Bank Failure in India: What's Going On? | Spring Money

Introduction

Recently the US witnessed the 2nd biggest bank collapse in its history after Washington Mutual in 2008, sending shockwaves around the world as to the robustness of the financial ecosystem in the country.

The fall of Silicon Valley Bank was followed by the stepping in of US regulators to save the depositors’ money and try to control the panic among startups who had deposited their money in the bank. Other banks, including Signature, Silvergate and First Republic, also simultaneously collapsed in what we know as one of the fastest bank runs in history.

But the pertinent question is, when banks were sitting on the pile of excess reserves and there was no issue of creditors defaulting on loans, then why did these banks collapse like a house of cards?

This article will go in-depth to understand this black horse event in detail and understand the implications and solutions for the global economy.

How Exactly Did Banks Collapse So Suddenly?

The 2 pertinent causes for the sudden fall of banks are:

1. Hike in Interest rates by the US Fed

2. Liquidity crunch in the bank’s balance sheet

Hike in Interest Rates

Amid the war brewing up in Ukraine, Covid-19 and the Market debt crisis, inflation reached its peak level in a very short period of time since March last year. The US Fed, in order to control inflation which already touched 9.1% in May 2022 (the highest in the last decade), started to raise the interest rates at a very fast rate. It is evident from the fact that interest rates have increased from 0.08% in January 2022 to 4.58% in January 2023.

As a result, the yield on several US Government treasury bills has also been raised at commensurate rates. For instance, the yield on the 1-year Treasury note increased to a 17-year high at 5.25% in March 2023, which was less than 0.5% in January 2022.

But why does this matter to the banks?

Let’s start with understanding what banks do with the money they collect from depositors.

As the banks receive the money from the depositors, they have to mandatorily put a certain amount of money as a reserve with the Central Bank (known as cash reserve ratio) and with themselves (also known as Statutory Liquidity Ratio). The percentage is fixed by the Central Bank. In the case of the US, the Federal Reserve sets reserve requirements as a percentage of certain types of deposits held by banks. As of April 2023, the reserve requirement for banks with more than $124.2 million in deposits is 10% for transaction accounts and zero per cent for non-transaction accounts.

Banks also invest some of their depositors’ money in short-term, highly liquid assets like treasury bills, certificates of deposit, or commercial paper. These investments provide the banks with some return and can be easily converted into cash if needed.

Moreover, banks also invest in longer-term securities like government bonds, corporate bonds, or stocks. These investments provide higher returns than liquid investments but are riskier and less liquid. Banks aim to earn returns on their depositors’ money while also maintaining a certain level of reserves and liquid assets to ensure they can meet the demands of their customers. These types of investments are included in the bank’s investment portfolio. Every bank that receives money from the depositors invests in several forms of securities and earns returns. It is similar to what individual investors do. The difference is that here, the invested money comes from the depositors and is not owned by the banks.

Now coming to the current situation, business borrowings started to go down due to high-interest rates, causing a decline in the loan portfolio of the bank. A loan portfolio essentially means the amount that the bank lends to individuals and entities. It is not an investment but a loan given to people at a certain interest rate. Here the bank can’t ask to return the amount before the end of the loan tenure.

Coming back to bonds, now as the yield goes up, the price for these bonds goes down. This happens due to the inverse relationship between bond yields and bond prices. For instance, if an investor buys a $1,000 bond paying 5% interest, but the yield on similar bonds increases to 6%, the bond becomes less attractive, and its value decreases. If the investor wants to sell the bond before maturity, they may need to sell it at a discount to its face value to make it more attractive to buyers who can earn a higher return on other bonds.

This resulted in a rapid decrease in the market value of already issued bonds, both government and corporate. Now if the investor has to sell the bonds in the market before the maturity period, the market value of their bonds will be less than the face value or the buy price, causing massive losses in their investment portfolio.

As it turned out, the investment portfolio of SVB had $91 billion of its assets invested in fixed-income securities, including Government Treasury notes. Out of this, $80 billion were invested in non-liquid mortgage-backed securities.

And due to market uncertainties, several startups already suffering from the cash flow crisis started to withdraw money from the bank. On the other hand, the US Fed stopped printing money, causing high inflation and a rise in the dollar’s value, which decreased the value of other currencies. Moreover, as the VC funding in the business ecosystem dried up, this caused the startups to withdraw their money from the bank.

But as the bank didn’t have enough reserves to return the depositor’s money, they had to sell the government bonds at lower prices, causing a huge loss in their balance sheet. These securities are also known as Held Till Maturity (HTM) Securities. These securities are bought for a fixed period of time (till their maturity) at a certain interest rate.

Now if the bank wants some emergency cash, they can sell these securities in the secondary market to get cash reserves.

Here comes the role of the liquidity crunch.

Liquidity Crunch

Liquidity risk refers to the inability of the bank to meet its obligations without incurring losses. This is also known as bad risk management of assets and asset-liability management of investment and liability portfolios. For instance, SVB had only 7% of assets as cash reserves compared to the industry average of 13%. The SVBs investment portfolio was dominated by 55% of fixed income securities as compared to the industry average of 24%.

Moreover, SVB bank provided insurance of only $250,000 to the depositors, which is too low than the actual amount they deposited in the bank as it mainly catered to the startups. Apart from that, around 88% of the deposits were not even insured. The same is the case with Signature Bank, where 90% of deposits were uninsured.

Now as the bank didn’t have enough cash reserves to meet the demand of the depositors, it resorted to filling up its reserves by selling the HTM securities from its investment portfolio. The bank raised $21 billion at a loss of $1.8 billion. However, the bank still couldn’t make up the required amount, causing it to raise a further $2 billion in equity capital from the market.

But this decision cautioned the depositors and led to one of the biggest and fastest bank run in history. A bank run occurs when many depositors want to withdraw money at the same time, and the bank is unable to pay all of them. This happens due to a lack of trust in the bank and might lead to the collapse of even a healthy bank within a few days.

While at the same time, several major startup investors like Peter Theil and Gary Tan (President of Y Combinator) also asked the startups to withdraw their money from the bank, causing further rush among the investors and startup community who had deposited their money in SVB.

Can we expect another financial crisis like 2008?

SVB being one of the major banks catering to startups around the world, the recent development has questioned the fate of several major startups from the US, India and other parts of the world. The collapse has impacted the liquidity of startups, which are already facing a credit crunch at a time of global economic slowdown and uncertainty.

Now the question is if startups can’t take out their money, at least for a short term, would that create a domino effect on the economy with major layoffs, credit default and eventual slow down just like the 2008 financial crisis?

The short answer is NO! Why? Let’s get into the details!

The 2008 financial crisis was the creation of the bankers, which once detonated, led to the collapse of major economies worldwide. It was mainly due to subprime loans or, simply put, a bunch of crap loans with no creditworthiness, floating by the major banks and backed by the credit rating agencies. Once the default rate rose, the panic wave caused the collapse of banks like Fannie Mae, Freddie Mac, Lehman Brothers, Washington Mutual, and a few other banks that were saved through government intervention.

However, this time, the issue is more psychological than credit default or bad loans. Here, we must understand that the entire banking ecosystem, since the advent of the modern economy, has worked on trust and credit creation.

Today, if all the depositors in any bank worldwide go together and ask for their money, every single bank will collapse. The reason is that no bank just keeps depositors’ money idle in their reserves. Rather, they give the money to people who require loans at a certain interest rate. And the entire cycle of what we call the money multiplier goes on.

In the immediate case, SVB had enough liquidity reserves to maintain its day-to-day operation. However, several world events and cautions by the Venture Capitalists led to a psychological impact on the depositors, causing an immediate panic.

Therefore, this situation doesn’t resemble what happened in 2008.

What’s the Way Forward?

What’s going to happen next is a difficult phenomenon to predict. However, two probable aspects must be dealt with as soon as possible.

1. Rebuild the depositor’s trust and reduce panic

2. Strengthening the Banking system to avoid another collapse.

Rebuilding Depositor’s trust

The situation is not particularly related to the banks’ fundamentals but rather the depositors’ psychology. And the panic will settle as time passes. The US Regulators roped in as soon as the stock of SVB plunged by 60% in a single day. The Federal Deposit Insurance Corporation took over the control of $175 billion worth of customer deposits. Moreover, FDIC has simultaneously created a new bank with the name of the National Bank of Santa Clara in order to protect the deposits and other assets of SVB.

Meanwhile, US regulators have already stepped in to look out for those banks that have a major chunk of Held Till Maturity securities in their investment portfolio and support them with cash reserves to avoid the bank run situation.

Strengthening Banking System

Although most of the major US banks are in healthy condition, a few regional banks are suffering from liquidity risk and must rebalance their investment portfolio from illiquid to liquid assets. Moreover, it is pertinent that the US Federal Reserve must decrease the interest rate to balance the bond yield.

Conclusion

The recent bank collapses have again intensified the fear of investors of a probable downfall of the global economy. Questions are raised on the robustness of the banking systems of countries around the world and how the malpractices of banks have led the situation to this close.

However, this collapse is not similar to the 2008 financial crisis and slowly, as the dust settles, investor sentiment will rise, and we might again witness a rise in the global market with the condition that no other financial shockwave comes along the way.