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SVB fall shows it’s not just about credit risk. It’s also about the silent role of interest rate

The SVB case has once again raised questions on the role of banking regulation and deposit insurance.

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California’s Silicon Valley Bank was shut down by regulators in the United States last Friday, followed by New York-based Signature Bank on Sunday. Several Indian startups with accounts at SVB may also be impacted by this sudden closure. Bank runs or panic withdrawals and the resulting contagion effects have once again raised questions about banking regulation around the world.

The SVB impact

When SVB announced last Wednesday that it needed $2.25 billion to shore up its balance sheet, most of its depositors were caught by surprise. Panic ensued, and depositors withdrew funds worth $42 billion in a day, making a bad situation worse and leading to its shutdown. The Federal Deposit Insurance Corporation (FDIC) said depositors would have access to only the insured deposits (up to $250,000) by Monday morning.

Many startups in India with deposits in SVB had difficulties accessing funds, especially those with deposits that are more than the insured amount. Losing access to their deposits would damage the ability of these firms to make downstream payments. Rajeev Chandrasekhar, the Minister of State for Skill Development and Entrepreneurship in India, is meeting with startups to assess the impact. Late Sunday evening, the Federal Reserve System (also known as the Fed) announced it would help banks meet the needs of their depositors. The UK arm of SVB has already been sold to HSBC. What seemed like the bank failure of a relatively small institution has turned into an event with global ramifications.

Also read: Credit guarantee helps banks take a chance on MSMEs but funding defaulters harms taxpayers

An unusual bank run

The SVB bank run is unusual for three reasons. First, it did not get into trouble because of a deteriorating loan portfolio. SVB clients were largely venture-capitalists who made deposits but did not need loans. SVB, therefore, invested these funds in US government bonds. When the Fed increased interest rates, the price of bonds fell, causing a liquidity crisis. The bank’s financial position was thus a result of poor management of its interest-rate risk and not its credit risk.

Second, since the client base consisted mostly of venture-capitalists, their demand for funds to SVB, for instance, to pay salaries to their employees, would be made at the same time. The homogeneity of the client base meant that the bank itself was not diversified.

Third is the response of the government. Bank failures are not new to the US. There is a well-understood process of resolution wherein the bank assets get sold over a period of time, and ownership changes hands. Initially, the response of the FDIC was as expected — it would only provide access to insured deposits and proceed with the sale of the bank. This was because SVB was not considered systemically important given its size (16th largest in the US in terms of deposits before its downfall). However, the Fed got into action with a Bank Term Funding Program (BTFP). With this program, the government will make available up to $25 billion, thus guaranteeing all depositors access to their funds. This funding comes from the insurance fund and not tax-payer money.

Also read: How Sitharaman can live up to her Budget promise of KYC simplification

The need for financial regulation

Banks are risky institutions. They take money from depositors and lend the same money to businesses. Repayment by creditors takes place over a long period of time, whereas depositors can withdraw their balances at any point. Instead of lending to customers, the banks sometimes invest in government bonds, whose prices fluctuate depending on the interest rate environment. The bank, thus, always faces a mismatch in the tenure of its funds. It keeps a buffer capital for such events, but this buffer can also fall short.

If all depositors were to withdraw their money at the same time, then the bank would not be able to meet these demands, causing a “bank run”. Countries around the world have constituted “deposit insurance” programmes. If a bank fails, part of the deposits that are insured is paid back to depositors. The insurance is financed through a premium charged to banks. In the US, FDIC, the country’s deposit insurance institution, not only insures bank deposits but also acts as a receiver of the bank — selling or collecting the failed bank’s assets and settling its debts.

The SVB case has once again raised questions on the role of banking regulation and deposit insurance. We have generally considered bank runs as emanating from credit risk and paid less attention to interest-rate risk. There are standard processes to deal with interest-rate risk in banks’ books. The question that regulators will need to examine is if the exposure of SVB to interest rate risk raised alarm bells earlier. Should SVB also have been subjected to more regular stress tests? Should banks be asked to keep a larger buffer of shareholder funds to absorb losses? Does this buffer fund change for banks that service only a community and are, therefore, not diversified themselves? Banking regulation will have to evolve to grapple with problems related to interest rate risk.

Renuka Sane is research director at Trustbridge, which works on improving the rule of law for better economic outcomes for India. Views are personal.

(Edited by Zoya Bhatti)

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