Sonoma State University economics experts discuss Silicon Valley Bank fallout

The recent Silicon Valley Bank (SVB) collapse, and related failures involving three other U.S. banks, sent shock waves through the financial industry in early March resulting in a run on SVB by its depositors that led to its takeover by the Federal Deposition Insurance Corporation (FDIC).

These events sparked an urgent call for the Federal Reserve and FDIC to not only quickly handle this crisis, but to do more to anticipate and prevent future incidents while also keeping them from becoming systemic — impacting the overall economy — by making changes in the regulatory landscape.

To understand these issues, the Sonoma State University School of Business and Economics held a public Fireside Chat webinar Friday to address the fallout and economic impacts resulting from the closure of Silicon Valley Bank.

The following are excerpts from the Q&A session moderated by Robert Eyler, Ph.D., professor of economics, and presented by Puspa D. Amri, Ph.D., associate professor of economics, who has an academic background in international finance, macroeconomics, monetary policy and the global political economy.

Explain what happened with SVB?

PUSPA AMRI: SVB built up a fragile balance sheet that grew very quickly over just a few years. Evidence suggests that risk management oversight and controls were lacking,” said Amri. “There was also a sharp increase in the monetary policy tightening environment. Interest rates went up very fast more than 400 basis points in just a year, hitting SVB on both the asset side and liabilities side.

Somehow there was a failure or shortcoming in the regulatory supervisory environment when it came to acting on risks that were building up while seeing signs and reporting things that were identified — but no link was made fast enough between identifying problems and engaging to correct them.

How important is what happened with SVB in terms of lending markets at the macro level or even more broadly financial markets?

AMRI: Banks take short-term deposits and turn them into long-term loans for profit. They also serve society as an important role to intermediate the needs between borrowers and savers. However, due to the difference in maturity between the liability side and asset side, there is a situation where there can be a mismatch between the two.

So, if there ever is any doubt about the solvency of a bank — or if there is much of a critical mass of those that start to doubt the value of the bank’s balance sheet — they might rush to pull their deposits out and liquidate their accounts. No bank is going to have enough ability to turn their assets quickly into liquid liabilities to meet their depositor’s rush at any point in time.

This problem could be connected to the financial world in general is that the moment that there are massive orders for withdrawals being put at SVB, investors started to immediately look at other banks that had a similar risk profile, and doing some of the same things that SVB must be doing, investing a lot of their assets into long-term government bonds and government backed mortgage securities (backed by government agencies).

In a normal environment this would not be a problem. However, monetary tightening by the Federal Reserve had an impact on lowering the value of those assets. As a result, we saw other banks also getting hit be their depositors, and shares of those banks was also falling.

Now that First Citizens Bank has bought SVB, are we out of the woods yet, and if not, why not?

ROBERT EYLER: It depends on for who, and what are our objectives. One thing I’ve noted is that the portfolio of the securities, the ones that have fallen in value and were the trigger of the initial problem, are still being liquidated by the FDIC.

First Citizens has taken over a lot of SVB’s loan portfolios, but the FDIC is still primarily in charge of selling those mortgaged backed long-term securities whose value tends to fall more the longer the duration of the asset itself. A lot of these government securities is being handled by the FDIC, which is a relief for First Citizen.

AMRI: In actual practice, liquidation of assets or transition of any institution is never easy. There may still be some issues to work out logistically for the people, small firms and corporations who borrowed money from SVB will they now be serving their debt through Citizens. How will that work? Citizens is quite excited to enter a new area of lending with portfolio clients.

Outlook for interest rates

If the Federal Reserve continues to raise interest rates and the inflation data suggests there is going to be more pressure of the FOMC (Federal Open Market Committee) to continue to think very deeply about whether we need to raise rates maybe another 50 or 75 basis points, is another increase — say a 50 basis point rise — going to occur in the second quarter of 2023? How much more risk does that bring into the banking industry and should we be worried about it?

AMRI: On the one hand, interest rate risks for all banks are still present.

However, the banking system is reacting to this event by internal tightening their own credit conditions and doing more due diligence on the valuation of their own portfolio and may increase the portion of their assets held as cash. A lot of regional U.S. banks have had a lower percentage of cash to total assets. Before its crash, SVB had only a 6% of its assets held in cash. Therefore, I expect a change in direction to higher ratios of cash in future.

The Federal Reserve has limited tools to achieve multiple objectives. The primary objective of the Federal Reserve is the dual mandate — price stability alongside maximum employment. But managing financial stability is also part of their mandate, too. So that can’t be achieved when you have such an inflationary environment such as this.

What happened the last time the Federal Reserve raised the federal funds rate?

Eyler said that what happened in the 1980s was the last time we saw the Federal Reserve funds interest rates rise with such velocity. We were just coming out of two phases of inflation and a double-dip recession in the late 1970s and early 1980s.

EYLER: Part of that was due to the spark of inflation through energy prices and a weird monetary experiment at end of the 70s that had to get relieved through relatively fast contraction of interest rates because it caused a lot of inflation.

But as the U.S. descended into the 80s what took place was a contraction of energy prices. You saw real estate loans going bad because they were a bet on energy prices staying high and able to pay relatively high interest rates. We also saw sovereign lending fail and saw a lot of countries walk away and default on their debt.

All that happening simultaneously really changed the risk characteristics of banks. Not necessarily because of what happened with interest rates rising in early 1980. One could make a case that the increase in interest rates attracted a lot of banks for risk taking that they thought in fact were being subsidized either by a sovereign government, and real estate that would never lose its value based on natural resources underneath.

When both dove down at the same time we had a similar situation with depositors walking away from some banks and investors becoming very nervous about continuing to infuse capital into those banks. So there are some parallels to the early 1980s and the long descent we took into early 1990s with bank failures.

Another characteristic I observed at SVB is that it wasn’t that they took a major credit risk, it involved taking an interest rate risk. Fragilities that were the cause of a past crisis don’t always appear in a new crisis. The last recent crisis memory we have took place in 2008-2009, when the biggest culprit was credit risk.

Financial institutions had a lot of assets that were very risky and could go sour very fast. Banks back in 2008-09 regulators were concerned with checking the source of the liability side to determine if it was financed by short term funding from the repo market, but risk can occur from other sources too.

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