US Banking Crisis and Risks of Global Contagion

Cheikh Ahmed Diop, Muhamed Zulkhibri , Mustafa Yagci

30 Mar, 2023

Introduction

The collapse of Silicon Valley Bank (SVB) and Signature Bank on 8-10 March 2023 has triggered deep financial turmoil in the US and prompted financial and monetary authorities to intervene to swiftly avert a contagion. SVB specialized in providing finance and banking services to venture-backed start-ups, most of which are technology firms. It was the largest US bank to fail since the global financial crisis (GFC) of 2008. SVB’s failure is generally attributed to liquidity exacerbated by large and quick withdrawals, net interest margins associated with the broader tech sector downturn, and rising interest rates that resulted in the deterioration of their balance sheets because of large unrealized losses.

The collapse of SVB occurred amid tightening global financial conditions and increasing uncertainty about global recovery prospects. As such, it is imperative to understand and examine the extent to which broader central bank policies interacted with SVB’s failure. In 2022, in response to the global inflation acceleration, central banks, especially the Federal Reserve System (the Fed) of the US, raised interest rates, from 0.125% in February 2022 (pre-East European crisis) to 4.625% in February 2023. Because of the shift from monetary easing to tightening, bond yields have started to reflect changing market sentiments in the US, the impact of which can be observed in bank balance sheets. As a result, the value of long-term assets, such as government bonds and mortgages, have deteriorated, exposing solvency concerns and liquidity stress, especially for mid-sized and regional banks.

Despite massive bailouts for the US banking sector, investor sentiment has remained fragile and global contagion risks remain. This topical paper aims to provide further insights into the US banking crisis as it unfolds. The analysis focuses on the following aspects: (i) understanding the circumstances that led to the crisis (ii) highlighting the policy reactions so far, (iii) assessing the risks of contagion globally, and (iv) drawing potential lessons and recommendations.

The Case of the Silicon Valley Bank Failure

SVB was created in 1983 and was among the top 20 US commercial banks at the end of 2022, with US$209 billion in assets. SVB provided funding for approximately half of the venture-backed technology and healthcare start-ups in the US. Of its deposit funding in 2022, 49% was in technology and 11% was in healthcare (Chart 1). It was a preferred bank for the technology sector since it supported start-ups that not all banks would consider due to their higher risk profile. At the end of 2022, SVB’s total deposits was at US$175.4 billion, of which US$151.6 billion were uninsured (above the US$250,000 FDIC insurance threshold).

The year 2020 was a lucrative time for tech firms, as consumers spent large amounts of money on digital services and electronics because of work-from-home arrangements during the pandemic. As a result, tech businesses received large cash inflows, and this required additional financial services from the banking sector. Instead of using other accounts, such as a money market, several tech firms left funds in their SVB primary account to take care of short-term business expenses. This meant that most of their working capital (for payroll and other short-term expenses) was in their SVB account.

Chart 1. SVB Deposit Funding, 2022

In 2021, due to record-low interest rates and a boom in start-up investment, SVB’s deposits grew by 100%, from US$62 billion to US$124 billion. SVB did not need to extend credit because it worked with tech start-ups loaded with cash, and about 44% of tech firms that went public in 2021 banked with SVB. Instead, SVB placed 56% of its assets in long-term US Treasury bonds, the long-term nature of which bore with it interest rate risk. Its primary customers, start-ups, were also very vulnerable to interest rate concerns due to the low-interest rate-driven funding boom.

As interest rates rose sharply beginning in 2022, the value of US Treasury bonds fell, and start-up funding decreased by 35% in 2022. As a result, start-ups began withdrawing investments from SVB. Crunching liquidity caused start-ups to burn through cash and many other start-ups withdrew deposits from SVB.  The deposit outflows were accelerating in the weeks before the failures. Moreover, SVB’s money was locked up in long-term bonds whose prices were decreasing and there was insufficient money for withdrawals, thus the crash.

SVB collapsed spectacularly quickly after 8-9 March 2023. In the run-up to the collapse, SVB incurred a US$1.8 billion loss on a forced US$21 billion bond liquidation from its available-for-sale portfolio on 8 March 2023. SVB then announced plans to raise US$2.25 billion in capital to help close the shortfall. On 9 March 2023, SVB witnessed a significant bank run, with US$42 billion in withdrawals triggered by depositors.  SVB stocks then plummeted. On 10 March 2023, the California Department of Financial Protection and Innovation (DFPI) declared SVB insolvent, and the Federal Deposit Insurance Corporation (FDIC) was appointed as the receiver. There are likely three causes that contributed to SVB’s lack of liquidity: tenor mismatch, reduced deposit base, and declining net interest margin.

Systemic Bank Failures and Policy Responses

In response to the 2008 GFC, a law enacted in 2010 and widely referred to as “Dodd-Frank,” created stricter regulations in the US for banks with at least US$50 billion in assets. These banks, which were deemed systemically important to the financial system, were required to undergo an annual Federal Reserve stress test, to maintain certain levels of capital and liquidity.

Prior to its failure, SVB was not considered systemically important from a regulatory standpoint, as it was a small player in the US banking system. At the time of its collapse, SVB had US$209 billion in assets. SVB has been exempted from this requirement, owing to a 2018 legislative change that increased the threshold for participation from US$50 billion in assets to US$250 billion. After SVB’s failure, credit spreads have increased dramatically, and Moody’s has downgraded the US banking industry from stable to negative.

The US authorities’ swift and bold response suggests that there is real concern about a possible financial contagion. The Fed, FDIC, and the Treasury Department announced on 12 March 2023 that the FDIC will complete the resolution of SVB while fully protecting all depositors, allowing depositors access to all their money starting 13 March 2023. This announcement was made to reassure depositors that the FDIC’s US$250,000 limit on deposit insurance would be lifted to avoid any systemic risk in the financial system.

On 15 March 2023, the Fed provided about US$153 billion as additional liquidity to the banks through the discount window and another US$12 billion through the Bank Term Funding Program (BTFP). A week before, borrowing was only about US$5 billion. Meanwhile, the daily average borrowing was around US$85 billion during the week, compared with US$4.4 billion just a week earlier. These are the highest levels of bank borrowing from the Fed since the GFC. Aside from these borrowings, the Fed also allocated around US$143 billion to guarantee all deposits at SVB and Signature Bank.

Clearly, the SVB and Signature Bank failures are part of an evolving situation, with developments happening by the day. However, it is likewise apparent how fast the Fed is attempting to contain the situation, possibly owing to lessons learned and safeguards put up after the 2008 GFC, to avoid an economy-wide–or worse a global–contagion.

Risks of Global Contagion Remain

SVB was particularly exposed to a financial shock due to weak corporate governance. It didn’t hedge its long-term Treasury bonds’ interest-rate risk and didn’t have a chief risk officer for most of 2022. However, poor government regulation may partially contribute to the collapse. Because rigorous Fed regulation was only applicable to banks with over US$250 billion in assets, the government may not initially find that SVB can cause a contagion. However, its collapse did fuel fears of a domino effect through systemic risk and contagion, suggesting a probable gap in regulation.

There are two phases of the contagion. The first phase of such crises is a run-on bank with weak balance sheets, meaning large potential losses relative to their levels of equity capital. When interest rates rise, the second phase of the crisis will focus on concerns about credit quality. These are what regulators are trying to contain and avoid.

In Switzerland, the subsequent pressure on Credit Suisse signals a global contagion risk. The bank ranks among the world’s largest wealth managers and one of the 30 systemically important global banks, whose failure would destabilise the financial system. Credit Suisse has been struggling with financial losses, compliance issues, and a high-profile data breach. A series of announcements regarding the institution’s financial health and its corporate governance caused a dramatic sell-off in the bank’s shares.

Conclusion and Lessons Learned

Recent bank failures in the US provide several lessons. First, the quick transition from monetary easing with ultra-low interest rates to monetary tightening with higher interest rates has a negative impact on bank balance sheets. Banks with a higher proportion of long-term assets such as Treasury Bonds or Mortgages are more vulnerable to these shifts due to the changing risk sentiment in the markets.

Second, the global growth of social media, digitalization, and digital banking has accelerated the rate at which bank runs can occur. The failure of SVB over the span of two days, for instance, shows the power of social media and how social media statements can spark a bank run. Recent bank failures indicate that the ease of withdrawing and wiring money transfers may make the banking system susceptible to unexpected risks.   

Third, the recent bank failures highlight that the moral hazard problem is still persistent in the functioning of the global financial system. With the rescue of the SVB and Signature Bank by the federal regulators, the discussion on the systematically important banks in financial regulation seems irrelevant as even banks with a relatively small share of the assets in the banking industry cannot be allowed to fail without government intervention. 

Fourth, the importance of regulatory oversight and supervision is under scrutiny. Regulatory failure paved the way for the recent bank failures as financial control on smaller banks was loosened a few years ago because they were not deemed to be systemically significant to the financial industry. However, contrary to this assertion, t financial instability is inherent to the capitalist system, and regulations will constantly have to catch up to changes in the market.

Fifth, there is no sign, to date, of contagion spreading to the emerging market and developing countries. However, recent banking crises show that market conditions and investor sentiment can shift swiftly and cause domino effects beyond the control of national authorities. In addition, there are new and important risks today that were not evident in earlier crises: a serious outbreak of inflation and geopolitical fragmentation.

Finally, the high level of inflation compounds the challenge of maintaining macroeconomic stability in emerging and developing countries, while averting the risks of financial instability. The successive crises have already put economies under heavy stress. In this context, a global banking crisis could have devastating impacts on the most vulnerable economies.

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