Black Swans appear without any warning. Predicting a black swan is akin to predicting the day of judgment. When the inevitable financial meltdown happens, one wouldn’t need to scream from a pulpit to make everyone aware; its effects would be felt all around us. Yet there are some people whose business it is to forewarn us of the consequences of the inevitable financial crisis, and others who profit from the loss of the unfortunate like vultures.
In the United States, interest rate hikes are the new enemy. Institutional investors and banks alike are losing money on their balance sheets because they bought government bonds when the rates were near zero percent. Any rate hike by the Federal Reserve means the price of the 10 year and 30 years treasuries decreases. This is what in a nutshell triggered the failure of Silicon Valley bank just last month.
Silicon Valley Bank had a windfall of deposits during the pandemic; its deposit base tripled between 2020 and 2022 to almost $200 billion. The bank wanted to play it safe and invested most of its deposits in Treasuries. The longer dated a government bond, the higher the return it gives. A 3-month, or even 3-year government bond did not vet the appetites of decision makers at SVB, so the executives at the bank chose bonds maturing in 10 to 30 years. Treasuries are risk-less assets because the chances of the US government defaulting on its liabilities are slim to none. However, the risk department at SVB did not foresee durational risks associated with these ‘safe’ bonds which we’ll come back to later.
After the pandemic, the United States had been facing supply shocks because of supply-chain disruptions which have since been exacerbated by the Russian invasion of Ukraine and the trade war with China. To add on to this, unemployment in the United States is at a record low and as of now there are twice the number of open jobs as there are unemployed people. This results in a phenomenon called supply-side inflation. Further, to combat the pandemic back in 2020, Biden’s administration decided to dole out massive amounts of money to individuals and businesses. This might have given people and small businesses a much-needed cushion, but it increased the money supply in the economy. All these factors have led to spiraling inflation in the last two years.
Governments and central banks combat inflation via monetary policy or via fiscal policy – sometimes through a combination of both. Fiscal policy means raising taxes which is highly unpopular. Monetary policy entails using the benchmark interest rate of the central bank as a lever to control spending in the economy and the purchase of financial assets in the open market to again spur activity in the economy. Most western governments have been solely focusing on increasing economic activity after the Great Recession of 2008 until the rising cost of living became a bane for voters spread across Western metropolises.
In the mid of March 2022, the Federal Funds Rate was at 0.25%. In the middle of March this year that rate was at 5%. The Federal Reserve was compelled to raise the rate by almost 5% in such a short timespan to combat surging inflation and as job reports show its work is still not done on this front. What happens when rates rise so furiously though is that there is a real risk of recession and loss of productivity in the economy. This is a dilemma that all central banks face: on the one side prevent the economic engine from overheating, and on the other hand make sure the engine keeps on running smoothly.
The Federal Reserve under Jeremy Powell had been so focused on fighting inflation that it did not pay due attention to the real financial risks associated with rising rates, which is bank failures. In the modern day, bank runs are an unheard-of phenomenon, but this is exactly what happened at Silicon Valley Bank. The problem at SVB was that its depositors’ base was too narrow, with the bank servicing primarily start-up and venture capital funds in the business of providing money to those very start-ups. When tech companies faced a downturn and started to withdraw money to cover losses, the bank realized it did not have enough cash in its coffers to cover all the withdrawals since all its holding were tied up in Treasuries.
Executives at SVB made two major mistakes with their depositors’ money: one, they did not diversify and put almost all those deposits in Treasuries; second, they did not appreciate the durational risk associated with Treasuries. It is true that unless the world goes topsy turvy, the US government will not default on its bonds, but any savvy investor must understand that over time, the price of those US Treasuries will fluctuate according to the Fed’s rates. Unlike the executives at SVB, majority of its customers were very financially savvy and once news broke out that SVB was selling its bonds at a loss and was divesting some of its equity to raise money for withdrawals, panic broke out amongst these fickle depositors and in a matter of hours they took out almost $41 billion on March 10 – almost 25% of the bank’s deposits – a new cell-phone era bank run which no bank can survive. The FDIC took over the bank the next day and gave a guarantee that all depositors would get their money back.
The Federal Deposit Insurance Corporation generally ensures bank deposits up to $250,000, but it gave a blanket guarantee to all depositors to make sure there are no other bank runs because majority of the banks in the United States are small regional banks – a vestige of the pre–Great War world when banks weren’t allowed to operate across state lines. All these banks individually might not be that important but all of them collapsing at the same time present a systematic risk to the economy. Like SVB, most of their depositor base is narrow, confined mainly to the local community around the bank. As of now, it is premature to talk about the financial condition of individual banks but as the closure of Signature Bank right after SVB and problems at the First Republic Bank show this crisis is far from over.
Even if these regional banks continue to function, they will start hoarding money instead of lending it out of fear of a SVB kind of situation. Large corporations in the United States raise money through capital markets, but the majority of households and SMEs in the US rely on their local banks to provide them with liquidity. The collapse of SVB has instilled fear in other smaller banks and they will be hesitant in lending money, which would lead to a credit crunch, and a credit crunch in main-street America would inadvertently lead to a recession, but this will be a strange recession because not only will the economy be contracting, because of a lack of credit but supply side problems will continue to persist, thus mothballing inflation further and the Federal Reserve would be stuck been a rock and a hard place. If it continues to raise rates to firefight the rising cost of living, the credit crunch will get worse, and more banks will fail. If it does not raise rates, then the USD will continue to lose its value and sustained inflation over the long run will harm the US economy more than a temporary rise in rates.
Rising inflation, along with a slowing economy is known as stagflation – what happened in most Western economies in the 1970s because of the oil price shock. However, at that time the USA’s debt to GDP ratio was at 100%, now it’s over 750%. The core problem in the country is too much debt – both private and sovereign. Now, the trilemma the policymakers in the United States face is how to manage inflation, a slowing economy, and a bank crisis. This will be a test of nerves and any wrong decision will lead to economic conditions worse than they were during the Great Depression.
After the pandemic, the United States had been facing supply shocks because of supply-chain disruptions which have since been exacerbated by the Russian invasion of Ukraine and the trade war with China.
In the United States, interest rate hikes are the new enemy. Institutional investors and banks alike are losing money on their balance sheets because they bought government bonds when the rates were near zero percent. Any rate hike by the Federal Reserve means the price of the 10 year and 30 years treasuries decreases. This is what in a nutshell triggered the failure of Silicon Valley bank just last month.
Silicon Valley Bank had a windfall of deposits during the pandemic; its deposit base tripled between 2020 and 2022 to almost $200 billion. The bank wanted to play it safe and invested most of its deposits in Treasuries. The longer dated a government bond, the higher the return it gives. A 3-month, or even 3-year government bond did not vet the appetites of decision makers at SVB, so the executives at the bank chose bonds maturing in 10 to 30 years. Treasuries are risk-less assets because the chances of the US government defaulting on its liabilities are slim to none. However, the risk department at SVB did not foresee durational risks associated with these ‘safe’ bonds which we’ll come back to later.
After the pandemic, the United States had been facing supply shocks because of supply-chain disruptions which have since been exacerbated by the Russian invasion of Ukraine and the trade war with China. To add on to this, unemployment in the United States is at a record low and as of now there are twice the number of open jobs as there are unemployed people. This results in a phenomenon called supply-side inflation. Further, to combat the pandemic back in 2020, Biden’s administration decided to dole out massive amounts of money to individuals and businesses. This might have given people and small businesses a much-needed cushion, but it increased the money supply in the economy. All these factors have led to spiraling inflation in the last two years.
Governments and central banks combat inflation via monetary policy or via fiscal policy – sometimes through a combination of both. Fiscal policy means raising taxes which is highly unpopular. Monetary policy entails using the benchmark interest rate of the central bank as a lever to control spending in the economy and the purchase of financial assets in the open market to again spur activity in the economy. Most western governments have been solely focusing on increasing economic activity after the Great Recession of 2008 until the rising cost of living became a bane for voters spread across Western metropolises.
In the mid of March 2022, the Federal Funds Rate was at 0.25%. In the middle of March this year that rate was at 5%. The Federal Reserve was compelled to raise the rate by almost 5% in such a short timespan to combat surging inflation and as job reports show its work is still not done on this front. What happens when rates rise so furiously though is that there is a real risk of recession and loss of productivity in the economy. This is a dilemma that all central banks face: on the one side prevent the economic engine from overheating, and on the other hand make sure the engine keeps on running smoothly.
The majority of the banks in the United States are small regional banks – a vestige of the pre–Great War world when banks weren’t allowed to operate across state lines. All these banks individually might not be that important but all of them collapsing at the same time present a systematic risk to the economy.
The Federal Reserve under Jeremy Powell had been so focused on fighting inflation that it did not pay due attention to the real financial risks associated with rising rates, which is bank failures. In the modern day, bank runs are an unheard-of phenomenon, but this is exactly what happened at Silicon Valley Bank. The problem at SVB was that its depositors’ base was too narrow, with the bank servicing primarily start-up and venture capital funds in the business of providing money to those very start-ups. When tech companies faced a downturn and started to withdraw money to cover losses, the bank realized it did not have enough cash in its coffers to cover all the withdrawals since all its holding were tied up in Treasuries.
Executives at SVB made two major mistakes with their depositors’ money: one, they did not diversify and put almost all those deposits in Treasuries; second, they did not appreciate the durational risk associated with Treasuries. It is true that unless the world goes topsy turvy, the US government will not default on its bonds, but any savvy investor must understand that over time, the price of those US Treasuries will fluctuate according to the Fed’s rates. Unlike the executives at SVB, majority of its customers were very financially savvy and once news broke out that SVB was selling its bonds at a loss and was divesting some of its equity to raise money for withdrawals, panic broke out amongst these fickle depositors and in a matter of hours they took out almost $41 billion on March 10 – almost 25% of the bank’s deposits – a new cell-phone era bank run which no bank can survive. The FDIC took over the bank the next day and gave a guarantee that all depositors would get their money back.
The Federal Deposit Insurance Corporation generally ensures bank deposits up to $250,000, but it gave a blanket guarantee to all depositors to make sure there are no other bank runs because majority of the banks in the United States are small regional banks – a vestige of the pre–Great War world when banks weren’t allowed to operate across state lines. All these banks individually might not be that important but all of them collapsing at the same time present a systematic risk to the economy. Like SVB, most of their depositor base is narrow, confined mainly to the local community around the bank. As of now, it is premature to talk about the financial condition of individual banks but as the closure of Signature Bank right after SVB and problems at the First Republic Bank show this crisis is far from over.
Even if these regional banks continue to function, they will start hoarding money instead of lending it out of fear of a SVB kind of situation. Large corporations in the United States raise money through capital markets, but the majority of households and SMEs in the US rely on their local banks to provide them with liquidity. The collapse of SVB has instilled fear in other smaller banks and they will be hesitant in lending money, which would lead to a credit crunch, and a credit crunch in main-street America would inadvertently lead to a recession, but this will be a strange recession because not only will the economy be contracting, because of a lack of credit but supply side problems will continue to persist, thus mothballing inflation further and the Federal Reserve would be stuck been a rock and a hard place. If it continues to raise rates to firefight the rising cost of living, the credit crunch will get worse, and more banks will fail. If it does not raise rates, then the USD will continue to lose its value and sustained inflation over the long run will harm the US economy more than a temporary rise in rates.
Rising inflation, along with a slowing economy is known as stagflation – what happened in most Western economies in the 1970s because of the oil price shock. However, at that time the USA’s debt to GDP ratio was at 100%, now it’s over 750%. The core problem in the country is too much debt – both private and sovereign. Now, the trilemma the policymakers in the United States face is how to manage inflation, a slowing economy, and a bank crisis. This will be a test of nerves and any wrong decision will lead to economic conditions worse than they were during the Great Depression.