21 March 2023
The collapse of Silicon Valley Bank (SVB) and Signature Bank raises more questions presently especially its impact for the GCC region including Kuwait.
We now know that the collapse was triggered by the asset-liability mismatch that is typical of many banks and financial institutions that got used to near zero interest rates. When interest rates went up (that too quickly) in order to combat inflation, most of them were caught in a balance sheet problem especially banks that borrow short-term and lend long-term. SVB is a specialised bank that was created mainly to fund start-ups (as the name Silicon Valley implies). However, SVB experienced a drastic rise in its deposits between 2019 and 2021, which it found difficult to match through its loan growth (mainly to venture capital funds and start-ups). With an average cost of its deposit at a mouth-watering 25 bps, it sought to pick up some good yields in the long-end of the curve (upwards of 150 bps) through Mortgage backed securities (MBS). Most of its MBS investments were Held To Maturity (HTM) with 10+ year duration (a space considered risky). The game changing event occurred when Fed raised interest rates all too quickly from near zero to 4.5% all within one year. This meant that the market value of all bonds (more importantly long-dated bonds) fell causing mark-to-market losses. Depositors now sensed better opportunity even in short dated treasuries and given this asset-liability mismatch at SVB, they started withdrawing their deposits. SVB’s liquidity was tied up in long-dated MBS, which if forced to liquidate will be at a steep loss. The drama came to an end with SVB quickly going into receivership. Two days later another bank called Signature bank, mainly into funding cryptocurrencies, also fell. The Federal Reserve was quick to stem the rot by announcing relief for both depositors and banks that were holding these long duration bonds in their balance sheets. In essence, it gave protection for both i.e, asset and liability side of banks. Fed had to do this since the bonds that banks were having as investments were sitting on huge unrealized losses while deposits beyond a small threshold is mostly uninsured.
What is worrying is the magnitude of the failures of these two banks. Back in 2008 when the global financial crisis unfolded, Washington Mutual was considered the biggest bank failure. Now, SVB and Signature bank will be counted as the second and third largest bank failures. More worryingly, back in 2008-2010 approximately 25 banks cumulatively accounted for a loss of $375 billion while in 2023 only two banks (SVB and Signature Bank) accounted for nearly $320 billion in losses. Hence, the current saga should count as big enough to warrant comparison with the 2008 GFC.
The SVB failure opens up some key questions:
1. How will Fed behave from this point forward?
Fed is in a tight spot and has a moral hazard issue. While it is primarily mandated to maintain price stability (meaning moderate inflation), it also has the responsibility towards financial system health where banks happen to be the main channels. The former mandate means Fed should keep increasing interest rates till inflation cools down, while the later implies that it needs to either pause or reduce interest rates to prevent further bank failures. Fed is clearly now in an economic dilemma between containing inflation and protecting banks’ health and confidence. Also, any containment of inflation should be demand led for the Fed to have conviction. If it is led by financial sector led recession, history is suggesting that it can be a long and deep recession. Fed has also come under the criticism of ignoring the duration risk that banks were taking without any risk considerations.
2. Will SVB failure lead to a contagion?
Close on the heels of SVB and Signature bank failure is the failure of Credit Suisse, a global wealth management institution that recently was sold to UBS in a deal brokered by the Swiss central Bank. Three bank failures in quick succession led to this question about contagion. However, Credit Suisse is a problem unique to the bank and has been in bad news for several years now with many leadership changes. The SVB and Signature bank failures can be a systemic problem across banks as many small and medium banks may have this asset-liability mismatch issues and may not be that strongly capitalized to withstand the pressure. With Fed support on both sides of the balance sheet, it can definitely avoid a contagion but that has costs too. If at all we see a contagion, it may be restricted to small and medium sized US banks. This actually helps large money-centre banks like JP Morgan and Citibank that can now increase their already high market share. Also, the current focus is only on bond investments by banks. In my assessment, the same risk applies to loans as well and this is yet to surface.
3. How will this impact GCC?
The SVB incident has two-fold impact i.e., funding access to start-ups and banks’ exposure to bonds and its falling values as yields rise. From a GCC point of view, the former issue may not be significant as the region’s start-up ecosystem relies minimally on global banks like SVB for funding. With regard to the second aspect of bank’s exposure to long-dated bonds that are held to maturity, here again GCC banks enjoy good capital adequacy ratios and manage their asset-liability mix quite prudently providing them the ability to manage any liquidity needs arising from pressure on deposits, the risk of which is extremely minimal. Bond markets had a very bad 2022 (like equity markets) and impact of such fall in market value of bonds (in a rising yield scenario) is a business risk that GCC banks are well aware of and would have been adequately provided for. The worst that can happen from this point is to force Fed’s hand from further interest rate hikes which can be inflationary. All GCC countries face this risk given the dollar peg.
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