What does history tell us about bank failures? Banks designed to fail. “Silicon Valley” is an #urgent example

What are the repercussions of the rapid collapse of Silicon Valley Bank? It is now arguably the most important question in global finance. What can financial history tell us about what might happen next?

First, the Silicon Valley bank was radically different in many dimensions: its deposits more than tripled from the fourth quarter of 2019 to $189 billion by the end of 2021, compared to industry growth of 37 percent over the same period. period, according to Autonomous Research.
Silicon Valley Bank also had an unusually high reliance on corporate finance and venture capital. About 95 percent of its deposits were uninsured at the end of last year, compared with a third in a sample of major US banks. The rush of depositors to withdraw their bank balances reminds us of hedge funds, which fled their main intermediaries in 2008.

To be sure, the Bank bet heavily, and surprisingly without a hedge, on long-term bonds when their prices were at their peak. Rising interest rates crushed trade, leaving the bank with an unrealized loss of almost $16 billion, more than its stock base. Then the withdrawal of deposits began to crystallize into a realized loss.

Given the highly private deposit base, which favors the tech industry, and huge trading fees, the Silicon Valley collapse may not prove systemic. David Serra, an investor and former banking analyst, argued that “one apple hit doesn’t spoil the whole bunch.”

But the failure has some important things to say about the broader banking market and its implications for the Federal Reserve.

The Silicon Valley bank’s collapse shares some of the characteristics of the 1984 failure of Continental Illinois Bank, then the largest bankruptcy in American banking history. It had a very unstable base of uninsured depositors, heavily biased towards those from international corporations, and a highly concentrated loan portfolio. Paul Volcker, then chairman of the Federal Reserve, opted for pragmatism and orchestrated a bailout involving the central bank and the Federal Deposit Insurance Corporation.

Incumbent policymakers may have been surprised by the pace of depositors rushing out of a digital bank, but an immediate policy response will be critical to stem the panic. Priority must be given to finding a way to keep uninsured depositors safe, something current Federal Reserve Chairman Jay Powell supported during the Bank of New England bailout in 1991.

The story also points to other lessons for investors. Firstly, banks will be much more sensitive to the risk of deposit flight and financing payments, which will lead to a tightening of financial conditions. This competition should considerably boost what is called the “central bank deposit beta” – the amount of interest rate increase that banks spend. Consensus has assumed that the cumulative beta for this tightening cycle will be only 40 percent, but it could easily exceed previous tightening cycles of 55 to 65 percent, although even the strongest banks would not have to pay that much. Banks’ net interest income will decline. It is likely to be less willing to lend, even to parts of the tech industry, at least temporarily.

Investors will look at other large exposures and weak deposit bases. Despite being the 16th largest bank in the US, Silicon Valley Bank has unfortunately not been stress tested by the Federal Reserve or the Basel international banking rules on liquidity. Fleeing to quality means that policymakers will need to act quickly and take credible steps to stop deposit outflows from other institutions now seen as weak.

So the demise of Silicon Valley may herald macrosystem change in a beleaguered economy. After bailing out Continental Illinois, Volcker told the Fed’s Open Market Committee: “My bottom line is that we don’t have room for any adjustment at this point given this situation.” In six months, the Federal Reserve cut interest rates by 0.50 percentage points. And with monetary policy suffering from “protracted and variable slack,” the Fed is likely to be cautious this time around, but may choose to pause raising interest rates or raise them again by 0.25 percentage point. at once.

Finally, there may be some hard lessons for providers of so-called cryptocurrencies, including stablecoins pegged to fiat currencies, in needing to prepare for sudden refunds to customers. The launch of the central bank’s digital currency plans may also be deliberately delayed

The central bankers have gone out of their way to tell us to worry about the non-bank sector because of hidden borrowing pools. But what stopped us is what is always at the center of banking crises: huge exposure to a large asset class that is considered low risk, in this case, US Treasury interest risk. Undo unconventional central bank measures has always been very difficult. And Silicon Valley Bank made it even harder

*Vice President of Oliver Wyman Advisors and former global head of banking research at Morgan Stanley