Never ignore bank frailty, even if the lender involved is not mainstream. The closure of Silicon Valley Bank (SVB) has already caused contagion, wiping tens of billions of value off banks in New York and across the globe.
The great financial crisis started with the collapse of broker Bear Stearns in the US and mortgage lender Northern Rock here in the UK.
The paradox of the current tremor is that it can be traced back to the aggressive effort by the Federal Reserve, the US central bank, to overcome inflation with aggressive interest rate hikes. Higher borrowing costs are considered a good thing for retail banks.
In the recent 2022 results season, the majority of High Street lenders raised their gross lending margin, which is the difference between what they pay savers and what they charge borrowers.
In almost every case, this produced ‘windfall’ profits, allowing banks to strengthen balance sheets, increase dividends and pay unholy bonuses to bosses.
Frailty: The closure of Silicon Valley Bank has already caused contagion, wiping tens of billions of value off banks in New York and across the globe
There is another side to the rate narrative, as we witnessed in the UK, when the Truss ‘moron premium’ whipsawed markets in autumn 2022. Concerns about the UK’s untested mini-Budget led markets to dump sterling and government bonds.
The sharp fall in gilt values played havoc with Liability-Driven Investments (LDIs), the derivatives at the heart of the pensions system. Without Bank of England intervention, insolvencies could have cascaded through the markets.
SVB is intimately connected to American West Coast tech. During Covid-19, there was a speculative bubble with venture capitalists and other financial groups shovelling cash at entrepreneurs and start-ups.
So much money was arriving that the techies couldn’t spend it quickly enough, and placed the surpluses on deposit with SVB – the banking darling of Silicon Valley. The bank invested much of this surplus cash in long-term US government bonds, which like UK gilts, are considered the safest asset class. As market interest rates soared, the underlying value of the bonds tumbled.
Fixed interest rate instruments work like see-saws. When rates move, the value of the underlying bonds goes in the opposite direction. As market rates climbed, business depositors, such as the tech companies, expected a better return. While most NatWest or Barclays consumers left savings where they are, corporations seek to maximise returns by moving cash deposits to higher returning venues.
At SVB, there was an effective run on deposits, so the bank sought to fix the problem by selling $21billion (£17.5billion) of long-term bonds. It replaced them with shorter-dated but higher yielding assets, leaving it with a big hole in its balance sheet.
The SVB model, as was the case at Northern Rock in 2007, is an outlier. Northern Rock was the only lender offering 110 per cent mortgages and financing almost all of its lending by turning long-term deposits into short-term repackaged securities. It looked to be an exception, but, as we later learned, almost every UK and American bank had loaded up their balance sheets with repackaged, high-yielding securities based upon rotten sub-prime mortgages.
The latest big sell-off of bank shares on both sides of the Atlantic is not just a knee-jerk reaction. Bonds have the imprimatur of sovereign governments and, with the exception of serial defaulters such as Argentina, are regarded as solid.
There is no escaping the reality that since the financial crisis, regulators have required banks around the world to maintain big volumes of bonds as a capital cushion.
The rapid rise in headline interest rates in the US roiled bond markets and has left the US banks sitting on giant unrealised losses.
It will not be a full-blown crisis unless wholesale and retail depositors take fright and pull out funds, forcing the banks to disgorge their bond holdings at a loss.
SVB may have started the rout but it is far from the only bank having similar difficulties. As always with financial contagion, one never quite knows where it will end. Shares in London quoted Molten Fund, which has a holding in fintech outfit Revolut, capsized in latest trading.
In the US, start-ups are being warned not to hold more than $250,000 (£208,000) of cash in any single institution. It doesn’t feel like 2008, but anyone who lived through the last banking catastrophe will recognise how speedily stability can unravel.