Some of the biggest bank failures since the Great Financial Crisis have occurred in the last month, with Silicon Valley Bank (SVB) topping the pack, followed by Signature Bank and Credit Suisse. There is never a better time to talk about what brought on the crisis in the first place in order to avoid making the same mistakes again, even if preventing a financial meltdown should be the main priority.
Some of the biggest bank failures since the Great Financial Crisis have occurred in the last month, with Silicon Valley Bank (SVB) topping the pack, followed by Signature Bank and Credit Suisse.
Many claim that depositors withdrew a large portion of their savings from banks as a result of the Federal Reserve's and other central banks' fast monetary tightening, which depreciated long-term assets and resulted in enormous unrealized losses on bank balance sheets. Such opinions are acceptable, but we should investigate why banks were not better equipped to handle rising rates that will unavoidably skew their balance sheets. It is doubtful that "poor management" was the root of the problem if multiple businesses (in any industry) commit the same error at the same time. They were ignoring threats that appeared to be clear due to some underlying indicators.
Contrary to what is currently widely believed, Silicon Valley Bank used to be well-protected against interest rate increases. SVB's CFO Daniel Beck publicly disclosed in April 2021 that the bank had hedges on $10 billion of bonds that were available for sale, specifically indicating that the goal was to "mitigate the impact of potential further rate movement" in the upward direction. But just a year later, SVB executives informed investors that they were "shifting focus to managing downrate sensitivity." Only $563 million of its $26 billion in securities, down from $15.3 billion the year before, were secured against rate increases by the end of 2022. Despite being ready to handle rate increases, Silicon Valley Bank changed course since it thought rates will soon decline.
We should look at the time after the Great Recession, when the monetary policy took a sharp turn, to see whether such anticipation was wrong. This marked the start of the "ample reserves" floor mechanism as well as numerous Quantitative Easing cycles.
The Federal Funds Rate was kept below one percent from December 2008 to June 2017. Before the commencement of COVID-19, when Chairman Powell immediately reduced rates back to near-zero levels, the Yellen-led Fed had been raising rates for a few years. Market participants started to realize that, in the event of an economic crisis, rates close to zero would become the new standard.
The United States saw its greatest observed rate of price inflation since the Great Inflation of the 1970s and 1980s in late 2021 and early 2022. Since then, the Fed's top officials have made it quite apparent that fighting inflation is their top priority, even if doing so results in higher unemployment. The Fed began its fastest increase in interest rates in American history in March 2022. Despite this, because of anticipation of future rate reduction, both real and nominal long-term interest rates are still at historically normal levels. These opinions are supported by the fact that the Fed's predictions, which are listed below, suggest that rate reductions will occur shortly.
Now imagine that you are a bank executive. As the Federal Reserve raises interest rates to combat inflation, many of your bank's long-term assets may lose value, resulting in unrealized losses. How important are the unrealized losses, though, if the Fed is about to decrease interest rates and you can just store your assets until they mature, at which point you'll probably see a realized gain? If that's the case, it's not a problem.
Most banks would have likely hedged rate increases more thoroughly in the counterfactual scenario where the Fed had not created such strong expectations of rate cuts following an economic downturn through its current forecasts and established precedent. Future realized gains would not be seen as being perceived as such a guarantee.
This is not to suggest that the current banking crisis was only brought on by the Fed and other institutions sending out incorrect signals. Unsuccessful risk management was another issue. The banking sector as a whole was suffering significantly from unrealized losses as a result of rate hikes, as Chart 7 in the FDIC's Quarterly Banking Profile (Q4 2022) makes abundantly obvious. However, very few businesses are failing.
Large clients like Peter Thiel withdrew their deposits mostly due to Silicon Valley Bank's 185:1 debt-to-equity ratio and technical insolvency.
In addition, despite its belief that the Fed would soon lower interest rates, SVB held on to significantly fewer interest-rate swaps and options (such as caps) than other, larger banks because it anticipated inflation to decline more quickly than it did and for the Fed to do so sooner.
While moral hazard undoubtedly had a role in banks' lack of risk aversion, earlier monetary trends were the main cause of the banking crisis in the United States, which swiftly spread to the rest of the developed world. It is essential for policymakers to avoid returning to zero interest rates and plenty of liquidity and repeating the same cycle.
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