The collapse of Silicon Valley Bank in the United States triggered a panic not only in its home country’s financial system but also in several other countries where many bank stocks had to bear the burnt as their shares plunged to lower levels.
Last Thursday, the investors and depositors tried to withdraw a whopping $ 42 billion from the Silicon Bank driven by a panic trigger and this is a classic example of how the stakeholders get trapped in a herd mentality to believe that that something bad may happen and they start withdrawing their support at a time when the dwindling bank needed it most!
This is not the first time that the news about a bank getting into trouble has made the people run on the bank and withdraw their deposits making things worse for the affected bank to handle.
The banks certainly do not keep all the deposits intact all the time every time. That is just not the only business that they do. The banks usually offer checking account services, basic financial products and saving accounts facility and make various loans to individuals and businesses.
Commerc
l banks make money through the difference in the interest paid by them on the primary deposits and the interest charged by them on the consumer and commercial loans given to their clients. Hence in a way, the customer deposits provide banks with the capital to make these loans. Besides, the banks earn money through charges and fees collected by them for a variety of financial products and services provided by them. In this process the commercial banks play an important role in the economy because they create capital, credit, and liquidity in the market.
What happens when deposits start slipping away
Silicon Valley Bank was established in the year 1983 and had specialized in banking for the tech startups. It provided financing to almost half of US venture-backed technology as well as health care companies. As the name suggests, it was a prominent bank in the Silicon Valley yet it was one amongst top 20 Banks in the United States having total asset to the tune of $209 billion at the end of the last year according to the Federal Deposit Insurance Corporation (FDIC). So even if its impact was confined predominantly to the tech sector yet the Bank was not too small a bank also to have not triggered a panic button among the depositors and investors.
When all the depositors run for the withdrawal of their money much at the same time, the bank is obviously under tremendous pressure and that is exactly what happened with this bank. But if we go a little deeper, the bank was having difficulty due to rampant increase in the interest rates which led to erosion of the long-term bonds that it had piled up during the regime of near-zero interest rates.
And so the bank was perceived as sitting on huge pile of unrealized losses in its bond portfolio. On the other hand, the venture capital started drying up due to high interest rates and that put pressure on the liquidity levels that the bank would have strived to maintain.
These triggers were present in the environment already and last week when the Bank announced that it had sold a bundle of its securities at a loss and it intended to sell US $ 2.25 billion in new shares to make its balance sheet healthier, the panic sort of situation was triggered and the venture capitalists asked their clients to withdraw their money from the bank before it was too late. Naturally if the demand for withdrawal of funds exceeds the liquid funds available for meeting that demand at that point of time, the bank will shut down its doors. Technically we call it a collapse.
Being resilient but fragile as well
Even as the bank was not too big to have caused a domino effect that adversely hit the banking industry during the global melt – down in the year 2008-09 and the US banking system is reported to be well capitalized as of now, yet the bigger question is how the stakeholders suddenly withdraw their support from an institution without even waiting for clarifications or the corrective action having been taken by the concerned bank or its regulators?
The answers are not easy. When the depositors run for their money, clearly, they have severe doubts about the solvency of the concerned bank but at the same time one needs to consider the fact that howsoever resilient the financial system or the capital markets may appear to be, it is a fragile world after all.
This simply means that not only there is a need to handle the economy at the macro level with care but also it is equally significant to be watchful of the policy implications on the sectors more directly affected by the policy level changes. The world we live in today is so interconnected that the trouble in a particular company or financial institution may give rise to chain reactions in other economies or related sectors in the domestic economy.
Luckily the timely measures taken by the U.S. government have tried to build up confidence in the banking system after the failure of Silicon Valley Bank which is considered as the largest bank collapse since the 2008 financial crisis.
Need for better governance at the institutional level
At the same time the companies or institutions need to consider the fact that it is important to diversify portfolios, products, or services so that if one sector performs bad, the other sectors or securities can compensate them. Besides they need to be cautious about having contingency funds to encounter the liquidity issues.
Persistent rise in interest rates drains out the liquidity from the financial system to some extent and the companies or the institutions which have enough liquid assets to tackle the contingencies are better equipped to sail through the crisis. Thus, the asset liability mismatch must be carefully monitored and corrective actions be taken on time.
Similar was the case with a New York-based bank ‘Signature’, which had large exposure to the tune of over 25 per cent of its deposits from the cryptocurrency sector, which also was facing severe liquidity problems. In an interdependent global economy, financial institutions need to diversify and limit their exposure to a single or too few sectors.
Regulators acted fast to protect the depositor’s interest
The speed with which the regulators and the government worked to close the affected banks was quick enough to give an assurance to the depositors that they would have access to all their deposits as usual, on one hand and to the banks that they could have access to their emergency funds, on the other hand.
Even as the regulators were in damage control mode and acted fast, the contagious impact of the bank collapse had spread across borders and turned many global indices to red. India was no exception either. And here also the bank stocks pulled the indices down to a large extent.
The crux of the matter is that both the regulators and the financial institutions have to handle the liquidity crisis more diligently than ever as we live in mutually dependent, intertwined and intricately linked globalized world where a noise or disturbance in any part of the world would send jitters in other parts and so every single entity in every single country has to be closely monitored and need to be more vigilant and responsive to the economic and social environment in which they exist and grow!
Reference: This article is published by the Author in the Newsletter “KnowFunda Digest” (10th Edition) on LinkedIn on March 15, 2023