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US Bank Run and effect on India
[/vc_column_text][vc_separator css=”.vc_custom_1647339034936{margin-bottom: 30px !important;}”][vc_column_text css=”.vc_custom_1678792764267{margin-bottom: 15px !important;}”]Bank run refers to a situation when there is loss of confidence in the bank and the depositors run to withdraw their money from the bank. Now the bank cannot pay everyone all at once (since that is how the monetary system of the world functions) and it falls. During the Great Depression of 1929, about 9000 banks failed globally, taking $7 billion worth of assets with themselves. It was then decided that is it imperative to protect deposit-holders and safeguard their assets. The Federal Deposit Insurance Corporation (FDIC) was created in the USA in 1933 and today insures $250,000 per depositors at FDIC insured US banks.
Now, globally, banks do fail every now and then. But the frequency is to the tune of 1-2 banks every year. There was no bank failure reported in 2021 and 2022 and the streak was broken now in 2023. As a comparison, some 157 banks failed during the global financial crises of 2008. The danger with bank run is that it can spread to other banks as well, which is called a financial contagion. So, what starts off as a problem for a bank quickly becomes a crises for the entire financial system.
Most recently, we are hearing the news of two US banks that have failed to respect withdrawals and the US Treasury, FDIC and the Federal Reserve had to step in, change the management, ensure the public that the government will go to extreme lengths to make sure that the system remains stable and no deposit holder loses any money. The two banks are the Silicon Valley Bank(SVB) and the Signature Bank. Both these banks, and several other banks, also saw their share prices drop about almost 60%-70%. Let us look at what started this episode in Silicon Valley Bank.
In January 2020, SVB had $55 billion in customer deposits on its balance sheet. By the end of 2022, that number exploded to $186 billion. These deposits were often from initial public offerings and SPAC deals—SVB banked almost half of all IPO proceeds in the last two years. That’s a lot of money to put to work. Some was lent out, but with soaring stock prices and near-zero interest rates, no one needed to take on excessive debt. There was no way SVB was going to initiate $131 billion in new loans. So the bank put some of this new capital into higher-yielding long-term government bonds and $80 billion into 10-year mortgage-backed securities paying 1.5% instead of short-term Treasurys paying 0.25%.
Silicon Valley Bank was hit hard by the downturn in technology stocks over the past year as well as the Federal Reserve’s aggressive plan to increase interest rates to combat inflation. The bank bought billions of dollars worth of bonds over the past couple of years, using customers’ deposits as a typical bank would normally operate. These investments are typically safe, but the value of those investments fell because they paid lower interest rates than what a comparable bond would pay if issued in today’s higher interest rate environment. Typically that’s not an issue, because banks hold onto those for a long time — unless they have to sell them in an emergency. But Silicon Valley’s customers were largely startups and other tech-centric companies that started becoming needier for cash over the past year. Venture capital funding was drying up, companies were not able to get additional rounds of funding for unprofitable businesses and therefore had to tap their existing funds — often deposited with Silicon Valley Bank, which sat in the centre of the tech startup universe. As customers asked for their money, SVB had to sell $21 billion in underwater longer-term assets, with an average interest rate around 1.8%. The bank lost $1.8 billion on the sale and tried to raise more than $2 billion to fill the hole. Investors could sense the trouble the bank was in and quietly urged the customers to withdraw their money to park it somewhere safe.
So Silicon Valley customers started withdrawing their deposits. Initially, that wasn’t a huge issue, but the withdrawals started requiring the bank to start selling its own assets to meet customer withdrawal requests. That required selling typically safe bonds at a loss and those losses added up to the point that Silicon Valley Bank became effectively insolvent. The bank tried to raise additional capital through outside investors but was unable to find them. The fancy tech-focused bank was brought down by the oldest issue in banking: a good ol’ run on the bank. Bank regulators had no other choice but to seize Silicon Valley Bank’s assets to protect the assets and deposits still remaining at the bank.
Financial assets create direct exposure to a different variety of risks, including credit risks, liquidity risks, market risks, and interest rate risks. Unlike many tangible assets, financial assets are often measured at fair market value for financial reporting. The Basel Committee developed the international regulatory framework for banks known as Basel III. As a result of preventing banks from assuming excessive financial leverage, Basel III has prompted banks to focus on asset quality, hold capital against other types of risk (such as operational risk), and develop improved risk assessment processes. Basel III also presents fundamental changes regarding the quality and composition of the capital base of financial institutions.
While most jurisdictions apply the Basel norms to their entire banking system, the US has a strong and powerful community bank lobby, and US community banks are usually quite aggressive in their use of the borrow-short/lend-long business model. So the Fed adopted a rule under which only the very largest international banks were subject to the full Basel NSFR requirements. It adopted a second tier, under which the ratio only had to be 85%, and a third tier where it was calibrated to 70%. And even then, the majority of US banks are not required to follow the NSFR or LCR standards at all. Despite being the 16th largest bank in the US by balance-sheet size, SVB was apparently not subject to the Basel regulation. SVB’s collapse is a textbook case of Asset-Liability Mismatch – where lenders use short-term hot money to lock in money long term. With depositors fast pulling money out of the bank, it was trapped with several loss-making bonds and few liquid papers. This is reminiscent of what happened to the Indian mutual fund industry soon after the IL&FS crisis when various debt schemes invested short-term money into illiquid papers.
Effect on India
The extent of exposure of Indian to the Silicon Valley Bank is limited to a few Indian startups’ and a clutch of Indian founders and tech workers in the US. The combined exposure to SVB is estimated to be in the range of $2.5-3bn. Indian banks are distinguished with hardly any exposure directly or indirectly to SVB. The collapse of SVB will not have any effect on the Indian banks as the Indian banking system is more insulated and regulated under the supervision of RBI. However, there will be some impact on the sentiment of the market in the short to medium term as it’s a global contagion, but will not affect Indian equity markets in the long term. This sentiment will also affect medium term returns on mutual funds with international exposure and traders who deal in foreign exchange.[/vc_column_text][vc_zigzag][vc_column_text]
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