The US financial crisis that ripped through the banking and financial system in 2008 and had a cascading effect on the world economy, has again raised its head and shook the system. Of course, this time it’s not the default on the subprime mortgages which impaired the cash flows in the banks and FIs’ balance sheets but with securities valuation.
The failure of Silicon Valley Bank (SVB) and Signature Bank in a gap of 48 hours (March 10 & 12) sounded an alert in the Fed’s office. SVB specialised in serving tech companies and Signature, clients with large scale crypto holdings. However, the malady and resultant agony for both turned out to be rather similar.
A bank is perceived to be a haven for parking investible surplus and rightly so, because of the statutory control administered by the central bank of the state. The pooled in deposit from the members of the public finds its way to either lending or investments. Both generate a certain percentage of return over a period which goes back to the depositors, based on the commitment made by the bank. In the process, the bank takes a cut which pays for the administrative and other running costs incurred by the bank. While this is a very simplified banking arithmetic cycle, it has other complexities when it comes to managing what in financial parlance, we call a “time value of money” (TMV).
When a bank buys into government treasury papers, bonds etc. the portfolio is always subject to mark to market (M2M) valuation which works on the cardinal principle of TMV. Let us take an example. Suppose a treasury paper has a coupon rate of 4% (interest payable on every January 1, 2023), Face Value $ 100 and it’s issued in 2015 and due to mature in 10 years i.e. 2025. In simple terms the return is 4% (current yield). But when one considers the TMV then the return till the maturity (ytm) is about 3.99677 i.e. less than 4%. This happens because of the depletion of value of money over a periodic time scale. In the bond market the daily valuation is done based on ytm. This would mean that based on the interest rate scenario the value (read price) of the paper will move up and down. Suppose in the above example we are to seek an ytm of say 4.75% - then the valuation would reduce to $ 94.10 apiece.
During a pandemic to support households, employers, financial market participants, and state and local governments, the US Government followed a liberal Covid stimulus policy offered through liquidity easing in the monetary system by triggering a cut in the Fed rate. While more cash has been released in the system, looking at the uncertainty of the economy the propensity to consume was significantly low during this period which sparked a “dash for cash”—a desire to hold deposits and only the most liquid assets. This gradually resulted in a deposit surge in the banking system. As a block, US banks registered a growth of about $5 trillion in deposits. SVB’s deposit grew significantly through the pandemic, from $61.8 billion in 2019 to 189.2 billion at the end of 2021 mainly boosted by venture capital and tech startups who were flush with funds. With no investment deals in sight, this huge money entered the bank coffers. For Signature it was on the piggyback of the price movements of crypto and during this period of its $89 billion deposits, more than one fifth has been contributed by such big customers having exposure to the digital assets.
Now the treasury manager had to deal with the “problem of plenty.” First, he had the option of lending the fund for a longer term, where rates are higher and offer a lower return to the depositor in a shorter term. Second, he might buy into treasury papers and bonds which are gilt edged with almost zero risk of default. In fact, as the Fed was cutting the policy rate the price of such papers across maturity had been on the uptick (the interest rate and price of bond move inversely). So additionally, as a third option, the treasury guy had a trading opportunity in such papers - buying higher yield and selling at a lower. Ballpark figure shows that appx $1.3 trillion worth of securities were picked up by the US banks during the period.
While all these were very fine, the scenario started changing around February 2022 with the disappearance of the Covid and life all around becoming normal. The play of interest rates in the economy led by Fed’s changing its outlook started having a reverse effect. The worth of the debt portfolio waned with high M2M losses and the short-term rates surpassed the long term, a scenario of inverted yield curve, which negatively impacted the loan assets as well. Fifteen years apart, the US banks found themselves trapped in the trough of rising interest rate and during managing duration risk rather than counterparty credit risk, a fallout of the subprime mortgage crisis.
It is said that bad news travels at the speed of light; good news travels like molasses, and in this age of faster communication over the social, electronic, and other media SVB and Signature’s crisis was further accentuated as depositors made a beeline to withdraw their hard-earned savings. No bank in any economy, how well-regulated that be, could withstand such a run to the bank and survive. Timely intervention of the government had saved the day for the banks and also ring fenced the system against the domino effect of other banks going under.
Across the Atlantic, another 167 years old bank, Credit Suisse has gone bust – albeit for a different reason which called for a hurriedly cobbled salvage deal of $ 1.1 billion offered by its closest rival United Bank of Switzerland (UBS). The series of events in the Americas and Europe, though not connected and rather coincidental, had every possibility of shaking up the global financial system, if not addressed at the right juncture, as the banks in the red are front runners in the list of “systematically important” financial institutions.
India thankfully had been left unaffected by the two crises. But the lessons are bigger. Traditionally our focus had been managing the credit risk i.e. borrowers not paying up which turns a loan asset sub standard or non performing. It also largely centres around the issue of capital adequacy. What about the interest rate risk, duration management etc which have a direct / indirect bearing on the bulk debt portfolio the banking sector holds either as Statutory Liquidity Ratio (SLR) or otherwise. As the size of the economy grows such imperfections are bound to creep in and need timely redressal through well calibrated statutory prescriptions.
We can only bank on someone if he is reliable and trustworthy. Let us make our banking entities safe so that they may be banked upon by all.
- The author is DGM (Operations) Peerless Financial Services Limited
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