The Trajectory Of An Unforeseen Banking Crisis

bank march28 lt

Around four months after the dramatic collapse of the FTX crypto exchange, on March 8 to be exact, crypto-focused bank Silvergate Capital Corporation (SI) announced that it would wind down operations and voluntarily liquidate Silvergate Bank. The cryptocurrency-focused lender had a week earlier warned it was delaying its annual report and said it was evaluating its ability to operate as a going concern.

The California-headquartered bank which had made big bets on the digital assets sector had reported a net loss of $1 billion in the fourth quarter, as depositors pulled out more than $8 billion in deposits amidst the implosion of FTX in November of 2022.

Crypto industry was shocked, but the wider financial world did not appear much perturbed. Crypto-based businesses announced contingency plans by jumping to associate with Signature Bank (SBNY), another crypto friendly bank. California-based Silvergate Bank and New York-based Signature Bank were the two main lenders to the crypto industry.

When all this was happening, the Federal Reserve had progressed a year into its ambitious plan to combat inflation by making monetary policy more and more restrictive. The Federal Funds Rate which was 0.00% to 0.25% in the first quarter of 2022 had been raised aggressively to 4.50%- 4.75% by the first quarter of 2023.

The Fed deemed it necessary to act aggressively on inflation management as the unprecedented liquidity released though the Fed's pandemic-driven monetary stimulus had permeated every nook and corner of the economy and lifted inflation to multi-decade highs. In the aftermath of the coronavirus pandemic, the Federal Reserve and central banks world over had adopted a strategy of liquidity infusion to avoid credit crunch to households and businesses.

It was not just prices of goods and services that stood impacted by the gush of pandemic-era liquidity. The flush of liquidity infused by the Fed reduced general interest rates to abysmally low levels. In a bid to shore up margins in an era of low interest rates, banks then parked excess liquidity in longer-term interest-bearing investments, often unmindful of the mismatch in duration between the funding profile and deployment profile.

Bond prices and interest rates have an inverse relationship. As the pandemic subsided and inflation reared its ugly head, the Fed realized the price rise was no longer transitory and required a fierce combat. As the Fed unleashed its fury on inflation with rapid rate hikes, the market prices of these long-term investments started to fall. The marked-to market losses on these bond portfolios increased and at the close of 2022, it stood near $620 billion for the U.S. banking system as a whole from both the 'Available For Sale' and 'Held To Maturity' categories. But market concerns about the monster called interest rate risk were muted because, as long as investments were allowed to mature, the marked-to-market or MTM losses were simply notional with no actual crystallization of loss.

But that was far from reality. In a banking world of fractional reserves, if depositors rush to retrieve their deposits earlier or faster than anticipated, banks would be forced to sell their bonds ahead of maturity to arrange liquidity.

Liquidity Risk is an equally wild monster like interest rate risk. According to the Basel Committee on Banking Supervision, "Liquidity is the ability of a bank to fund increases in assets and meet obligations as they come due, without incurring unacceptable losses". The guidelines issued in 2008 also warn that "Liquidity risk management is of paramount importance because a liquidity shortfall at a single institution can have system-wide repercussions".

In the event of a distress sale, the loss on sale of securities would no longer be notional and lead to an erosion of capital. It was in such a predicament that start-up lender Silicon Valley Bank's holding company SVB Financial Group (SIVB) announced on March 8 - the same day that Silvergate Bank announced a winding down - a $1.75 billion share sale to make up for the capital erosion, consequent to a huge MTM loss of $1.8 billion it had recently suffered.

What followed was an unprecedentedly rapid and massive run on the 16th largest U.S. bank. Amidst a scramble by depositors to retrieve deposits, the California Department of Financial Protection and Innovation on March 10 ordered the closure of Silicon Valley Bank and appointed the Federal Deposit Insurance Corporation or FDIC as receiver. In a subsequent deal, First-Citizens Bank & Trust Company (FCNCA) agreed to assume all deposits and loans of Silicon Valley Bridge Bank, N.A., from the FDIC.

The reasons for the demise of the California-based SVB have been variously attributed to unhedged interest rate risk, significant liquidity risk inherent in a funding profile dominated by connected depositors, a heavy reliance on uninsured deposits, as well as a concentration risk that stems from a business model that serves exclusively the technology and venture capital sector. What has apparently exacerbated the incidence of these business risks are modern communication dynamics of a social media-driven bank run and digital banking advancements that exponentially expedited the pace of bank outflows.

It was a tumultuous weekend for the U.S. banking system, its regulators and for the financial world at large. Just as markets came to terms with the shocking demise of SVB, the New York State Department of Financial Services announced on March 12 the closure of Signature Bank and the appointment of the Federal Deposit Insurance Corporation or FDIC as receiver. Subsequently, Flagstar Bank, a wholly owned subsidiary of New York Community Bancorp, Inc., (NYCB) agreed to assume the deposits of Signature Bridge Bank, N.A., from the FDIC.

Whilst Signature Bank did not apparently have interest rate risk incidence from a depreciated bond portfolio, it reportedly had a high dependence on uninsured deposits and triggered a large run a few days ahead of its closure. Its downfall has also been ascribed to concentration risk, lax risk management and its deep foray into crypto business including its association with FTX. In February 2023, the bank was hit with a class-action lawsuit that alleged it "permitted" the comingling of customer funds by FTX. Signature Bank's Signet Platform, a real-time payments platform, was hugely popular with crypto businesses and played a big part in mobilizing its deposit business.

The turmoil that led to the sudden disappearance of three banks was enough to trigger concerns about broader risks in the U.S. banking sector. Major U.S. banks as well as regional players had to face investor flak. Amidst the developments, Moody's also changed its outlook on the U.S. banking system to 'negative' from 'stable' and also downgraded several banks.

The Department of the Treasury, Federal Reserve, and Federal Deposit Insurance Corporation issued joint statements indicating actions taken to strengthen public confidence in the U.S. banking system. U.S. President Joe Biden also stepped in to say that the administration's actions should provide Americans confidence that the U.S. banking system was safe. In addition to regulatory support, larger institutional players also joined hands to support the industry.

The Federal Reserve Board also announced that it would make available additional funding to eligible depository institutions to help assure banks have the ability to meet the needs of all their depositors. The action aimed at bolstering the capacity of the banking system to safeguard deposits and ensure the ongoing provision of money and credit to the economy is however feared to undo some of the quantitative tightening that the Fed embarked upon recently to combat inflation.

Amidst fears of a full-fledged banking crisis in the U.S., Switzerland-based Credit Suisse (CS) shocked markets on March 14 with a "material weaknesses" flag in its much-delayed 2022 Annual Report. In its annual report, the Swiss bank, which ranked among the top 30 banks that regulators considered to be systemically important, said that "management did not design and maintain an effective risk assessment process to identify and analyze the risk of material misstatements in its financial statements."

Cash-strapped Credit Suisse had been struggling amidst losses triggered by collapse of the US family hedge fund, Archegos Capital, and the British supply chain finance firm, Greensill Capital. The delay in the publication of its 2022 annual report and the recent queries by the U.S. SEC triggered concerns about the health of the bank. The admission of a material weakness in its recent announcement exacerbated the solvency concerns. Comments by Saudi National Bank's Ammar Al Khudairy, chairman of the lender's biggest shareholder that it would not boost its stake in the lender for regulatory reasons turned out to be the final nail.

As counterparty banks scrambled for credit protection, the spread on Credit Suisse credit default swaps surged to distress levels last seen during the Global Financial Crisis. Though the Swiss National Bank stepped in with a quick lifeline of $54 billion to Credit Suisse, it did not suffice, and rival UBS Group AG (UBS) was in less than a week forced to take over the bank at a heavy discount to its market value.

Unlike the banking crisis in the U.S., that was more of interest rate risk and liquidity risk, the Swiss behemoth's downfall has been largely attributed to a compromise with ethics, fair play and trust, and its risky business strategies.

The Credit Suisse crisis was a bombshell that risked a banking crisis contagion to Europe and the wider world. Sensing the danger, the Bank of Canada, the Bank of England, the Bank of Japan, the European Central Bank, the Federal Reserve, and the Swiss National Bank announced on March 19 a coordinated central bank action to improve U.S. Dollar liquidity.

The speed at which large financial intermediaries have been totally wiped out from the financial landscape has stunned even avid industry watchers and calls for introspection from multiple perspectives.

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