An overview – by Dennis Dendas
What happened?
With a size relative to Belfius Bank in Belgium and clients being primarily start-and scale-ups from the tech and biotech sector, the Silicon Valley Bank does not come across as causing a potential systemic risk to the financial markets… Or does it?
A vulnerable business model created by restrictive monetary environment
SVB derived the majority of its income from the interest margin by investing customer deposits in long-term paper, mainly US government bonds which are generally considered low risk and highly liquid and mortgage bonds.
That became its vulnerability when the US central bank abandoned its cheap money policy and raised policy interest rates sharply while unwinding QE and releasing formerly held bonds back into the market to fight inflation. While net interest margins rise and future profitability of the bank may increase, current solvability may not due to deteriorated asset prices.
A textbook example of poor ALM
When interest rates rise – as they recently have – the prices of the “safe” bonds the banks purchase drop (interest rates/yields and prices move in opposite directions). This is typically not a problem because everyone still assumes that the bonds are low risk. If they drop in price, the bank just holds them until they mature and they get paid 100 cents on the dollar.
However it becomes a problem when suddenly the banks’ depositors start to demand their money back and those unrealized losses embedded in the US Treasury bonds become realized.
The depositors of SVB, mainly Tech companies, in general, have little income and do not make a profit. Their valuation depends on future profits. The higher the interest rate, the less the profit that may be realized in the future is worth today. Investors became less eager to give young tech and biotech companies fresh money. As a result, they were obliged to use their financial reserves that they had parked at SVB. In order to meet the cash withdrawals, SVB had to sell assets. Also long-term bonds, whose market value had fallen due to higher interest rates. SVB suffered a loss on the release of liquidity. To strengthen its balance sheet, SVB planned a $2.25 billion capital increase. That set off alarm bells. Doubts about the financial solidity prompt customers to withdraw their money in a hurry. That run on the bank caused a liquidity crisis at SVB and made the bank go bust.
SVB paid the price for its one-sided focus on young tech companies. The rise in interest rates put them all in the same boat. Almost all of them had to draw on their bank reserves to finance their operational activities which saddled SVB with the aforementioned major liquidity issue.
Signature bank, a crypto friendly depository bank collapsed following the collapse of evenly crypto friendly regional banks SVB and Silvergate bank. The collapse of SVB and Signature created a ripple effect on both major U.S. banks and smaller, regional banks, as investors lost confidence. Only the third decline of more than 25% in a week for the KBW index of big US banks in 31 years followed — the only other instances were in the Covid lockdown and in the aftermath of the Lehman Brothers bankruptcy. The KBW index erased all its gains of the last 25 years. It is now at the same level it was on March 11, 1998. The fear of contagion caused bank stocks to drop in Europe as well, however, not as severe, EU bank stocks slumped 5.84 percent on Monday in response to the demise of SVB —but rallied on Tuesday, closing back up 2.46 percent.
Potential effects on European credit markets
What made SVB so special was it became the go-to bank for tech start-ups and venture capitalists. But experts say that dominance was very specific to the US. SVB’s exposure was highly specialized and generally, large and medium sized banks in Europe are more diversified. Moreover, due to the limited presence of SVB in Europe, contagion risks are relatively small. In addition, in 2019 US bank regulations for banks with a balance sheet total of less than USD 250 billion were loosened, while in Europe no such loosening took place, leaving European banks similar in size with more robust capital and liquidity buffers under the Basel III legislation.
Nonetheless, similar issues could arise at European banks who were not able to convert deposits into loans and bought low risk sovereign debt instruments that are heavily reliant upon interest-rate moves and could potentially be largely underwater at the moment. A combination with the potential of deposits threatening to flow away because there is suddenly an alternative again: government bonds, which yield significantly more than cash on deposits, might cause difficulties even though capital and liquidity buffers are more robust.
Interest rates & credit spreads
Even though contagion risks seem small and European banks seem to be in better shape. The market reacted heavily over the fear of liquidity issues. With the typical flight to quality being clearly visible and corresponding yields evaporating on Monday:
- The biggest one-day slump for the 2-year Treasury yield (61 basis points) since 1982; the fall during the Black Monday crash of 1987 was 59 basis points.
- The biggest one-day drop in the 2-year German bund yield (41 basis points) since Bloomberg’s data started in 1990.
- The sharpest steepening in the US 2-year/10-year yield curve (48.2 basis points) in the last 40 years, save only Sept. 11, 2001, when it steepened by 50.6 basis points.
At the same time credit spreads are on the rise indicating, amongst others, higher expected probability of defaults due to potential fear of drying up of liquidity in the market, being it more pronounced for high yield securities.
Central bank policy
The current turmoil came on the back of globally rising interest rates. Central banks use the lever of interest rates to cool business activity and, in turn, inflation. This tightening of monetary policy causes headaches for startups, as it dries up funding and restricts consumer spending. On the other hand, the collapse and the financial vulnerabilities that it has laid bare could jeopardize the central banks’ efforts to rein in price rises. The expectation is that SVB’s demise will pressure central banks into slowing interest rate hikes. Central banks will now have to consider the impact of any further interest rate hikes on the stability of the financial system.
As of late last week, investors had largely been bracing for a 50-basis-point increase at the Fed’s March 21- 22 meeting, but that hefty hike has been priced out of expectations since the SVB crisis upended financial markets. Odds of a 25-basis-point hike are about 75%, with 25% chance of no hike at the meeting, according to the CME Group’s FedWatch tool as of Monday afternoon. Similar revisions of the expected policy rate at the ECB occurred overnight as shown in the below graph:
Expectations are that central banks will keep focus on inflation but, probably at a lower pace.
The corporate view
What does this mean for corporates on the European mainland?
As credit risk is expected to increase, increasing premiums and thus spreads in combination with an expected tightening of credit policies within banks might make it difficult for interest-sensitive sectors such as start-ups and real estate and high leverage companies to ensure funding in the months to come. Now that risk aversion is increasing due to the current panic, you can expect a credit crunch. If banks lend less money to businesses and households, this will further slow down the economy. The number of defaults on debt securities threatens to increase significantly this year according to Dr. Van Nieuwerburgh (Columbia Business School).
The defaults have started. Especially on loans for office buildings, whose income is suffering from the rise of hybrid work since the pandemic. Banks pass on that risk when refinancing, so that the interest rate rises even more for a commercial RE investor. The RE company can decide in these circumstances to put the building back to the bank. “You can already see that many banks are scaling back their loans to the real estate sector. The credit crunch has already started there.”, says Van Nieuwerburgh.
Sources:
https://www.tijd.be/ondernemen/banken/hoe-silicon-valley-bank-in-ijltempo-kapseisde/10453495.html
https://www.dw.com/en/what-silicon-valley-banks-collapse-means-for-europeans/a-64984513
