If you’ve been reading international headlines, you will know that Silicon Valley Bank in the United States collapsed last week. The Wall Street Journal offered a succinct explanation. The bank had been investing in what was considered “safe” investments such as government-backed mortgage bonds since the Covid-19 pandemic started. The problem was that when interest rates started to rise quickly, as they did last year, the fixed interest payments weren’t able to keep up.

“The assets were no longer worth what the bank paid for them, and the bank [SVB] was sitting on more than $17-billion in potential losses on those assets at the end of last year. Then last week, the bank faced a tidal wave of $42-billion of deposit withdrawal requests. It wasn’t able to raise the cash it needed to cover the outflows, which prompted regulators to step in and close the bank,” said the Wall Street Journal’s Telis Demos.

Andrew Williams, an investment director at Schroders, says depositors appear unlikely to lose money, even in the United Kingdom with HSBC mopping up SVB UK for just £1; an immaterial acquisition for HSBC — adding just 0.2% to HSBC’s $3-trillion balance sheet — but a potentially crucial one for SVB’s UK tech client base.

‘Poor management’

Sebastian Mullins, a multi-asset fund manager at Schroders, says the problems surrounding SVB are not wholly surprising given the rate of monetary tightening following a period of exceptional stimulus, and this is unlikely to be the last of such events.

“The problems that have arisen reflect a combination of factors including poor management at the individual bank level. In SVB’s case, there was a concentrated customer base (tech) and limited hedging of either loan or security risk, which resulted in large unrealised losses as yields increased; these losses were then realised as assets were sold to fund the depositors who withdrew their funds,” he says.

Mullins also points to regulatory failure at the smaller end of the US banking sector.

“Those banks with total assets of less than $250-billion aren’t held to the same standards with regards to regulatory scrutiny and stress testing as the bigger banks,” he observes. He says that policy tightening is designed to withdraw liquidity and re-price risk in the economy, and business models that prospered in a free money/abundant liquidity environment were always likely to come under pressure.

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The Federal Reserve (Fed) has moved quickly to limit the contagion from SVB by guaranteeing depositors and announcing a term funding programme to ensure banks and other related institutions can meet their obligations to depositors and manage their liquidity requirements. They are keen to ensure the contagion to the broader banking sector is minimised and confidence in the US banking sector is restored.

“The market has also jumped to the conclusion that this will force a U-turn in Fed policy (tightening to easing). We don’t share this view because the extent of the rally in US Two-Year Treasuries likely reflects short covering by hedge funds who had recently moved to price further aggressive tightening by the Fed. At this stage, we see it as volatility rather than a change in trends,” Mullins says.

He says the Fed can’t reasonably expect to raise rates eight times in less than 12 months for a total increase of 450bps in the Federal Financial Report and not expect damage to be done. He adds that core inflation in the US remains way too high.

“They [the Fed] may pause, or slow down to get more clarity but they [are] unlikely to pivot until clear evidence of moderating inflation is present. Financial distress together with moderating demand indicators, including the labour market, would be helpful but unlikely to be persuasive enough at present, given the labour market remains relatively tight,” Mullins says.

‘A fatal shock’

Williams says such events are a reminder that banks are businesses that critically depend on the confidence of depositors and investors. 

“There are much larger capital buffers than in the past and liquidity regulation in Europe has been designed to limit the risks from deposit outflows and/or other funding shortages. However, a rapid loss of depositor confidence can still be a fatal shock for any bank,” he adds.

Annabel Bishop, a senior economist at Investec Bank, says the Fed is likely to only hike interest rates by 25 basis points next week, rather than the 50 basis points that markets had anticipated. 

“Locally, the South African Reserve Bank is likely to follow the Fed’s interest rate decision of next week, also hiking by 25 basis points or even leaving interest rates flat on 30 March if the Fed does the same,” she says, adding that a 50 basis points hike in the repo rate would strengthen the rand.

Iain Cunningham, the co-head of multi-asset growth at asset manager Ninety One, cautions that the failure of SVB is a consequence of something much bigger — and we might be facing the start, rather than the end, of a broader cycle of delinquency, default and bankruptcy.

Cunningham points out that US authorities have announced the full backstopping of depositors at SVB, while also implementing a new system-wide lending programme to ensure that banks can meet requests to withdraw deposits.

A false equilibrium

“Many will remember from the Global Financial Crisis [GFC] that it was full deposit insurance that was ultimately required to halt deposit flight and, as a result, this action should stem the emergence of systemic risk for the time being. 

“However, the failure of SVB is a consequence of something much bigger. Over the past 12 months, we have been rapidly exiting from a false equilibrium that began to form in the years after developed world economies emerged from the GFC.

“A false equilibrium is a theoretically unstable or unsustainable situation that has been so long-lived that it appears to be a true equilibrium. The false equilibrium here is the decade and a half of excessively easy money, through near zero or negative interest rates and quantitative easing,” he says.

In other words, Cunningham says, policymakers have, for some time, set policy far too loose relative to prevailing economic fundamentals, evidenced by the material appreciation in asset prices over the period. Policymakers have been willing to “pivot” or add stimulus at any sign of a wobble, seeking to minimise economic and market volatility.

Such action has increased confidence and deeply embedded this false equilibrium in the decision-making processes of many households, corporations and even governments.

“Unfortunately, history shows that even relatively short periods of mispricing the cost of money can lead to capital misallocation with economic participants taking more risk than they should, with tolerance for leverage, duration and illiquidity risk all increasing during such periods.

“By their nature, false equilibria cannot last forever. The doubling down of easy money during and post the pandemic ultimately created inflation, which broke the condition required to maintain the false equilibrium. 

“Over the past 12 months, several major central banks have, after a slow start, moved quickly to fight inflation and as a result, we have moved rapidly away from an environment that had become normality and the assumed equilibrium for many,” he says.

Economic cycles tend to be characterised by the growth of imbalances or excesses during the expansion, followed by their cleansing during a recession.

“The false equilibrium of the past decade has created obvious imbalance and excess, and inflation has clearly broken the condition required to maintain it. The failure of SVB is a consequence of something much bigger and is likely to be the beginning of a broader delinquency, default and bankruptcy cycle rather than the end,” Cunningham concludes. DM/BM