these assets were "held-to-maturity bonds," and selling them prematurely would result in significant losses. Despite this, Silicon Valley Bank sold $21 billion of securities, resulting in a loss of $1.8 billion.
The market reacted with panic, concerned about the bank's future. Companies began looking for ways to transfer their deposits out of the bank, resulting in withdrawal and transfer requests exceeding $42 billion in just one day on March 8. Many startup companies and fund companies scrambled to flee the bank. Meanwhile, Silicon Valley Bank had only slightly over $10 billion of available funds.
However, the bank did not declare bankruptcy but instead took prompt action to address the crisis.
Will it pose systemic risks?
The scale and interconnectivity of Silicon Valley Bank is significantly lower than that of Lehman Brothers Bank, which means that the direct spillover effect of its asset sell-off, which involves fundamentally sound underlying assets such as US Treasury bonds and MBS, is unlikely to trigger a chain reaction of risk exposure among other banks. Furthermore, as the underlying assets of Silicon Valley Bank, including US Treasury bonds and MBS, are relatively healthy, there is no risk of the spread of panic selling of underlying assets.
In addition, from the perspectives of CDS spreads, financial conditions, money market liquidity, and money market interest rates, the current US financial market environment remains stable, and there is no concern of a "liquidity shock" evolving into "liquidity risk."
Since 2008, with the tightening of financial institution supervision and the promotion of Basel III, the Tier 1 capital adequacy ratio of US commercial banks has significantly increased. At the same time, with experience in dealing with the previous crisis, the Federal Reserve has created a large number of structured monetary policy tools that can directly inject liquidity into markets with a high concentration of systemic risks. With these rich tools at their disposal, the probability of a concentrated outbreak of systemic risks has decreased.
Would the Silicon Valley Bank incident force a shift in US monetary policy?
Following the incident at Silicon Valley Bank, market risk aversion has significantly increased. In combination with the impact of rising unemployment rates, the market has been pricing in a shift in monetary policy.
Currently, the probability of systemic risk erupting in the US banking sector is low. The proportion of small and medium-sized banks that pose a risk is low, and their contagion effect is limited due to high deposit insurance coverage. Therefore, the likelihood of the bankruptcy of Silicon Valley Bank forcing the Federal Reserve to shift its policies is low. Looking back at the experience of the Fed raising interest rates significantly during the savings and loan crisis in the 1980s, the probability of a shift in US monetary policy is not high.
The bankruptcy of Silicon Valley Bank may further exacerbate the volatility in the pricing of the federal funds rate. After the bankruptcy of Silicon Valley Bank, the market began to discuss whether the Fed would pause or stop raising interest rates. In 2022, the Fed only needs to focus on its inflation target, but in 2023, it will face a greater challenge in achieving a balance between maximum employment, stable prices, and financial risks. Currently, the 10-year to 2-year Treasury yield spread is at a historically high percentile range. In January, the personal consumption expenditure price index unexpectedly rebounded. If inflation continues to remain sticky, the degree of the term structure inversion may deepen.
Subsequent Impact
According to Garry Tan, the CEO of YC Combinator, a well-known startup accelerator, the events surrounding Silicon Valley Bank are potentially catastrophic for startups. The bank held deposits for numerous tech companies, and if they are unable to retrieve them, they may be unable to pay debts and salaries, resulting in a "mass extinction-level event" for startups.
As a result, 125 venture capital firms, including Sequoia, have issued a joint statement calling on the government to intervene, and Elon Musk has also expressed his openness to the issue on Twitter. The potential outcome is still unclear, and we must wait to see how events develop. However, this serves as a cautionary tale against engaging in short-term debt, long-term investment strategies.
It is vital to remember that while many people strive to change the world, the world can also change us. Let us hope that these events do not occur for anyone.
