Thursday, March 30, 2023

Systemic risk and Silicon Valley Bank

The sudden fall of Silicon Valley Bank in the United States, soon followed by another bank, Signature Bank, has sparked many comments and concerns about the systemic risk of banking in that country, and therefore, the health of the economy. It cannot be denied that the bankruptcy of SVB represents an important milestone in the economic history of that nation, since it is the second largest bank insolvency in its history. However, it can also be seen as an isolated case.

The SVB was a bank with a clientele focused on the technology sector. In this sense, it was exposed to the vicissitudes of that part of the economy, much more than other banks in the United States. However, the problems of that bank were not due to that concentration of an industry, but to other structural situations and risk control within it.

Banks, especially in the United States, manage their deposit reserves through investments in bonds, which are debt instruments, which may have a short or long-term maturity. For a long time, the Federal Reserve (Fed), which is the central bank of the United States, kept interest rates very low, practically at zero, and bond yields were also low.

Due to the inflation situation that has occurred in that country, and around the world, the Fed was forced to increase interest rates. One of the consequences of this rate increase is that bond prices have plummeted: as rates rise, bonds already in the hands of investors (in this case, a bank) are worth less. , since the interest rate they pay is fixed and less than the new Fed rate.

Ordinarily, a change in the price of an asset would not have an immediate effect on the solvency of the bank, because if those assets are held to maturity, they are simply repaid at par. But, in the case of the “available-for-sale investments” portfolio, US rules require the bank to update prices from time to time, and in the case of SVB, they were forced to sell that portfolio at a near loss. to US$2 billion.

Faced with that huge loss, the bank found itself undercapitalized, prompting depositors to run to withdraw their savings and eventually causing its downfall. But what is clear is that the SVB was poorly managed, without adequate steps to ensure that the risk of rising interest rates could be managed without resulting in a loss of that magnitude.

The Federal Reserve also, to avoid contagion or systemic risk in all banks, explained that they would be paying all the deposits (bondholders and shareholders of the SVB will lose their investments).

Although the entire financial sector in the US is challenged by rising interest rates, it is also clear that mismanagement of the SVB was the cause of its downfall, and while it is a stress on the US banking system, prudential management will have a calming effect on the market.


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