Silicon valley bank crisis: reasons and impacts - explained, pointwise

General Studies Paper 3

Context: Recently, the California-based Silicon Valley Bank (SVB), a cornerstone of the US technology and startup industries, has failed. This marks the biggest bank failure since the 2008 financial crisis. The Silicon Valley Bank crisis has resulted in the subsequent seizure of SVB assets by regulators has generated a global wave of risk aversion, particularly among start-ups, including Indian startups.

About the Silicon Valley Bank Crisis

• After a period of record low-interest rates during the pandemic, central banks around the world, led by the US Federal Reserve, started raising key rates aggressively to tackle inflation. This has dampened investor sentiments
• This is because investors do not like to take risks when the money available to them becomes expensive due to higher interest rates. As a result of the higher interest rates, investors in technology start-ups became reluctant to take risks.
• As higher interest rates led to a funding crunch for technology start-ups, SVB’s clients started pulling out their money to meet their liquidity needs.
  Under this pressure to meet customer withdrawals, SVB sold a $21 billion portfolio consisting mostly of US Treasuries at a huge loss of $1.8 billion.
• Moody’s immediately downgraded the bank’s credit rating to Baa1 negative outlook from A3.
• This was followed by further losses to SVB. To fill this loss, SVB announced it would sell $2.25 billion in common equity and preferred convertible stock. This sudden announcement triggered concerns about its balance sheet and its shares plummeted 60%.
• SVB also failed to find alternative sources. Hence, it ended up being shut down by regulators, following which it was handed over to the FDIC.
• The FDIC has added that it would seek to sell SVB’s assets, adding that future dividend payments may be made to uninsured depositors.

What is the reason behind Silicon Valley Bank Crisis? 

Aggressive raising interest rates:

• Global borrowing costs have risen at the fastest pace in decades over the last year as the Federal Reserve lifted U.S. rates by 450 basis points from near zero, while the European Central Bank hiked the eurozone by 300 bps.
• Due to this, the value of existing bonds that were issued at lower interest rates has fallen. Banks, which bought these bonds are sitting on steep unrealised losses.
  Another facet of the rising interest rates was the decline in funding for startups as the venture capital ecosystem don’t want to take risk.
• Heavy investment in long-term government bonds: SVB’s invest heavily in US government bonds. A spike in interest rates has led to a sell-off in bonds, leaving banks exposed to potential losses on the securities they hold.
• A downturn in technology stocks: Silicon Valley Bank was hit hard by the downturn in technology stocks over the past year.
  “Run on the bank”: The bank failed after depositors — mostly technology workers and venture capital-backed companies — began withdrawing their money in panic, creating a “run on the bank”.
• Soft Regulations: In 2018, regulations were loosened for regional banks like SVB – among other things, it reduced the amount of potential loss reserves mandated for these banks.

What will be the potential impact of the Silicon Valley Bank Crisis on the World Economy?

• Impacts on small businesses: According to a petition to the US government, around 10,000 small businesses with accounts in Silicon Valley Bank may be unable to pay their employees in the next 30 days, and approximately 1 lakh jobs are anticipated to be affected as a result of the collapse.
• Impact the technology industry: It will immediately impact the US technology industry and US competitiveness worldwide and ultimately set back US competitiveness by a decade or more.
• Can trigger a run on the bank: Its collapse has already instilled fear among founders and management teams to look for safer havens for their remaining cash, which can trigger a bank run on every other smaller bank.
• Vulnerability to the rising cost of money: The SVB crisis spread concern about hidden risks in the banking sector and its vulnerability to the rising cost of money.

What will be the potential impact of the SVB Crisis on India? 

According to some experts, India is unlikely to be affected by any contagion effects. This is because:

• Indian banks have minimal exposure to US lenders.
• In its 2022 Financial Stability Report (FSR), the Reserve Bank of India (RBI) said that macro-level stress tests for credit risk showed that domestic banks would be able to comply with minimum capital requirements even under severe-stress scenarios.
• Improved capital-to-risk-weighted-assets ratio (CRAR): The system-level CRAR in 2023, under baseline, medium and severe stress scenarios, is projected at 14.9%, 14% and 13.1%, respectively, the RBI said.

Note: The minimum regulatory requirement for CRAR for scheduled commercial banks is 9%. Adding on a counter-cyclical buffer, the requirement is 11.50%.

• Improvement in NPA: Banks have stepped up efforts to clean up asset quality and their profitability has also improved. Further, gross NPAs were at a seven-year low of 5% as of September 2022.
• The increase in the 10-year yield has been less than the policy rate hikes by the RBI.
• Banks have sharply reduced the modified duration of their bond portfolios over the last six years, according to the latest RBI data.

Note: Modified duration refers to the change in the value of a bond when interest rates change. The higher the modified duration of the bond portfolio, the more the risk of incurring losses when bond yields rise.

Benefits for the Indian economy from the SVB crisis:

• Boom for emerging markets: A fall in US bond yields typically improves the appeal of higher-yielding fixed-income assets in emerging markets.
• Bring corporates back to India: Falling US dollar rates coupled with SVB Crisis might bring back big corporates in India, who had shifted to overseas lending due to depreciation in Indian National Rupee (INR) against the US dollar.”

Impacts on Indian start-ups:

• Most of the named Indian startups got money from SVB, they are not depositors. SVB either lent them money (as venture debt) or invested in them in the form of equity. It realised its profits via a sale or got repaid by the companies, depending on the structure. Therefore, there is no impact on the start-ups themselves.
• However, some start-ups with deposits in SVB are impacted. For example, among its most notable funding was an investment of a total of $1.7 million in One97 Communications, the parent company of Paytm. Other start-ups that had received funding from SVB include Bluestone and Carwale.

What should be done to prevent big bank failures? 

• Maintain constant vigil: All the stakeholders, including bank boards, auditors and the regulator have to maintain constant vigil, given the high stakes for safety and stability.
• Indian banks should keep capital as measured under the current Basel regime (international standards set by bank regulators).
• Ensure Cooperation and coordination: Cooperation and coordination among all central banks will be helpful in bringing transparency and accountability and also help in minimising the spillover effect of bank failure.
• Ensure proper selection: The selection of the board of directors has to be prudent. The auditors’ selection has to be done with care.
• Board members of banks usually spend most of their meeting time on governance issues, business updates, and “problem children.” They should focus instead on the businesses that use the most capital.

Strict actions from central banks: The central bank has to continuously monitor the lending institutions on various parameters including fit and proper. While supervising the banks, the Central bank should not avoid any loopholes in the management and should take strict action against them.