Just as it seemed the world had come to terms with a certain level of uncertainty that was triggered last year by the US Fed tightening monetary policy, the Russia-Ukraine war and the Covid resurgence in China, a new source of uncertainty sprang up over the last few days—financial stability concerns in the US economy as manifested through the collapse of the Silicon Valley Bank (SVB). The shock reverberated through the US stock market with shares of several banks plunging. Some European banks have begun experiencing steep losses in share prices as well. For India, the relevant questions are: can something like this happen here, and what lessons can we learn from this saga?
Several analysts and commentators in India have written extensively about this episode. The general consensus seems to be that, thanks to the business model of Indian banks, the regulatory oversight of the RBI, relatively gradual monetary tightening in India compared to the US, and careful management of the yield curve by the RBI, an event like this is unlikely to occur in Indian banking.
While that may be true, this episode nonetheless offers some important lessons for Indian banking and its regulation.
Market risk in banks: This episode is a rare one where a bank collapsed due to market risk and not credit risk i.e. not due to a rise in non-performing loans, something we have witnessed frequently in India. The total marked to market losses that US banks are currently sitting on owing to the fall in the value of the government bonds in their portfolios, are estimated to be $600 billion on a capital base of $2 trillion, thereby implying that market risk has eroded about 30% of the capital base of US banks. Generally, In India we do not pay adequate attention to market risk in banks. But banks are steadily increasing their holding of bonds (see here: https://www.moneycontrol.com/news/opinion/why-banks-are-buying-more-bonds-6139661.html) which enhances their exposure to market risk. It is high time we started looking at this risk carefully.
Swift resolution: It was remarkable to see the speed with which the authorities acted to resolve the SVB crisis. Within a matter of days, the Fed and the FDIC (Federal Deposit Insurance Corporation) stepped in, evaluated the situation, and reopened the bank under a modified name. The bank is now being auctioned off and will be sold shortly. FDIC also publicly announced that they would bail out all the depositors.
Quick action is critical in the resolution of financial entities to restore public confidence, and prevent a contagion. It requires clearly laid-out laws, and protocols and also institutions empowered to implement them. Else, each resolution is dealt with on a sui generis basis and could lead to inefficient outcomes as is often the case in India. While we now have a bankruptcy law for non-financial companies, we do not yet have a well-defined law for resolution of financial entities. It is also important to note that the FDIC followed the expected pecking order of loss absorptions – they wiped out equity holders, followed by bond holders and saved the depositors. Contrast this with the Yes Bank resolution in India where AT1 bond-holders were written down before equity.
Moral hazard: One action taken by the FDIC however may offer lesson of what not to do. They announced that they would bail out not only the 7% secured depositors, but also the uninsured depositors.
In case of a bank failure, deposit insurance is meant to safeguard the deposits of small investors. Large depositors whose deposits are beyond the threshold stipulated in the deposit insurance schemes ($2,50,000 in the case of SVB) are expected to be “informed” depositors who should take into account the robustness of the bank before making a deposit. Such depositors are expected to bear the risk of the bank defaulting. Bailing out these depositors as if they were insured, creates a “moral hazard” problem. It creates expectations among the uninsured depositors of similar institutions that they too will be bailed out if such a situation arises. It generates an illusion of implicit government guarantee for all depositors.
Age of social media: As the depositors started shifting out of the bank, SVB had to sell some of its bonds to repay them, but in doing so it incurred losses since the bonds had lost value with rising interest rates. The size of this loss and the potential for future losses in relation to its capital doomed the bank and created the perfect recipe for a “bank run”. Once panic spread in social media about the bank’s stability, this ensured that the run happened very quickly, before the bank or the authorities had any time to react. Some commentators have rightly called it a “Twitter” driven collapse. This exposes the vulnerability of banks to such attacks in the era of social media.
Over and above these lessons for Indian banking, this episode has once again brought to focus the old issue of the trade-off between price stability and financial stability, and how should central banks deal with this. The roots of the SVB collapse lie in the policy decisions taken during the pandemic, when the US Fed first injected abundant liquidity into the system, and then aggressively raised interest rates to fight inflation.
The crucial question therefore is: should a monetary authority (for example, the Fed or the RBI) take financial stability into account when setting its monetary policy or be guided by the mandated objectives of inflation control and economic growth? The SVB episode is likely to reignite the debate on this issue.
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