Is Banking on the Brink?
Foster Professor Philip Bond explains the collapse of Silicon Valley Bank and weighs the challenges ahead for the entire banking industry
It’s been an eventful week for the banking industry—and not in a good way.
Silicon Valley Bank collapsed, followed by Signature Bank, sending a shockwave of anxiety throughout the myriad tech startups that did business with these institutions. After much deliberation, the federal government guaranteed deposits in both banks beyond the FDIC insurable limit. And startups breathed a sigh of relief.
So, crisis resolved? Or is Silicon Valley Bank a financial canary-in-a-coalmine? We asked Philip Bond, an expert in banking at the UW Foster School of Business, to explain what happened and consider what might come next.
Foster Business: What brought about the collapse of Silicon Valley Bank?
Philip Bond: At the core was an imbalance of assets and liabilities. A bank’s assets are the loans it has made. And a bank’s liabilities are its deposits. Most bank loans are issued at a fixed rate over long periods of time—sometimes five or ten years. When interest rates rise, the value of existing loans drops because the stream of payments in the future is now worth less than they used to be. And when banks go to trade loans on the secondary market, they are worth less than they used to be.
With Silicon Valley Bank, so many of its depositors were startups that were experiencing a general funding decline. So, they had been gradually drawing down their deposits. With money flowing out of the bank, it had to sell its assets: loans. But those loans were now worth less because of the higher interest rates. When more depositors withdrew funds from SVB—a “run” on the bank—it really just expedited what was going to happen eventually.
If people had kept their money in Silicon Valley Bank but started demanding a higher rate of interest, it would still have faced the same problem, just in slower motion.
It sounds like interest rates are at the core of this crisis.
Correct. In the past, interest rates have not moved very much or very quickly. Recently, though, the interest rates have been rising much faster than they have in a long time.
Despite the higher prevailing interest rates, deposits at most banks continue to pay very, very low rates of interest. The difference between prevailing rate and the rate the bank is paying is what is called the “spread.” And the spread is really quite large right now. If you can invest in a lot of short term, very liquid assets and earn 4%, it creates a wide gap between that potential 4% and the close to 0% you earn on most traditional bank deposits.
A great deal is at stake in the extent to which depositors wake up and either move their money to earn a higher return or force banks to offer higher deposit rates.
Let’s consider those two possible scenarios separately. First, how exposed is the larger banking industry to a potential demand for higher rates?
Colleagues at other schools who have access to the data are estimating that the market value of assets at the average US bank is down by about 9%, which is very close to the typical capital buffer in the industry.
If banks become forced to pay something closer to the prevailing rate of 4% interest on their deposits, it would mean that the average bank in the United States would be not quite insolvent, but close. Again, that is only in the extreme event that they’re actually forced to raise rates to 4%. This is not what we’ve seen and not what we’d expect to happen.
On the other hand, we also haven’t seen such an extreme gap between the deposit rate and the prevailing rate.
Second, why don’t people just move their money somewhere that offers a higher rate?
People in this business talk about deposit “stickiness.” This could be defined as the opposite of mobility. There is a fair amount of pain and cost in moving your money.
A few years ago, researchers in the United Kingdom calculated that the expected duration of one’s bank account exceeds the expected duration of their marriage.
This was based on the UK banking system, which has nowhere near the options of the US system. But the message is that bank deposits, for whatever reason, tend to be very sticky.
And when you think about a startup in Silicon Valley, the idea that they are going to diversify their banking—disperse, say, $10 million among 40 different banks to ensure it’s all FDIC insured—is not realistic. (update: my colleague Jarrad Harford informs me that there are new automated products that do this).
How much actual jeopardy did SVB’s collapse put startups in?
The risk that the startups faced was actually quite small. While Silicon Valley Bank was insolvent, I don’t think it was badly insolvent. The big difference from the 2008 financial crisis is that Silicon Valley Bank’s assets are still pretty easy to sell. Everything I’ve seen suggests that Silicon Valley Bank—and most banks, for that matter—could liquidate their assets and be able to cover 95% of their deposits, in most circumstances.
So, not really that much jeopardy?
Of all the risks that startups take on, the possibility that their bank account might shrink by 5% seems a long way down the list.
What about other banks? Are there still some that are “too big to fail?”
At this point, I feel it’s too early to judge whether the bigger banks are much safer. I don’t have easy access to their balance sheets, but I would expect many banks to be exposed to similar risk as Silicon Valley Bank was.
Everything depends on how much banks end up having to raise the deposit rate. If they do have to move to something close to 4%, then I think many of them are in substantial trouble. In that case, fundamentally bank assets would not be worth enough relative to liabilities.
Could the risk of this affect economic policy at the highest level?
An interesting dimension to this is the extent to which the Federal Reserve backs off the interest rate rise because they start worrying about the damage they’re doing to banks. I could see it going either way.
Has hyperbolic media coverage of the Silicon Valley Bank episode contributed to a sense of panic?
The talk of Silicon Valley startups losing all their cash was a bit hysterical, because that was not an issue.
Some people are interpreting that the federal government stepped in to save Silicon Valley. I believe it was almost the reverse. That the government action was intended to reassure depositors at other banks.
I think the media is mixed on its understanding of the extent to which the situation is a potential problem for the entire banking industry—including even the largest of banks. The dilemma, I should note, is how loudly to say this.
Philip Bond is a professor of finance and business economics and the Edward E. Carlson Distinguished Professor in Business Administration at the Foster School of Business.
Adobe Stock Image by Andreas Prott.