The Silicon Valley Bank run and lessons for China
Dr. Xiaobei HE: "A Global Systemic Risk Event Triggered by Small and Medium-Sized Banks"
You probably have read quite some analysis of the run on the Silicon Valley Bank in the United States and then the forced sale of Credit Suisse to UBS. The East is Read today presents an analysis by Dr. Xiaobei HE, Deputy Director of the Macro and Green Finance Lab at the National School of Development (NSD), Peking University (PKU).
Dr. He’s research interests include financial stability, monetary economics, and climate policies.
Before joining the Lab, she was a senior fellow at the National Institute for Finance Research, Tsinghua University. She was a visiting fellow at the Financial Research Institute of the People’s Bank of China.
Her publications include articles in leading academic journals, chapters in edited volumes (Handbook of China’s Financial Markets), and the book 《金融危机的预警、传染和政策干预》Financial Crisis: Early Warning, Contagion and Policy Intervention.
Dr. He holds a Ph.D. degree in Economics from Goethe University Frankfurt, a Master's degree in Economics from Hong Kong University of Science and Technology, and a Bachelor's degree in Engineering from Tongji University.
Dr. Xiaobei HE: A Global Systemic Risk Event Triggered by Small and Medium-Sized Banks - Lessons From Silicon Valley Bank
Publish Date: 2023-03-17
This is a global systemic financial risk event triggered by regional small and medium-sized banks: Silicon Valley Bank (SVB) and Signature Bank rank only 16th and 29th among US banks in terms of asset size, far behind the scale of large banks. However, they have caused turmoil in the global financial market and brought down Credit Suisse, a Global Systemically Important Bank (G-SIB). This typical bank run incident highlights the value and vitality of the research of the three economists who won the Nobel Prize in Economics in 2022: Why are banks so vulnerable? What are the consequences of bank crises? How to prevent the systemic risk?
1. Why are banks so vulnerable?
The collapse of SVB was a classical bank run event (Diamond and Dybvig, 1983). SVB had one of the best business models, focusing on serving technology startups and thus deeply tied to the world's most promising companies. Before its collapse, SVB credit rating was Investment Grade. Why did it collapse so quickly within two days? This brings us to the inherent vulnerability of banks.
Banks exist because the real economy has a need for maturity mismatch: depositors have temporary liquidity needs, while businesses need long-term investments. Maturity mismatch (i.e., borrowing short and lending long) is the core function of banks, but this also determines the inherent vulnerability of banks (Diamond and Dybvig, 1983). Long-term assets are not easily liquidated, and once a large number of depositors withdraw funds, banks face liquidity shortages, an issue which emergence of deposit insurance policy has greatly alleviated (Diamond and Dybvig, 1983).
However, deposit insurance is not enough to eliminate the risk of bank runs in the financial system. On the one hand, wholesale financing is not protected by the deposit insurance policy; on the other hand, not all retail deposits are insured by deposit insurance in practice in various countries. The. deposit insurance of the U.S. only protects deposits below $250,000, but unprotected deposits are unevenly distributed among banks. SVB mainly relies on corporate deposits, with 92.5% of its deposits not covered by deposit insurance. Signature Bank, which primarily serves high-net-worth individuals, also has a similar problem.
What was the trigger for the bank run? The tech startup industry is one of the most interest rate-sensitive sectors and is the first to be affected in the current environment of the Federal Reserve's rate hikes. A large number of SVB's deposit clients are tech start-ups which began to consume cash to maintain operations in 2022, and thus SVB’s deposit amount has significantly decreased. To meet withdrawal demand, SVB needed to sell its long-term assets (held-to-maturity securities). In an unprecedented interest rate hike environment, the prices of these assets fell sharply, and once sold, the paper losses turned into capital losses, affecting the bank's ability to pay. SVB's securities assets accounted for 55% of its total assets, twice the average of American banks. Therefore, when it announced the sale losses, depositors were worried about the bank's stability, and withdrawals reached $42 billion within a day, accounting for one-third of its deposit size. No bank could withstand such a rapid cash burn rate.
2. Why did it trigger financial risk contagion?
Bank collapses are not uncommon, with several occurring in the U.S. each year on average. SVB is not considered a systemically important bank, and the U.S. regulatory authorities promptly stepped in to rescue the market. So why did it still trigger large-scale financial risk contagion?
Panic has always been the main driver of financial risk contagion. US regulatory authorities are well aware of this and quickly introduced rescue plans before the contagion spread. First, the FDIC provided insurance for all deposits of SVB and Signature Bank, effectively eliminating the most urgent risk of bank runs. Second, the Federal Reserve created a liquidity tool, the Bank Term Funding Program, or BTFP, allowing banks not to sell assets to meet short-term payment needs, thus avoiding "unrealized" losses turning into realized losses that erode capital, significantly reducing the risk of asset sales.
However, panic in the financial markets did not stop.
Market panic stemmed from doubts about the stability of small and medium-sized banks, which essentially reflected a lack of trust in banking regulation. In this crisis, the situation of large US banks and regional small banks was quite different, with investors selling stocks of of the latter. In fact, many small and medium-sized banks in the US mainly focus on lending and do not hold enough eligible collateral like government bonds to receive support from the BTFP. As with all financial crises, there was a large-scale flight to quality in the market, with depositors and investors quickly moving their deposits and assets from small and medium-sized banks to large banks, leading to the sale of small and medium-sized banks' assets. On the one hand, the market believed that systemically important banks were subject to stricter regulation and thus more stable. On the other hand, they also expected financial institutions to be "too big to fail."
However, while large US banks were relatively stable, large European banks were severely impacted. This is because, compared to their US counterparts, large European banks have had weak profitability since the 2008 financial crisis, and their balance sheets are far less healthy than those of large US banks. In particular, Credit Suisse, the world's fifth-largest financial group and a Global Systemically Important Bank (G-SIB), had already been experiencing turmoil and faced even larger-scale client redemptions during this storm. It ultimately had to accept assistance from the Swiss central bank, becoming the first large bank to fall.
3. What are the consequences of the banking crisis?
Currently, regulatory authorities in the United States and Europe are willing to take measures to prevent a financial crisis. What impact will this have on the economy and financial markets once the financial panic subsides?
There are multiple feedback mechanisms between the macroeconomy and the financial system. The seasonal downturn in the technology industry is the trigger for the SVB crisis, but the collapse of SVB will also have negative impacts on the technology industry and the macroeconomy. According to Bernanke (1983), bank failures cause financial crises evolving into economic crises (Great Depression), which involves another core function of banks: screening eligible borrowers, granting loans, and monitoring. Once banks fail, this screening and monitoring skill cannot function, the financial transaction costs for borrowers rise (reflected in increased credit spreads), borrowers have difficulty obtaining credit, investment and consumption decline, aggregate demand decreases, and the economic recession intensifies.
The collapse of SVB will trigger the above-mentioned problems. SVB has a market share of over 50% in the financing field of American high-tech startups and is an irreplaceable financial core in the Silicon Valley venture capital circle. SVB has business dealings with more than 600 venture capital institutions and 120 private equity funds worldwide, and VC/PE and startups generally have accounts at SVB. The collapse of SVB will exacerbate financing difficulties in the innovative medical industry, adding insult to injury.
More importantly, this global banking crisis will make even prudent banks cautious about asset expansion, and small and medium-sized banks will reduce credit supply and risk asset allocation, which will decrease aggregate demand and drag down the global economy.
4. How will policymakers respond?
Will the Federal Reserve worry about the worsening banking crisis and slow down its interest rate hikes? Even if the Federal Reserve slows down its rate hikes, it will not be due to the banking crisis. Market operations during the 2020 pandemic panic have proven that the Federal Reserve has the ability to maintain financial market stability through the creation of various liquidity tools, and its swift rescue this time also demonstrates its preparedness. Therefore, the federal funds rate only needs to be used to maintain price stability and employment. As with the Bank of England's operations during the 2022 pension crisis, the Federal Reserve can fully provide liquidity to the market (whether actively or passively) while raising interest rates. If the Federal Reserve slows down its rate hikes, a more likely reason is the rising probability of an economic recession caused by this banking crisis.
The deeper impact of this banking crisis should be on the direction of financial regulation. Although U.S. Treasury Secretary Janet Yellen has emphasised that this round of rescue plans will only save depositors and not banks (shareholders and creditors), expanding the coverage of deposit insurance itself has already created a moral hazard, as banks have not paid corresponding premiums beforehand. Moreover, the Federal Reserve's BTFP tool has also allowed banks with a lack of prudent risk management to avoid the risk of asset sales. Although this backstop is necessary, it ultimately undermines financial market discipline. As Bernanke (2013) said, short-term financial crisis rescue actions come at the expense of long-term financial system instability, as financial institutions do not bear the consequences of their excessive risk-taking behaviours. However, Bernanke (2013) also said that there is no good solution for the moral hazard yet, and it must be addressed by establishing more effective prudential regulation to minimise the probability of a financial crisis and thus reduce the impact of the moral hazard. In fact, after the 2008 financial crisis, countries around the world have significantly strengthened their supervision of banks, including the introduction of Basel III in 2010 and the Dodd-Frank Act in the United States. The goal was to strengthen the prudent supervision of banks.
However, the SVB incident showed that on the one hand, the bank itself had serious risk management failures, and the regulatory authorities did not effectively supervise it. On the other hand, the relaxation of financial supervision (rather than the Federal Reserve's interest rate hike) also sowed the seeds of this crisis.
Although the unprecedented rapid interest rate hikes are a test for financial markets, interest rate risk is the most common risk for banks, and they usually use interest rate derivatives to hedge these risks. However, SVB held $120 billion in securities assets but only had $5.5 billion in nominal value of derivatives. If the regulators required SVB to conduct regular stress tests, the risks would not have accumulated to this level. In fact, the Dodd-Frank Act, introduced in 2010, required banks with assets above $10 billion to undergo annual stress tests. However, due to economic recovery and lobbying against high bank regulatory costs, the United States passed the "Economic Growth, Regulatory Relief, and Consumer Protection Act" in 2018, easing regulatory requirements for small and medium-sized banks and raising the threshold for stress tests to $250 billion. The scale of SVB before its collapse was $220 billion. Furthermore, due to its smaller asset size, SVB did not need to meet the Liquidity Coverage Ratio (LCR) or Net Stable Funding Ratio (NSFR) requirements. This is why the bank failed to maintain a reasonable liquidity level to cope with the continuous risk of deposit outflows after experiencing rapid deposit expansion (by the end of 2021, deposits were about three times those at the end of 2019) and rapid contraction (a 9% decrease in 2022).
This round of banking crisis shows that focusing only on systemically important financial institutions is not enough to maintain financial stability, and there are still flaws in the existing prudent regulatory tools. First, the existing bank supervision framework reduces compliance costs for small and medium-sized banks, but when risks erupt, regulatory authorities have to step in, disrupting market discipline and creating moral hazards for the next crisis. Second, the prudent regulatory requirements for large banks also need rethinking. Credit Suisse meets the capital and liquidity requirements of Global Systemically Important Banks (G-SIBs). In fact, based on existing stress tests, its liquidity coverage ratio is sufficient to cope with large outflows of funds lasting more than a month during stress periods. However, this still underestimates the extent of market panic and the speed of capital outflows. It is necessary to reconsider stress tests and incorporate risk contagion channels.
Overall, it is predictable that this banking crisis will push the United States into another tightening cycle of financial regulation, and medium-sized banks are likely to face higher regulatory requirements.
5. What are the implications for China?
Although the SVB crisis has not directly affected the Chinese market, it has important implications for China's financial regulation.
First, the risks faced by regional small and medium-sized banks in China cannot be ignored. The return on assets in China's banking sector is significantly lower than that of its U.S. counterparts, and a significant portion of its assets are not included in non-performing assets, which can be considered "unrealized losses.” If economic growth slows, financial risks will accumulate further. Although China does not have banks like SVB that focus on serving a specific industry, many small and medium-sized banks have been deeply rooted in regional economies for a long time, and their assets are highly concentrated in specific industries. The risks of these industries will ultimately become pressures on the banks. For example, as the economy transitions to low-carbon, the asset problems of city commercial banks in regions with high carbon-intensive industries will gradually be exposed. At the same time, the SVB incident shows that even high-growth potential industries may cause significant pressure on banks during a downturn. Green loans and inclusive loans in China are growing much faster than the average loan growth rate, but if there is a lack of price signals to guide, it may ultimately burden banks.
Secondly, the risks of small and medium-sized banks may evolve into a financial crisis through financial risk contagion, and preventing systemic risk requires effective prudential regulation and policy tools. China's financial regulation has long focused on heavy control and light supervision, lacking prudential regulatory tools and oversight. The evolution of the SVB incident to the rescue of Credit Suisse proves that the current understanding of financial risk contagion is still limited, and existing risk monitoring indicators and regulatory requirements have not been able to defend against contagion effectively. Although China has not experienced a comprehensive financial crisis, there have been multiple bank runs in history. With the deepening of financial market reforms, the risks of banks may gradually be exposed. Regulatory authorities should pay attention to conducting bank stress tests, especially developing macroprudential stress tests that can simulate financial contagion, building a financial risk monitoring indicator system, and enriching the prudential policy toolbox to prevent systemic financial risks.
Lastly, a market-oriented exit mechanism for financial institutions should be established under the framework of the Financial Stability Law, improving the financial safety net and guarding against moral hazards. The rescue plan of U.S. regulatory authorities in this crisis has been controversial internationally and will affect future financial regulation reforms in the U.S. and globally. Establishing a contingency plan for financial risk disposal and a market-oriented exit mechanism for financial institutions helps break the "too big to fail" and government bailout expectations, reducing moral hazards. At the same time, the role of the financial stability guarantee fund should be fully utilized to prevent the transfer of losses and costs in the risk disposal process to public funds. (Enditem)
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