So what happened last weekend?
Silicon Valley Bank, (formerly) the 16th largest in the country, as well as the smaller Signature Bank were closed by regulators due to potential insolvency. To fully understand what happened, a little primer on how banks operate will help. Banks receive customer deposits, and instead of simply sitting on the cash, they purchase investments and make loans. With the profits they make, they pay the depositor a rate of interest in return.
Two assumptions are embedded into the banking model. One is that only a small amount of customers will withdraw funds over a given period of time. The second is that the bank's investments and loans will be generally profitable. Because of Silicon Valley Bank’s unique situation, these two assumptions broke down.
First, as their name would imply, they are a major bank for start up and tech related companies. As you have probably heard on the news, it has not been the best year for tech companies. Revenues are down, and just like if a person loses their income, they will start withdrawing more cash out of their bank account to make ends meet. This happened at a massive scale throughout 2022 and 2023 at Silicon Valley Bank.
Second, in 2021 the bank made (now questionable) investments in long duration, low interest bonds. Since then, the Federal Reserve has been raising interest rates, which makes the value of low interest bonds decline. To keep up with the withdrawals of their depositors, the bank was forced to sell these depreciated assets. Word spread of their situation and potential insolvency, and two days later the bank was shut down.
In response to this, the Federal Reserve took several actions to extinguish the panic from spreading. They backstopped the depositors, so they could have full access to their funds immediately. They also created a program, where banks could exchange any qualifying depreciated assets for a loan, thus removing the requirement that they are forced to sell when the investments are down. The FED essentially created a bandaid for the wound they inflicted.
The next question is will they continue hiking rates on their March 22nd meeting. Initial reports (before the collapse) were anticipating a .25% or .5% rate hike (inline with previous rate hikes), but now the consensus view is they will not hike rates, in order to calm nerves. Another argument is they will continue raising because they have provided a solution to the negative impacts of higher rates. Time will tell.
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