In 2017, Mark Carney told us bank failures were a thing of the past. Sadly, in the last couple of weeks, we’ve seen the collapse of five banks, including SVB… the second biggest bank failure in US history. It seems the idea that bank failures are a thing of the past is itself a thing of the past.

In this article, I’ll look at the collapse of SVB. Next month, I’ll address the question of how much we need to worry about more banks collapsing.

This isn’t a story of greedy bankers, but of shifting goal posts

The context is, of course, the Financial Crisis of 2007/8.

This “revealed substantial weaknesses in the banking system and the prudential framework, leading to excessive lending and risk-taking unsupported by adequate capital and liquidity buffers.” From now on, a holding of adequate low-risk collateral would be the name of the game. And what could be lower risk than government bonds?

In September 2019, BNY Mellon described US government Treasury Bills as “the ultimate risk-free assets”. As such, they were the apex of global collateral and securities finance. Everything seemed to be going very well.

Then, the pandemic struck, lockdowns were imposed, and there was a huge monetary expansion. To some, including me, inflation looked inevitable. That, in turn, meant interest rates would have to rise.

Now, when interest rates rise, the price of bonds falls.

This doesn’t really matter if you hold your bond to maturity; you’ll still get your initial stake back. However, if you want to sell your bonds, the price you get depends on the interest rate prevailing at the time. If the rate is higher than when you purchased the bond, you’ll have to sell at a loss.

Unfortunately, the central banks didn’t see inflation coming. And when it came, they compounded the error by misdiagnosing it as “transitory”.
Indeed, in June 2020, Jerome Powell, chairman of the US Federal Reserve, went so far as to say: “We’re not thinking of raising interest rates, we’re not even thinking about thinking about raising interest rates.” In other words, if you are a bank, don’t worry; the value of the government bonds in your collateral is rock solid.

The banks were reassured and carried on as normal. Unfortunately, Powell was wrong. Very wrong.

A bank’s collateral is structured in a specific combination of long-term, and short-term assets. Each has a range of acceptable usage defined by the regulator. Long-term assets are valued at maturity, but short-term are “marked to market”: valued at the current market price.

If a bank faces liquidity problems, it will have to transfer some of its designated long-term assets into its liquid account.

Until the Bank Term Funding Program was unveiled on 12 March, collateral for the liquid account was always “marked to market”. So if interest rates have risen, any bank transferring assets from long-term to the liquid account will suffer an immediate paper loss; the value of its collateral automatically falls.

On 9 March a Venture Capital newsletter questioned the SVB balance sheet. This precipitated a bank run at Twitter speed. Colossal amounts of money were withdrawn from the bank via smartphone apps. SVB was forced to sell off huge numbers of government bonds at a gigantic loss. From this point on, the collapse was inevitable.

Remember, this isn’t a story of greedy bankers committing fraud, or making silly investments in opaque high-risk assets.

No, the scene was set when the authorities failed properly to consider the implications of rising interest rates on banks’ collateral.

There are many eventualities in the economy the authorities cannot reasonably be expected to foresee. The effect of rising interest rates on the bank’s collateral is not one of those eventualities.

However, in the UK at least, we’ve had a happy ending. SVB UK was ring-fenced; it was therefore possible to sell as a self-contained entity. Over the weekend of 11/12 March, a deal was brokered with HSBC. The importance of the deal cannot be overstated. You know what percentage of UK venture capital funded firms banked with SVB? 50%.

If the deal hadn’t been done, the morning of 13 March would have seen many companies going into administration. What kind of companies? I leave you with the words of Dan Mahony, chairman of the BioIndustry Association.

“We would have lost companies working on such things as a novel treatment for cystic fibrosis; a novel lung cancer drug; a new ovarian cancer drug; and a completely new approach to drug discovery to tackle the toughest types of cancer. Together they have the potential to cure millions of patients in the coming years.”

Peter Lawlor is the Principal Economic Advisor to 7Ridge Capital and an adviser to senior Wall St figures. These are strictly his own views