The Silicon Valley Bank blew up over the weekend. FTX- the cryptocurrency ‘bank’ blew up in November 2022. Signature Bank also has gone under. Over a dozen regional banks had their shares suspended in trade on Monday after falling nearly 20%. Who’s next? More importantly, who’s to blame? Is it because of the relentless rate hikes taking place in the US right now or because of something else- like a lax regulatory environment. The coming week news cycle will be dominated by timelines of the fall of a largeish reginal bank that funded start-ups and tech companies followed by human interest stories about the people who ran the bank or worked here. But the main interest for markets should be: what caused the crash, are the conditions translatable to other organisations and what can be done to prevent future occurrences of this sort?
First things first though, is that the Federal Reserve has stepped in immediately to announce that ALL deposits will be protected- meaning that, over and above the US$ 250,000 that Federal insurance covers, depositors will not lose their money. Shareholders and unsecured bondholders will lose everything Of course, this is still early in the unfolding drama as there is talk of the entity being sold off to one of the large 4 banks- the Bank of England has already announced that HSBC will buy over the UK operations; the Fed has offered banks loans up to 1 year on easier terms than usual and loan collateral will be valued at par instead of at face value. Questions about the underlying strength of the US financial system, however, remain open.
Perhaps, with the numerous announcements made by the tech giants in the last few months of thousands of workers apiece should have been a warning that the bank- which lends to that very sector, would be under business pressure. And, if one factors in the zero-profitability growth-at-all-costs nature of funding that backed these businesses it’s easy to see how things could have gone disastrously wrong so quickly. Still, despite the very limited economic damage the bank could do if it failed in isolation, the danger is the crisis of confidence this is sending through the financial world. It wasn’t that long ago when we had the financial crisis, and it required a US$ 700 billion package to rescue the US banks. That crisis started off with a handful of US and UK Banks which went under- Lehmann Brothers, Bear Sterns, Washington Mutual and Northern Rock. The contagion spread and became global as panic spread. The two key words are panic and confidence- if either of those pillars give then any rescue is nearly impossible. So, it is natural that the Fed acted with lightning speed over the weekend to shore up confidence and head off any panic that might arise.
Which brings us to the central question of whether the rate hikes in the US have helped cause this moment to arise or do we have to look elsewhere? And in one way, the answer must be: absolutely. Setting aside all questions about whether interest rate hikes have been the right medicine for inflation caused by supply side issues it’s a no-brainer to understand that a large part of the decades long rise in asset valuations have been facilitated by a policy of low interest rates; flooding the zone with liquidity during past crises only made it a turbocharged combination that fuelled speculation in ALL asset classes- including cryptocurrencies. The Fed reacted slowly to the rising inflation post-pandemic as the world got back to business and- when they did act, put the cause of inflation down to resurgent demand and wage pressures, then tried to engineer a demand slowdown with the double whammy of higher rates and lower supply. In other words, they tried to inflate the cost of money to deflate the demand for money. The trouble is- this isn’t as straightforward as it looks since a lot of the money behind the speculative forces was leveraged borrowings. And often leveraged on inflated valuations of other assets.
So, when the asset threads started unravelling because funding became harder and more expensive this set off a chain reaction of margin calls that cascaded upon further price falls. The markets have been orderly- so far, and equity markets- usually highly sensitive to economic winds, have been stable- moving sideways for most of the period of rising rates.
This is not a guarantee of future volatility, and it usually needs a catalytic event to break the market confidence- like Lehmann Brothers and Bear Sterns were. The critical difference between this moment and earlier ones is that the Federal Reserve seems to have a disregard for the direction of asset market levels- they have done away with the Fed put and seem to treat falls in asset prices as overdue corrections. If they continue with this laissez-faire attitude towards markets, then they may treat the failure of this bank as collateral damage in their (misguided) war against inflation. They look to be concerned not to let this escalate and will ring-fence the damage but not act beyond that.
The better, more accurate explanation for this failure probably lies in the rescinding of certain parts of the Dodd-Frank Act by the Trump administration which curtailed Fed oversight of regional banks, much like the relaxation of rules for the railway companies by Trump- both of which have led to the train-wrecks lack of oversight usually inevitably brings about. All the details of SVB’s lending patterns/ borrowing or funding mistakes will invariably become public over the next few weeks but- given the strong capitalisation ratios/ profitability of the larger banks, it is likely to point towards management malpractices facilitated by weak oversight rather than adverse market conditions.
Longer term rates in the US have already softened- the 10-year gilts were off by 20 basis points on Monday, as banks lean into the belief that the Fed will have to pause their rate hike programme. But- if they contain the crisis quickly and effectively, then the likelihood is that this will be just a blip in their planned schedule. Meanwhile, the equity markets are taking this very badly. Over to the Fed now.