SubscriberWrites: There are lessons to be learned from failure of banks. Here are a few

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Bhagat claims that the Silicon Valley Bank (SVB) collapsed primarily due to Mark-to-Market losses on older US treasury bonds, but this is not entirely accurate. While SVB did experience losses from the reduced value of these older bonds, they were not Mark to Market losses. SVB had to book these losses because it needed to sell these bonds to meet its liquidity requirements. The bank faced unanticipated withdrawals from depositors, including tech and healthcare companies and startups, which were facing their own losses and liquidity crunches in the rapidly increasing interest rate environment.

Unlike Indian regulations, US regulations are tiered when it comes to the Mark to Market valuation of bonds held by banks. The largest banks must Mark to Market a larger proportion of their bond portfolio than smaller banks. If SVB had been valuing its bond portfolio at Mark to Market, its losses may have been less sudden. However, it is unclear how much less sudden the losses would have been given the pace of interest rate increases in the US. Ultimately, the losses for SVB were due to the materialization of liquidity risks that were accentuated by interest rate risks. Liquidity risks are high-order risks, and they are almost always the proximate cause of bank failures.

To prevent a similar failure from occurring in the future, the US Federal Reserve has introduced the Bank Term Funding Program (BTFP), which acts as a lender of last resort. The program is mandated to provide loans to other banks that have experienced significant unrealized losses on their government bond holdings and are consequently vulnerable to substantial deposit withdrawals. This facility permits banks to trade assets, such as US Treasuries, for cash at their full face value, regardless of their current market value.

The history of banking and financial crises across the world shows that while the set of circumstances leading to each crisis may differ, there are often similar underlying factors at play. These underlying factors, such as excessive risk-taking, over-reliance on certain assets, or inadequate risk management practices, can increase the vulnerability of financial institutions to external shocks.

One such external shock that can cause a systemic scarcity of liquidity is persistent inflation above the target central bank level or band. This can lead to a situation where a banking regulator may have to rapidly raise its rates in order to control inflation. Such a move can have significant implications for banks and other financial institutions, particularly if they have not adequately factored in such scenarios in their business plans and risk management strategies.

It is therefore crucial for banks and other financial institutions to conduct regular stress tests against known market risks, including inflation and interest rate risks. Stress tests can help identify vulnerabilities and weaknesses in the institution’s balance sheet and risk management practices, and help them develop effective contingency plans to deal with potential crises.

Chetan Bhagat is correct in his suggestion that stress tests against market risks should be an integral part of India’s banking sector’s risk management practices. Such tests can help ensure that the Indian banking sector is better prepared to deal with potential crises and can help mitigate the impact of external shocks on the financial system.

The writer is a co-founder at Prime M2i Consulting Pvt Ltd.

These pieces are being published as they have been received – they have not been edited/fact-checked by ThePrint.