Benel Lagua l March 24, 2023 l The Manila Tiimes
SILICON Valley Bank (SVB), the 16th-largest lender in America, with about $200 billion in assets (roughly P11 trillion) has been shuttered and placed in receivership under the Federal Deposit Insurance Corp. (FDIC). Note that the Philippines’ largest universal bank has assets of roughly P3.7 trillion. The CNN headline underscored the collapse of SVB in a 48-hour timeframe. On March 8, SVB announced it had sold a bunch of securities at a loss (of around $1.8 billion), and it would sell new shares of $2.25 billion to plug a hole in its balance sheet. That triggered a panic among venture capital firms (the bank’s main clientele) to withdraw money from the bank. The bank’s stock started its deep dive the following day Thursday. By Friday morning, trading in SVB shares was halted. On the same day, California regulators intervened and shut the bank down.
As The Economist reported, however, the SVB collapse was not really a 48-hour thing. It was “gradually, then suddenly.” Its financial position deteriorated over several years. But the sudden failure occurred in a two-day time frame.
“SVB is a bank for startups. It opened accounts for them, often before larger lenders would bother. It also lent to them, which other banks are reluctant to do because few startups have assets as collateral. As Silicon Valley boomed, so did SVB.”
Its success made SVB cash-rich. “Since banks make money on the spreads between the interest rates they pay on deposits, and the rate they are paid by borrowers, having a far larger deposit base than loan book is a problem. SVB needed to acquire other interest-bearing assets. By the end of 2021, the bank had made $128 billion of investments, mostly into mortgage bonds and treasuries.”
“Then the world changed. Interest rates soared as inflation became entrenched.” Note that the bank purchased bonds at their peak price. When interest rates go up, bond prices go down. Because bonds pay known cash flows, the present value of future returns go down when discounted using the prevailing and higher market rates. Unfortunately, SVB clients started to need their deposits. The maturity transformation problem kicked in. SVB had to fund it by selling off its bond portfolio. They reportedly lost P1.8 billion in the process.
While it is true that the SVB situation is quite unique given its specialized clientele, the lessons of the panic withdrawal bring to fore the 2022 Nobel Prize in Economic Science where Ben Bernanke, Douglas Diamond and Philip Dybvig won for their work on bank runs.
Their basic insight was that banks offer vital services to the wider economy: gathering information on borrowers, providing a liquid means of saving and deciding whom to extend credit. They resolve the tradeoff between liquidity and returns. In the absence of financial intermediaries like banks, the desire for liquidity imposes real costs. Banks solve this because the need for cash, while unpredictable at the level of the individual, is more predictable in the aggregate.
Banks are crucial to the economy but are also dangerous. As Diamond and Dybvig point out, a system in which financial intermediaries borrow liquid but invest illiquid tends to have multiple equilibrium. This is the problem of maturity transformation as it involves the transformation of an asset with a short maturity, such as a bank deposit, into a longer one like a business loan.
Destructive bank runs can happen, and the policy response should focus more on containing the panic than on preventing financial excesses. The authors make a case for financial regulators to provide a safety net to rule out self-fulfilling panic while at the same time imposing provisions to limit the exploitation of moral hazard.
Panic will not persist, using game theory, if depositors believe they will be whole. Thus, a system of insuring deposits, and a central bank acting as a lender of last resort can prevent runs. The authors used math and models to underscore a position many now take for granted.
With all this knowledge even magnified in a Nobel Prize, why did SVB collapse? Very simply, the prescription of Bernanke, Diamond, Dybvig was insufficient in SVB. Some 93 percent of SVB clients were uninsured, and their businesses were facing tough times. Its customer base of tech startups had real reason to run, and they did. Moreover, SVB was apparently not diversified enough. They may have many clients, but their successes and failures are all strongly correlated. It was classic concentration risk.
As this column is being written, the US authorities have announced efforts aimed at strengthening confidence in the banking system to avert a contagion effect. Regulators committed to make all depositors whole, including those exceeding the typical $250,000 threshold for FDIC insurance. SVB depositors were promised to have access to all their money. A new “Bank Term Funding Program” is in the works. If only this assurance were given to SVB depositors, maybe they would not have panicked. But will the signals be comforting enough to arrest the domino effect?
Have we finally learned our lesson? The US FDIC insurance coverage is close to P14 million. In the Philippines, the coverage is just P500,000, less than 4 percent of the coverage in America. Does that mean local banks are more prone to a panic run? We can only hope and pray otherwise. Meanwhile, our regulators should be proactive to avoid a similar dilemma on our shores. And it starts by improving deposit insurance coverage and strengthening the review of bank concentration risks.
*** Benel de la Paz Lagua was previously EVP and chief development officer at the Development Bank of the Philippines. He is an active Finex member and an advocate of risk-based lending for SMEs. Today, he is an independent director in progressive banks and in some NGOs. The views expressed herein are his own and do not necessarily reflect the opinion of his office as well as Finex.