What can we learn from the SVB collapse?

The recent collapse of Silicon Valley Bank (SVB) has sent shockwaves throughout the financial sector, making it the second-largest bank failure in US history. The tech-focused lender was unable to raise fresh capital after a run on deposits ( A bank run occurs when a large group of depositors withdraw their money from banks simultaneously), which led to emergency measures by US regulators. This begs the question: how did we get here, and what are the potential broader economic effects?

During the Covid-19 pandemic, the US government provided its citizens with significant financial support through stimulus checks. As a result, Silicon Valley Bank received billions of dollars in deposits, causing its deposits to triple in size. The bank used these funds to make loans and invest in secure securities, anticipating potential market instability. 

Silicon Valley Bank differed significantly from other banks in terms of its debt classification. While banks with assets of at least $1 billion typically categorised only 6% of their debt as held to maturity at the end of 2022, Silicon Valley Bank allocated 75% of its debt to this category. However, the mass printing of money to support the economy led to concerns about high inflation. To combat this, the Federal Reserve increased interest rates, causing bond values to decrease. 

This would not have been problematic if the bank did not need to sell the bonds. Unfortunately, the unexpected departure of deposits caused SVB to sell its bonds at a significant loss, resulting in a need to raise capital. Investors panicked, and a sell-off of stock ensued, resulting in a loss of trust and triggering a bank run. Customers attempted to withdraw approximately $42 billion in deposits within a single day, exacerbating the already challenging situation.

In a dramatic turn of events, regulators had to intervene and seize Silicon Valley Bank on 10 March morning, as they sought to prevent a possible financial catastrophe. In an effort to calm market panic, the Federal Reserve has stepped in to provide a lending facility as a backstop and guarantee the safety of all deposits at SVB. Despite this intervention, the collapse of SVB has sparked concerns about the fragility of the financial system. 

In addition, the New York-based bank, Signature Bank, was also seized on Sunday the 12th, which is the third-largest bank in US history. The collapse of Silicon Valley Bank has come as a shock to many, given its reputation as a leader in serving innovative tech startups and venture capitalists in Silicon Valley. Its sudden downfall has raised questions about the stability of other banks and financial institutions, particularly in light of the continued economic uncertainty.

Those events have already had an impact in Europe. HSBC has acquired the UK subsidiary of Silicon Valley Bank for a nominal sum of just over $1. The acquisition came after a tense weekend for regulators, who scrambled to find a way to protect the bank's depositors following the collapse of its US parent. The deal allowed the bank to avoid insolvency, which the Bank of England had been prepared to impose if a buyer couldn't be found. 

The central bank hailed the sale as a boost to confidence in the UK's financial system. Initially, the Bank of England downplayed the significance of the collapse, stating that the bank's UK subsidiary had a limited presence and did not perform any critical functions in the country's financial system. 

However, by Saturday afternoon, technology companies and investors were urging authorities to find a solution, citing the bank's importance to the vibrant startup scene in the UK, which is the most active in Europe. This created pressure for a quick resolution to protect the bank's customers. 

On Sunday, the UK Treasury worked tirelessly to develop a plan that would cover the bank's customers' short-term operational and cash-flow needs. The acquisition by HSBC came as a welcome relief and helped to restore confidence in the UK's financial system. The incident serves as a reminder of the fragility of the banking sector and the need for regulators to act swiftly and decisively to prevent a collapse that could have far-reaching consequences.

The recent collapses of Silicon Valley Bank and Signature Bank have an impact on the financial industry, with many experts voicing concerns about the potential for broader economic fallout. The possibility of a domino effect cannot be dismissed, whereby panic spreads to other parts of the banking system, triggering a wider crisis. 

While the First Republic bank has announced a monetary injection, it remains to be seen whether this will be enough to restore market confidence and prevent further damage. The financial crisis of 2008 serves as a stark reminder of the disastrous consequences that can arise from a banking system collapse. It led to one of the deepest recessions in US history, with many businesses unable to recover and families losing their jobs, life savings, and even their homes. The impact of such a recession would extend far beyond US borders and have significant repercussions on the global economy.

This collapse also has far-reaching implications for the economy as a whole. The impact of these events has been felt by both investors and policymakers, and it has thrown the Federal Reserve's plans for tackling inflation off course. The Fed has been raising interest rates as part of its efforts to combat inflation, but the collapse of these banks has created a new challenge. Officials have recognised the potential for simultaneous fallout from both financial instability and inflation, which makes the situation even more complex. 

To address this challenge, the Fed has announced an emergency lending facility, similar to the bank-funding facility, which demonstrates its willingness to take decisive action to address financial instability. This move comes as the Fed grapples with how to continue raising or maintaining interest rates while mitigating the risks of further instability in the financial system. The situation is complicated and will require careful consideration and nuanced decision-making by the Fed. However, the central bank's actions thus far indicate its commitment to tackling the challenges posed by this collapse while still prioritising its goal of managing inflation.

Moving forward, it will be important for regulators and policymakers to closely monitor the financial sector for signs of further instability and to take swift action to address any emerging risks. As the Fed navigates this difficult landscape, it will be critical for all stakeholders to work together to promote financial stability and economic growth. By doing so, we can ensure that the lessons of this crisis are learned and that we are better prepared for any future challenges that may arise.

The situation is particularly concerning considering that KPMG had given Silicon Valley Bank a clean bill of health just two weeks prior to its collapse. Similarly, Signature Bank collapsed only 11 days after KPMG completed its audit. Auditors have a critical responsibility to identify and address potential risks and significant issues that arise after a company's financial books are closed but before the audit is finalised. 

It is worth noting that Silicon Valley Bank's deposits reached their highest point at the end of Q1 2022, but declined by $25 billion, or 13%, in the final nine months of the year. This means that the bank's deposits were dwindling during KPMG's audit period. If this decline had an impact on the bank's liquidity when KPMG issued the audit report, this information should have been disclosed. The question, then, is whether KPMG was aware of or should have been aware of the situation.

The collapse of Silicon Valley Bank and Signature Bank has left the future looking uncertain. The crucial question is whether the panic has subsided or not. If investors and customers continue to sell stocks and withdraw their money, other banks could collapse, leading to a domino effect. In this scenario, the Fed would struggle to maintain its fight against inflation, and we could be forced to accept the reality of coexisting with high prices, which terrifies people. The 'soft landing' that was promised by Jerome Powell and his colleagues now seems like a distant dream, and a recession may be on the horizon.

The collapse of SVB has highlighted the need for banks to have robust risk management practices in place and for regulators to maintain close oversight to prevent similar situations from occurring in the future. It has also exposed the vulnerabilities of the banking system. The failure of a financial institution, especially one as large and prominent as SVB, can have far-reaching consequences. It can shake the confidence of investors, customers, and other stakeholders and lead to a ripple effect throughout the broader economy. The fallout from such a failure can be severe and long-lasting. 

It is essential that banks take proactive steps to identify, assess, and manage risk. This includes implementing effective risk management frameworks, establishing clear risk appetite statements, and conducting ongoing risk assessments to identify potential threats and vulnerabilities.

In addition to these internal measures, regulatory oversight is critical to ensure that banks are operating in a safe and sound manner. Regulators must maintain a robust supervisory framework that includes regular monitoring, stress testing, and risk assessments to identify potential issues before they become significant problems.

M. Kabir Hassan is a Professor of Finance at the University of New Orleans, US.

José Antonio Pérez Amuedo is a PhD doctoral Student at the University of New Orleans, US.

Disclaimer: The views and opinions expressed in this article are those of the author and do not necessarily reflect the opinions and views of The Business Standard.