Banking is by nature dangerous as depositors lend banks their cash and banks make investments the cash by buying belongings. Banks “borrow quick” (from depositors) and “lend lengthy” (for instance, dwelling mortgages and enterprise loans). Lengthy-term lending carries default threat, failure to repay, and interest-rate threat, the autumn in an asset’s worth when rates of interest improve.
Think about you obtain a $100,000 30-year Treasury bond in 2020 with a median annual curiosity yield of 1.56%. (This was the precise common). Now assume you wanted to promote the bond in Could 2023. How a lot would you get for it? Solely $63,848.50, since rates of interest had risen to three.7%, making the 1.56% bond unattractive to patrons. To promote the bond, you will need to drop its worth.
SVB introduced losses on its bond investments on March 8 and phrase unfold rapidly on social media, sparking the financial institution run. The financial institution run required it to promote its belongings, and lots of have been long run. When the worth of belongings falls in need of a financial institution’s deposit liabilities and a run happens, chapter follows. Furthermore, the vast majority of SVB’s deposits exceeded the $250,000 insurance coverage restrict.
Why did SVB make such poor asset investments? First, the only clarification is that the portfolio managers have been inexperienced or just silly.
Second, and maybe extra possible, to draw and maintain multimillion-dollar money depositors, the financial institution needed to pay a horny rate of interest. As a result of the Fed held short-term rates of interest close to zero till Could 2022, the one solution to entice these jumbo accounts was to go “lengthy” on investments since long-term belongings usually pay larger rates of interest.
Third, the banks’ threat managers could have foolishly believed the Fed’s steerage that it might maintain inflation to a median fee of two%. If the Fed might obtain that objective, long-term rates of interest would stay low and secure.