Silicon Valley Bank and Signature Bank went out of business very quickly. They went out of business so quickly that they could be used as examples of classic bank runs, which happen when too many people take their money out of a bank simultaneously. After Washington Mutual went bankrupt in 2008, SVB and Signature were two of the three biggest banks to fail in U.S. history.
How could this happen when banks have been sitting on record amounts of “excess reserves” (cash held above what regulators require)?
Credit risk, which is the most common type of risk a commercial bank faces, is not what is happening here. As an economist who knows a lot about banking, I think it comes down to two other big risks that every lender faces: the risk of changing interest rates and the risk of running out of money.
Interest rate risk
When interest rates rise quickly in a short amount of time, a bank faces an interest rate risk.
Since March 2022, that’s exactly what’s happened in the U.S. So far, the Federal Reserve has raised rates by 4.5 percentage points, which is a lot, to try to stop inflation from going up so fast. Because of this, the rate of return on a debt has gone up at the same rate.
In March 2023, the interest rate on one-year U.S. government Treasury notes hit a 17-year high of 5.25 percent, up from less than 0.5 percent at the start of 2022. The yields on 30-year Treasurys have gone up by almost 2%.
The price of a security goes down when its yield goes up. So, when rates went up so quickly and in such a short amount of time, the market value of previously issued debt, like corporate bonds or government Treasury bills, went down, especially for debt with longer terms.
55 percent of the assets of SVB, which is what people call Silicon Valley Bank, were in fixed-income securities, such as U.S. government bonds.
Interest rate risk that causes a security’s market value to drop isn’t a big deal as long as the owner can keep the security until it matures and collects its original face value without losing any money. The unrealized loss stays hidden on the balance sheet of the bank and goes away over time.
But if the owner has to sell the security before it matures when the market value is lower than the face value, the unrealized loss becomes a real loss.
This is exactly what SVB had to do earlier this year when its customers, who were having money problems, started taking out their deposits even though they were expecting interest rates to go up even more.
Now we can talk about liquidity risk.
Liquidity risk is the chance that a bank won’t be able to pay its bills on time without losing money.
For example, if you spend US$150,000 of your savings to buy a house and down the road, you need some or all of that money to deal with another emergency, you’re experiencing a consequence of liquidity risk. Your house is now holding a big chunk of your money, which is hard to turn into cash.
Customers withdrew more money from SVB than it could cover with its cash reserves. To help meet its obligations, the bank sold $21 billion of its securities portfolio at a loss of $1.8 billion. Because equity capital was being used up, the lender tried to get more than $2 billion in new capital.
Customers of SVB were shocked by the call to raise equity. They lost faith in the bank and rushed to withdraw cash. In this digital age, a bank run like this can make even a healthy bank go bankrupt in just a few days.
Part of the reason for this is that many SVB customers had deposits that were much higher than the $250,000 limit covered by the Federal Deposit Insurance Corp. They knew that if the bank failed, their money might not be safe. About 88% of deposits at SVB were not covered by insurance.
The signature bank had a similar problem because when SVB failed, many of its customers took out their money because they were worried about liquidity risk. About 90% of the money people put in was not insured.
Due to the Fed’s campaign to raise interest rates, all banks face interest rate risk on some of their holdings today.
As of December 2022, this has caused banks to have unrealized losses of $620 billion.
But it’s unlikely that most banks will face significant liquidity risk.
Even though SVB and Signature were following the rules, the way their assets were set up was not like the average for the industry.
The signature had a little more than 5% of its assets in cash, while SVB had 7%. The average for the industry was 13%. Also, 55 percent of SVB’s assets are in fixed-income securities, while the average for the industry is only 24 percent.
The U.S. government’s decision to backstop all deposits of SVB and Signature regardless of their size should make it less likely that banks with less cash and more securities on their books will face a liquidity shortfall because of massive withdrawals driven by sudden panic.
However, with over $1 trillion of bank deposits currently uninsured, I believe that the banking crisis is far from over.