This week's news has been dominated by the crisis in banking and the second biggest banking failure in US history. If one had to point to the root of the current global banking crisis, it would be the "mismanagement of risk", fuelled by a significant dose of depositor and investor fear. This is the common denominator at all the banks that were and still are most impacted.
Silicon Valley Bank did not adequately hedge it's treasury bond and mortgage backed securities portfolio which had been purchased during the zero interest 2020-2021 environment, leaving it with significant growing unrealized losses as interest rates rose. Under normal banking and economic conditions this would not have been a significant risk. However under significant stress and difficult economic conditions with depositors withdrawing significant funds, the bank could be exposed to having to raise funds to meet withdrawal demands and in order to do that it would have to sell its bonds and mortgage backed securities at a significant loss.
Banks are meant to be in the business of managing risk and mitigating for exactly these types of scenarios. Instead of hedging that risk one must assume that it considered that risk to be an outlier. In either case, one would be right in questioning the judgement of management. As depositors withdrew funds, SVB had to sell its portfolio of bonds and mortgage backed securities for a loss of approximately $1.8bn. When SVB announced this fact to the market - a market that was already on edge - along with the need to raise additional capital, large Silicon Valley VC's began pulling their funds out of the bank which combined with dire messaging amplified through the megaphone of Twitter turned into a stampede. Over $40 billion dollars was withdrawn in 3 days causing the second largest banking failure in US history and new management - that is, the FDIC - to step in.
Other notable banking failures in the last week include Silvergate Capital and Signature Bank who had too much risk exposure to the centralized brokerage companies and counter-parties that failed in the crypto markets. Likewise, in these instances, proper risk management would have contained, hedged or managed these positions and the potential risk of outright catastrophic loss.
There are no doubt countless ways the crisis at SVB could have been contained or mitigated. The VC and banking community could have banded together and shored up the bank. The ammounts in question were manageable in proportion to SVB's overall capitalisation. Given the central role that SVB had played in its back yard to support the prolific Silicon Valley engine of innovation that could have resulted in a mutually beneficial outcome and solution. That did not happen and the mere fact that it did not happen will have shaken up the VC community as it contributed to the implosion of the very bank that has served them well. That being said, it was the management of SVB that failed to implement common sense risk mitigation and expose themselves to a forest fire in the making if the right conditions were to happen. In so doing it laid itself open to a giant size risk that could bring about its own demise. And that is what happened.
By Friday March 10th last week, the companies impacted by SVB - with deposits at the bank -and the banking system as a whole were on edge, in particular the smaller regional banks who were likewise sitting on a mountain of unrealized bond losses and had likewise not hedged this risk adeqautely. It's ironic that banks who are meant to embody smart risk-management practices have since 2008 become prey to taking over-sized risks in the pursuit of profits and greed.
The Government and central bankers stepped up over the weekend guarranteeing that all depositors would have access to their funds. A sound step that probably stayed off a far worse outcome this week had they not done so. Irrespective of the central bank’s decision to shore up the system, all banks and especially the more vulnerable regional banks have seen their share prices pummeled. Depositors are on edge and uncertainty remains in the markets.
The risk of contagion has spread globally. Credit Suisse which has been struggling for years due to "poor risk management" has seen depositors pull money out of the bank this week forcing the Swiss central bank to extend a $50 billion lifeline.
Governments, central banks and the big banks are now cooperating and stepping up to shore up and restore confidence and faith in the system. They will continue to do so until the markets are re-assured. In the last couple of days 10 of the big banks along with the government announced that they are cooperating to provide funds/loans to First Republic bank where similiar fears of depositors leaving have surfaced as they - like SVB - are carrying significant unrealized losses on long term bonds.
We may well see further consolidation in the banking/finance sector as a result of this crisis with the weaker regional banks merging or being bought out by the larger banks.However, this crisis will pass because the central banks, governments and big banks will do whatever it takes to restore confidence in the banking system and will provide all the liquidity needed for the system to correct itself. That effort is fully underway.
This crisis will give pause for thought for Jerome Powell and the Federal Reserve. They have moved decisively and cautiously in their efforts to combat inflation and that will continue until the evidence of a reversing trend is clear. The current banking crisis will add another front in the fight against inflation, in the short term.
With a full banking crisis underway, a transition is occurring by necessity - a loosening of credit - to provide liquidity for the markets to move through and past this banking crisis. While the Federal Reserve is not going to abandon their fight against inflation it will be re-assessing the economic landscape in wake of the current financial banking crisis. It has been moving cautiously but steadfastly and will continue to do so. If the trend in economic data is steadily moving the needle on inflation then one might expect a pause and eventually a shift in Federal Reserve policy that can ease in a new cycle.