The collapse of a bank is a catastrophic event, and the recent downfall of Silicon Valley Bank (SVB) and Silvergate Bank has left many wondering how it could have happened. The answer, in SVB’s case, is breathtakingly simple: the bank paid higher interest rates than its competitors, attracting large deposits from financially savvy venture capital-backed firms in the valley. However, most of those deposits were uninsured, leaving the bank vulnerable to a run on deposits if anything went wrong.
SVB put much of its money into long-maturity bonds, hoping to profit from the difference between slightly higher long-term interest rates and what it paid on deposits. However, when interest rates rose, the market value of those long-term bonds fell, and the assets were not worth enough to pay everyone back if they came asking for their money. This is a classic example of “duration mismatch,” where the bank’s long-term assets don’t match its short-term liabilities.
Additionally, nearly 90% of SVB’s deposits were uninsured, making them more prone to flight in times of trouble since the Federal Deposit Insurance Corp. didn’t stand behind them. This, coupled with the fact that SVB had less onerous liquidity rules than the biggest banks, made it more vulnerable to market shocks.
It’s important to note that this isn’t just about Silicon Valley Bank. The failure of SVB and Silvergate may prompt regulators to take a fresh look at liquidity rules, but the real problem here is duration risk. Banks are allowed to put long-term assets into a “hold to maturity” bucket, which doesn’t count declines in the market value of those assets. But if everyone comes asking for their money back, the bank has to sell those securities and realize their market value. This can be disastrous if interest rates have risen and the market value of those long-term assets has fallen.
The larger implication of all this is that the Fed faces many headwinds in its interest rate-raising efforts. If duration risk has seeped into the too-big-to-fail banking system, interest rate rises could induce a hard choice between yet more bailouts and a financial storm. Let’s hope the problem is more limited than that.
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