Hello, friends Two of America’s major banks have collapsed. California’s Silicon Valley Bank and New York’s Signature Bank. This is said to be the second biggest banking failure in American history.
The 2008 collapse of the Washington Mutual Bank was the biggest. it was followed by the 2008 financial crisis. Bringing a global recession. People are worried that this banking collapse might create another recession like in 2008.
Because if America’s financial system crashes, the impact can be seen all over the world. What happened exactly? How did it happen? and what will be the probable impacts?
Come, let’s try to understand it in today’s article.
“Silicon Valley Bank collapsed on Friday.”
The collapsed Silicon Valley Bank is causing shockwaves across the entire business world. Silicon Valley Bank It is the epicenter of tech startups, venture capitals. The collapsed bank had invested in around 21 Indian startups. The bank stock lost 80% of its value this week. 60% in one day alone.
We need to first understand how banks work:
From the perspective of an individual, the bank is the place where we keep our hard-earned money We deposit our money with the banks for safekeeping. But from the perspective of a bank, The bank is running a business.
They won’t work for you for free. Banks have a distinct business model. The money deposited by you with the banks, Banks would want to use it to make money for themselves. There can be different ways of making money.
For example;
Giving loans to other companies and individuals. The interest charged on that loan would be the profit for the bank. The second source of income is investing in various places. Banks invest the money deposited with them in the stock market, government bonds, or for buying gold for example. Similar to how individuals invest their money at various places, Banks can do the same to earn more money.
History of SVB BANK:
You can understand it better with the example of the Silicon Valley Bank. coming to the SVB, it was established in 1983. initially, this ban Its headquarters are located in Santa Carla, California.
SVD invested a large chunk of its money into real estate. In the early 1990s, half of this bank’s portfolio was made up of the real estate property business. all your investments are collectively known as a portfolio. every person has a portfolio. any investment into stocks, gold, or even in cash.
Makes your portfolio You would have seen financial experts advise that Every portfolio needs to be ‘diversified’. One shouldn’t invest all the funds into a single asset.
It is highly risky. Suppose you use all your savings to buy gold. Since someone told you buying gold is a good investment option. and then one day, the gold market crashes.
What would happen to you?
Your savings turned into dust.
First loss of SVD Bank:
Friends, something similar happened to SVB back then.50% of their portfolio was real estate investments. and in 1992, California’s real estate market crashed terribly.
Due to this, the bank had to incur a loss of $2.2 million.
After this, the bank realized that they needed to diversify their portfolio, so after 1995, the contribution of the real estate business remained around 10%. Why did I tell you this? Because the bank is going through a similar thing. But on a much larger scale.
Moving on from 1995 to the 2000s,
Investing in the IT Sector:
The bank was known for a new thing. This bank was heavily investing in startups. especially, technology-based startups. For the technology-based companies that were in the venture stage, the bank would give loans to those companies especially.
By 2015, the bank had expanded so much, that it was reported that 65% of all startups in America Were served by this bank. The companies in the tech industry were the biggest customers of SVB.
The name fits the bank very well. The technology-based companies in Silicon Valley were banking with the Silicon Valley Bank. Friends, several Indian technology-based startups were also among these companies. In this aspect, the SVB was unique.
It was working almost exclusively for technology-based startups.
All types of entities borrow loans from it. Companies across industry lines use the bank.
But this wasn’t the case for SVB. By the end of 2022, SVB was the 16th biggest lender in America. with the value of its total assets at $209 Billion.
So why did the Silicon Valley bank crash?
Friends, the problems began with the Covid-19 pandemic. With global lockdowns, venture capitalists from all over the world began investing in software companies. People saw that even during the lockdown when everything else had to shut down, Software-based companies are the most successful.
That runs through computers and mobile phones. This is why in 2021, the startups raised a lot of money. In America, $330 Billion was raised in total. almost double the record of the previous year.
If these technology-based startups have so much money They would want to deposit the funds with the bank. and SVB was the number one preference of technology-based startups. This is why in March 2021, the value of the total deposits with the bank was around $124 Billion.
It was at $62 Billion the year before. A 100% increase. This was a huge jump with so much money being deposited into the bank suddenly. Compare this to the other banks,
They did not see such a large jump. JP Morgan Chase Bank saw an increase of 24% only. Since the bank had so much money in the form of customer deposits, they decided to use it to make even more money. So SVB used the billions of dollars.
To invest in government bonds. Friends, this wasn’t unusual. As I told you earlier, Banks have their business models, they can invest the deposits at various places to make more money. Investing in government bonds is considered relatively very safe. Government bonds and corporate bonds were also bought as investments.
If you aren’t familiar with bonds, let me explain it briefly. when large companies or governments require funds They issue bonds. When you buy the bonds and invest your money in them, the money goes to the issue and is used by them. but in a way, this money is akin to a loan from you.
The issuer promises you interest rates. and at the end of the period of the bond, suppose 5 years, the issuer would return your money with interest. So investing in bonds is often beneficial for you. Basically, by investing your money, you will receive interest at predetermined rates.
This will be your profit. and for the issuer, this is a source of borrowing. They issue bonds due to the immediate need for funds. SVB bought a large number of bonds at a time when The prevailing interest rates in the market were quite low. According to America’s Federal Reserve, the interest rates were around 0%-0.25%. Extremely low.
It was expected that the interest rates would remain low, but this didn’t happen. The interest rates increased. without going into too many technicalities, all you need to understand is that bond price and interest rate have an inverse relationship.
If interest rates go down, bond prices go up. The longer the period you hold the bond, the riskier it becomes. The interest rates can fluctuate while you’re holding onto it. The price may fluctuate. It might benefit you or may cause you losses. But if the price of the bond you’ve bought falls, you will have to bear the losses.
The Increase of Interest Rate by the US Government:
This turned into a worst-case scenario for SVB. The American government increased the interest rates. by raising the interest rates, the value of the bonds held by SVB crashed. they suffered a huge loss. But this wasn’t the only loss.
The second negative impact was even greater. Increasing the interest rates The interest rate on borrowing loans increases as well. For startups and companies, taking loans became more expensive.
So they would avoid taking loans. What else could they do to meet the funding requirements? They would use the money they have deposited into the banks.
By 2022, after the interest rates had increased, the tech startups wanted to withdraw their deposits to meet financial needs. Venture capitalists weren’t funding them anymore. Since they had their deposits with SVB, they wanted to make withdrawals at the same time, which became problematic for the bank.
Why did the US Government do this?
Friends, there’s a simple reason for it. To control inflation. Friends, there’s an interesting relationship between inflation and interest rates. when the economy of a country is facing a slow-down, The central bank often reduces the interest rates. so that it is easier for people to take loans. with low interest rates, more people would want to take loans. with more loans, more people would have expendable money.
More expendable money would mean that they can spend on various things. With this, the money circulation in the economy would increase and it would boost the GDP. This is why during the pandemic; interest rates were lowered by the government.
On the other hand, if inflation is on the rise in an economy, Interest rates are increased to control it. Increasing interest rates would make loans more expensive. Fewer people would want to take loans.
People would not have enough money to spend, and the spending would decrease.
With lower spending, inflation could be controlled. This is a general and simplified explanation.
Over the last several months, inflation has rapidly increased in America and Europe Due to several reasons, one of which is the Russia-Ukraine War. To control this inflation, the Federal Reserve increased interest rates. This can be considered the root cause.
Bad decision-making by the SVB Bank:
Bad decision-making by the bank was also at play here. Interest rates will continue to fluctuate; you need to have a robust portfolio So that it can bear these fluctuations.
Due to the demands of the customers, SVB started selling the bonds. Selling them at a loss. recently they sold about $21 billion worth of bonds. at a loss of $1.8 billion. Avoiding the downgrade was another reason They sold the bonds at a loss of $1.8 billion. As soon as the news became public,
The value of the shares of SVB began increasing. As of 9th March 2023, the shares of this bank were down by 60%.
The day before, the rating of SVB was downgraded by Moody’s at this point, no matter what the bank did, it would have been impossible to avoid the crash. as soon as the news broke that the bank did not have enough funds and that it was selling its investments at billions of dollars in losses.
Everyone that had deposited their money with the bank, rushed to withdraw it. They were worried about their money. and everyone rushed together to get their money back. Was different in the other 2 cases.
Whatever happened here, according to the publicly available information, there was no scam. The bank did not commit any fraud. Though the bank indeed hid some facts and did not make timely disclosures to the public, but this is a case of bad decision-making.
People in charge of the management of the bank made wrong decisions, It turned out to be the wrong time, and to some extent, this was simply bad luck. You might be thinking that the root cause was the increase in interest rates by the US government.
The response of the American Government On the Bank Run of SVB:
The American government responded that The California Department of Financial Protection and Innovation pounced on the SVB’s office. The receivership of the bank was handed over to the FDIC.
Federal Deposit Insurance Corporation. Customer deposits to the tune of $175 billion were used by FDIC to create a new bank. National Bank of Santa Clara. The assets of SVB were taken over so that usual business activities could be continued. and then began the search for a bank willing to merge with SVB. That’s right. Merger is a solution here.