Silicon Valley Bank Bailout: At what cost?

Crisis averted, but at what cost?

The US regulators dodged a bullet this weekend. They rushed to ensure that all depositors in the now-bankrupt Silicon Valley Bank will be protected. This is likely to avoid the SVB crisis to spread to other regional banks, as uninsured depositors scrambled for the exits. Markets have also calmed down after crashing by more than 4% in the last 4 trading sessions. 

Putting out the fire…

The US Fed announced a liquidity facility known as the ‘Bank Funding Term Programme (BFTP)’, allowing banks sitting on huge MTM losses on their bond portfolios to borrow from it using their bond holdings as collateral at face value, rather than their written-down market value. This comes as a huge relief for banks, who will no longer have to sell their security holdings at a loss to avail some short-term liquidity needs, the mere reason which triggered the SVB crisis.

…which they themselves started

The question that emerges from this crisis is, how did regulators miss seeing this crisis? The fact that SVB faced concentration risk would have been quite evident from its annual reports. It held $157 billion in deposits in just 37,000 accounts at the end of 2022. After providing a false sense of comfort that inflation was transitory, the Fed did a dramatic U-turn and went on to raise policy rates at a breakneck pace. But how did the blatant interest rate risk completely be missed from their radar?

Don’t get us even started on the rating agencies. SVB went from investment grade to default overnight. But that is nothing new. 

The bigger issue

Will this bailout not lead to moral hazard? 

A moral hazard is when one party takes a risk knowing that they are protected against it and pass on the cost to another party. This is usually a result of an information bias, where one party knows more or both have incomplete information.

Will this not encourage bad investor behaviour and cause banks to become laxer with their risk management? 

This funding program means that banks can now sit back and relax and pretend that there have been no losses on their bond portfolios. As of now, they can simply borrow against these bonds at face value. It’s like they are back to pandemic days and that the interest rate hikes haven’t happened at all. 

In a nutshell, banks can easily access funds from the fed despite following reckless and terrible risk management policies. 

Retail investors stand to lose

A regular investor may not be able to comb through the financial complexities and detailed reports to identify this problem beforehand. They react to news when it is usually too late. Panic ensues, resulting in runs on banks which creates a liquidity trap where they want to withdraw money from the bank and the bank does not have enough to cover the request.

The rule of the free markets over?

Banks have failed in the past, and bank runs where customers rush to get their money upon hearing of a bank’s solvency concerns can be dated back to the 1930s. Usually, when there is a run on the bank, market forces lead to a correction over time. People withdraw funds exacerbating the solvency problems and leading to a vicious cycle till the bank collapses. 

By announcing the selective bailout where SVB’s shareholders and debtholders lost everything the Fed has shown that it will not allow the free market to operate and sort these issues. It has paid off more than 89% of the $200 billion held in deposits. 

Nothing is “too big to fail”

Silicon Valley Bank is now wiped out but who bears the cost of bailing out the depositors? As per the Fed, “Any losses to the Deposit Insurance Fund to support uninsured depositors will be recovered by a special assessment on banks.” This means that bigger and more secure banks may have to bear the costs for someone else’s mistake. And these costs are likely to be passed on to depositors. 

All this has evoked memories of the Lehman Brothers crisis. The only saving grace here is a consensus belief that there won’t be any global systemic impact. The assets that banks are holding now are US treasury bonds, which are perceived as the safest in the world compared to the subprime assets 15 years ago which frankly, very few understood.

As more and more skeletons come out of the closet, apart from covering them up, the US regulators need to take a cold hard look into them to avoid another 2008, as nothing is “too big to fail.”