The collapse of the technology-focused Silicon Valley Bank sparked fears on Wall Street that the banking system was being crippled by a relentless cycle of interest rate hikes.
Why did Silicon Valley Bank fail?
Silicon Valley Bank had already been hit hard by a slump for technology companies in recent months, and the Federal Reserve’s aggressive plan to raise interest rates to combat inflation compounded its problems.
The bank held billions of dollars in Treasuries and other bonds, which is typical for most banks as they are considered safe investments.
However, the value of previously issued bonds has begun to fall because they pay lower interest rates than comparable bonds issued in today’s higher interest rate environment.
Such bonds are not sold at a loss unless there is an emergency and the bank needs cash. Silicon Valley, the bank that collapsed on Friday, had an emergency.
His clients were mostly start-ups and other tech-focused companies that needed more cash in the last year, so they started withdrawing their deposits.
That forced the bank to sell a portion of its bonds at a huge loss, and the pace of those withdrawals quickened as word spread, leading to Silicon Valley Bank’s insolvency.
What did the government do on Sunday?
The Federal Reserve, the US Treasury Department and the Federal Deposit Insurance Corporation (FDIC) decided to guarantee all deposits at Silicon Valley Bank, as well as at Signature Bank of New York, which was seized on Sunday .
In essence, they agreed to guarantee all deposits, above and beyond the insured deposit limit of $250,000 (£205,000).
Many of Silicon Valley’s emerging tech clients and venture capitalists had more than $250,000 in the bank.
As a result, up to 90% of Silicon Valley’s deposits were uninsured. Without the government’s decision to back them all, many businesses would have lost the funds needed to pay payroll, pay the bills, and keep the lights on.
The purpose of the extended guarantees is to prevent bank runs, where customers rush to withdraw their money, by establishing the Fed’s commitment to protect the deposits of businesses and individuals and calming nerves after a harrowing few days.
Also late on Sunday, the Federal Reserve launched a large emergency lending program aimed at bolstering confidence in the nation’s financial system.
Banks will be able to borrow money directly from the Federal Reserve to cover any potential spate of customer withdrawals without being forced into the kind of money-losing bond sales that threaten their financial stability.
Such forced sales are what caused the collapse of Silicon Valley Bank. If all goes to plan, the emergency loan program may not actually have to lend a lot of money.
Rather, it will reassure the public that the Fed will cover its deposits and that it is willing to lend a lot of money to do so. There is no limit to the amount banks can borrow, apart from their ability to provide collateral.
How is the program intended to work?
Unlike its more byzantine efforts to bail out the banking system during the 2007-08 financial crisis, the Fed’s approach this time is relatively straightforward. It has established a new line of credit with the bureaucratic name Bank Term Financing Program.
The program will make loans to banks, credit unions and other financial institutions for up to one year. Banks are being asked to post Treasuries and other government-backed bonds as collateral.
The Federal Reserve is being generous on its terms: it will charge a relatively low interest rate, just 0.1 percentage point above market rates, and it will lend against the face value of the bonds, rather than market value.
Lending against the face value of bonds is a key provision that will allow banks to borrow more money because the value of those bonds, at least on paper, has fallen as interest rates have risen.
At the end of last year, US banks held Treasuries and other securities with about $620 billion (£509 billion) of unrealized losses, according to the FDIC. That means they would take huge losses if they are forced to sell those securities to cover a rush of withdrawals.
How did the banks end up with such huge losses?
Ironically, a large part of that $620 billion in unrealized losses may be tied to the Federal Reserve’s interest rate policies over the past year.
In its fight to cool the economy and reduce inflation, the Federal Reserve quickly raised its benchmark interest rate from near zero to around 4.6%.
That has indirectly raised the yield, or interest paid, on a variety of government bonds, most notably two-year Treasuries, which had topped 5% through the end of last week.
When new bonds with higher interest rates arrive, existing bonds with lower yields become much less valuable if they have to be sold.
Banks are not required to recognize such losses on their books until they sell those assets, which Silicon Valley was forced to do. –
How important are government guarantees?
They are very important. Legally, the FDIC is required to seek the cheapest route when liquidating a bank.
In the case of Silicon Valley or Signature, that would have meant sticking to the rules on the books, meaning only the first $250,000 in depositors’ accounts would be covered.
Going beyond the $250,000 cap required a decision that the failure of the two banks posed “systemic risk.”
The Fed’s six-member board unanimously reached that conclusion. The FDIC and the Secretary of the Treasury also accepted the decision.
Will these programs spend taxpayer money?
The United States says that guaranteeing the deposits will not require funds from taxpayers. Instead, any losses from the FDIC insurance fund would be recovered by imposing an additional fee on the banks.
However, Krishna Guha, an analyst at investment bank Evercore ISI, said political opponents will argue that the FDIC’s higher fees “will ultimately fall on small banks and Main Street businesses.”
That, in theory, could cost consumers and businesses in the long run.
Will it all work?
Guha and other analysts say the government’s response is expansive and should stabilize the banking system, though share prices in midsize banks, similar to Silicon Valley and Signature, plunged on Monday.
Paul Ashworth, an economist at Capital Economics, said the Fed’s lending program means banks should be able to “weather the storm.”