#NoiseVsSignal – Silicon Valley Bank Collapse raising alarm bells for other…

The Silicon Valley Bank(SVB) collapse is a unique situation as the second-largest bank in US history is unable to pay its depositors. The reason this is unique is that there is no fraud or compliance issue with the bank. This makes it a bit scary !!!

I will explain how ?

The main business of a bank is to accept money from depositors at lower interest and lend or invest at higher interest. This bank, just like all other banks, has invested in long-term bonds for higher interest (10-year Treasury bonds) along with a part of the money being lent. The difference between the lending and borrowing rates is your net interest margin, which is most banks’ primary source of income. During COVID-19 in 2020, SV bank had deposits of 62 billion dollars, rising to 124 billion dollars in 2021. Now the trouble started when the Federal Reserve, in 2022, started increasing interest rates. The challenge was due to substantial rate hikes of more than 200 basis points in less than a year in 2022. This is an inverted yield curve, where the short-term interest rate is higher than the long-term interest rate. The impact of this is that if we see that the bank wants to sell its long-term bonds, they are trading at a discount due to the inverted yield curve, which makes it difficult for the bank to encash unless it books a loss on its investment and repay its investors. The run on the SV Bank was caused due to liquidity crisis caused due to ALM mismatch, and I would say it’s a stroke of bad luck at least for SV Bank. The bigger worry is that most of the market participants have is two-fold:

• first, whether run on SV Bank will have a contagion effect ? and
• second, if this can happen to SV Bank, can it happen to other banks?

The answer to the first question is yes, there will be a contagion, but it will be limited to borrowers and account holders. The second worry is real because the problem of the inverted yield curve still exists and the Fed doesn’t intend to stop at the current level. The risk to the market is that if the Fed continues further with the rate hike cycle, other banks may fall into this trap as well.

Unlike the 2008 collapse of one bank and the subsequent collapse of another due to cross-lending structures, this is different!

If a May Day situation arises, there will be a common reason for the house of cards to collapse… Rate Hike!