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In a world characterised by uncertainty underscored by the frosty Sino-American relations, the Ukraine conflict, supply chain bottlenecks and increased regionalisation, market imperfections have only increased, contributing to rising inflation globally. Inflation was initially thought to be transient and was expected to pass. Most central bankers globally initially took this view and expected inflation to disappear. However, when inflation was persistent, the central bankers globally changed their approach and went on an increased interest rate spree. The US Federal Reserve has raised interest rates by 450 basis points in the past year, an unprecedented rate hike that had the potential to shock the returns of many banks, especially the ones that did not have a diversified portfolio. The banks that fall into this category are usually specialised banks focusing on regions, client categories or product categories. With this background in mind, we need to look at the current banking crisis in the US.
The banking business has always been primarily driven by duration mismatch, as it is the duration mismatch that allows the banks to generate returns. Periods of crisis can often exacerbate this mismatch to the point where banks collapse. The issue of Silicon Valley Bank (SVB) has been very similar. The asset-liability profile of the bank may offer us more insights. SVB had many deposits from the Silicon Valley ecosystem of participants such as fintechs and startups. Often these participants needed banking relationships only to park their funds and did not need credit lines from their banks. As a result, SVB did not have significant loan exposures compared to the deposits they accepted and instead had a considerable amount of funds invested in fixed-income securities. As the fintechs and startups experienced significant challenges in raising cash flows, they started utilising the cash balances from the deposits maintained with SVB. This happened when market interest rates and mark-to-market losses on the fixed-income portfolio of the bank were increasing. As the demand for funds increased from the depositors, the bank had to start liquidating their fixed income portfolio to meet the deposit withdrawals, resulting in significant losses eroding the bank's capital. As the news spread that the bank was struggling to meet liquidity, the pressure on deposit withdrawals mounted significantly, resulting in a bank run. Many deposit holders had deposit balances beyond the threshold covered by the Deposit Insurance, which is USD 250,000. These challenges reverberated through the entire global financial ecosystem, increasing pressure on every geography to identify their exposure to the crisis. As a result, it became imperative that the US Fed calm the markets through its announcement of intent to save the bank.
Stress testing: We understand that macroeconomic stress tests, which are mandatory for all banks, were exempt for banks with a balance sheet of below 250 billion USD – an exemption made available under the previous government. As a result, no stress tests revealed any results of a crisis. Stress tests would need to be mandatory for all banks across the ecosystem.
Deposit concentration: In case of a runoff, the concentration of deposits amongst a certain category of customers and within a particular specific geography poses significant solvency risks to a bank. Banks would need to start tracking their deposit concentration as a metric more closely while conducting their liquidity risk management exercises.
Focused balance sheet hedging by banks: Leaving exposures unhedged in a highly volatile environment is a significant judgment error. It would be worthwhile for banks to look at hedging their balance sheet, basis changed market expectations on interest rates.
Deposit insurance: Deposit insurance coverage needs to be reevaluated. While 100% deposit insurance arrangements may not be possible, backstop arrangements that could be specified during times of crisis would need to be explored.
Financial stability risk to be balanced with inflation management: The financial regulator's responsibility is not just inflation but also financial stability. The second-order effects of a 450-basis point increase in interest rates over the past year were not thought through comprehensively by the regulator, resulting in liquidity and solvency challenges for banks. It would be worthwhile for the US Fed to develop a Market Stabilisation Fund, that could provide liquidity during these times of stress to banks facing sustainability challenges due to increased interest rates.
The impact of the SVB crisis on the Indian Banking system is minimal, given that India has still not moved its rupee to full capital account convertibility. India has had its share of learnings regarding bank failures and the key learnings from the SVB crisis rhyme with the Indian banking crisis in the past. Hence, many reforms are already in place, thanks to the banking regulator. Given the kind of world that we live in today, black swan events seem to have become the norm and it would be wise to walk steadily and work proactively.