Bank failures can be a scary and concerning prospect for the public, but it is important to understand what they are, why they happen and what you can do to protect yourself.
What are Bank Failures and Why Do They Happen?
In the last year, the Federal Reserve has been increasing interest rates at the fastest pace in 40 years in an effort to curb inflation. As short-term rates rise, banks may find it more difficult and expensive to attract deposits from their customers. This can lead to a decrease in liquidity, making it harder for banks to meet their obligations and respond to unexpected events. At the same time, banks may hold long-duration bonds, such as Treasury and mortgage bonds, as part of their investment portfolio. These bonds are considered safe and liquid, but they can be subject to sharp mark-to-market losses when interest rates rise rapidly.
When banks need to raise cash to meet client deposit withdrawals, they may be forced to sell these long-duration securities at a loss. This can reduce their capital base and make it more difficult for them to weather future market fluctuations. To prevent bank failures, it is important for banks to manage their risk exposure and maintain sufficient capital reserves. A bank failure occurs when a bank is unable to meet its financial obligations to its depositors and creditors.
Consequences of Bank Failures
Moreover, bank failures can have serious consequences for the broader economy. They can lead to a decrease in credit availability, which can slow economic growth and exacerbate financial instability. The failure of Silvergate Capital and Silicon Valley Bank, sent shockwaves through the markets, prompting many investors to wonder whether these failures are manageable or could lead to significant financial contagion with economic implications.
Both banks were niche players that catered to areas of the market that flourished during the pandemic tech boom. Silicon Valley Bank catered to venture capital firms and tech start-ups, while Silvergate Capital was a major banking partner for the crypto industry. The lack of diverse deposit bases and their concentrated loan books left both banks in a vulnerable position.
The speed of the Fed’s rate hikes over the last year caught the banks by surprise, exposing a huge mismatch between their assets (investments) and liabilities (deposits). As deposits were getting more expensive to attract as short-term interest rates rose, their assets, invested in safe, liquid and high-quality Treasuries and mortgages, were sitting on huge mark-to-market losses due to the sharp rate increases over the last year. When the banks needed to raise cash to meet client deposit withdrawals, they were forced to sell these long-duration securities at a loss that reduced their capital base.
The proliferation of social media likely accelerated the failure of Silicon Valley Bank and Silvergate Capital.
Government’s reaction
The government has reacted swiftly to stabilize markets. The Fed, Treasury and Federal Deposit Insurance Corporation (FDIC) introduced a new loan facility called the Bank Term Lending Program (BTLP), which will provide loans up to a period of 12 months to help banking institutions access capital when needed. Banks can pledge their bonds as collateral and receive the par value of those investments as a loan (avoiding selling their investments at depressed levels). The depositors of Silicon Valley Bank and Signature Bank will also be made whole, including those above the FDIC insured limits. These swift actions should reduce the potential for significant outflows of bank deposits at other institutions.
One potential positive outcome could be that the Federal Reserve proceeds with a more gradual approach to increasing interest rates, and consequently concludes its tightening phase earlier. This could benefit the economy, as well as both fixed income and equity markets.
