The downfall of several U.S. banks over the past two years, particularly Silicon Valley Bank (SVB), Signature Bank, and First Republic Bank, provides a detailed case study of the intersection of regulatory oversight, economic pressures, and sector-specific vulnerabilities. This period of instability in the banking sector showcases how systemic risks can quickly escalate when a combination of macroeconomic shifts and internal mismanagement collide.
Causes of Bank Failures
The most significant catalyst for the collapse of these banks was the aggressive interest rate hikes initiated by the U.S. Federal Reserve beginning in 2022. In an effort to combat rising inflation, the Federal Reserve raised interest rates at an unprecedented pace, the fastest in decades. While this helped control inflation, it had a detrimental effect on banks that had significant investments in long-term, low-interest government bonds. As interest rates surged, the market value of these bonds plummeted, leaving banks like SVB with substantial unrealized losses. For Silicon Valley Bank, this situation became untenable due to its exposure to the technology and venture capital sectors. SVB had amassed large portfolios of bonds and other assets at lower interest rates and was heavily reliant on deposits from tech startups. When these sectors slowed in 2022, startups began withdrawing funds, leading to a liquidity crisis. SVB’s inability to sell its assets without incurring major losses triggered a panic, resulting in a rapid run on the bank.
A similar scenario unfolded with Signature Bank, which also experienced large deposit withdrawals after the collapse of SVB. Signature was particularly vulnerable because a high percentage of its deposits were uninsured, meaning they exceeded the Federal Deposit Insurance Corporation’s (FDIC) $250,000 limit. Once depositors began pulling funds, Signature, with heavy exposure to real estate and cryptocurrencies, could not meet the liquidity demands, leading to its failure in March 2023. The speed at which digital banking allows depositors to withdraw funds exacerbated the situation for both SVB and Signature Bank, as the withdrawal of deposits occurred at an unprecedented pace.
Let us understand the fall of the banks using a metaphorical play
Regulatory and Risk Management Failures
The rapid failure of these banks exposed significant gaps in risk management, particularly regarding interest rate risks and depositor behavior. None of these institutions had hedged adequately against rising interest rates, leaving them vulnerable as the Federal Reserve’s tightening policies took hold. Moreover, their reliance on niche customer bases – tech startups in the case of SVB, and cryptocurrency firms and real estate in the case of Signature – heightened their exposure to sector-specific downturns. In each case, poor diversification compounded their problems.
Another key issue was the high proportion of uninsured deposits. In SVB’s case, nearly 90% of deposits were uninsured, making the bank extremely vulnerable to runs when customers began to lose confidence. Similarly, Signature Bank and First Republic Bank also had significant levels of uninsured deposits. As these banks faced liquidity crunches, the uninsured depositors had no incentive to keep their funds in the institutions, further deepening the crisis.
Regulatory oversight has also come under scrutiny in the wake of these collapses. Critics argue that many mid-sized banks like SVB and Signature were not subjected to the same rigorous stress tests and capital requirements as larger, systemically important institutions. This was partly due to regulatory rollbacks under the Economic Growth, Regulatory Relief, and Consumer Protection Act of 2018, which eased some of the post-2008 financial crisis requirements for smaller banks. These reduced requirements meant that institutions like SVB were not fully prepared to withstand the shock of rising interest rates and sudden liquidity demands.
The Post Collapse Period
In response to the bank failures, U.S. regulators acted swiftly to contain the fallout. The FDIC took over both SVB and Signature Bank to protect depositors and ensure continuity of services. Perhaps most notably, the U.S. government guaranteed all deposits at these banks, including those above the FDIC-insured limit, to prevent further panic and stop the contagion from spreading to other regional banks. This move was critical in restoring confidence in the broader financial system.
The Federal Reserve also introduced the Bank Term Funding Program (BTFP), which allowed banks to borrow funds using their bond portfolios as collateral. This program was designed to ease the liquidity crunch without forcing banks to sell their securities at a loss, thereby preventing further destabilization in the banking sector.
Learnings
The downfall of SVB, Signature Bank, and First Republic Bank reveals important lessons for both the banking industry and regulators. The first is the critical importance of risk management, particularly in an environment of rising interest rates. These banks underestimated the impact of rate hikes on their bond portfolios and failed to hedge against these risks adequately. Additionally, the collapse underscores the dangers of having a highly concentrated depositor base, particularly when most deposits are uninsured. In times of crisis, these depositors are likely to flee quickly, creating a self-reinforcing cycle of liquidity stress.
The case also points to the need for stronger regulatory frameworks for mid-sized banks. While not considered “systemically important” like the largest U.S. banks, these institutions still play a vital role in the economy and can trigger significant market disruption when they fail. Stricter capital and liquidity requirements, as well as more frequent and robust stress testing, may help prevent similar failures in the future.
In conclusion, the recent downfall of several U.S. banks serves as a stark reminder of how quickly economic pressures, compounded by regulatory gaps and poor risk management, can lead to financial instability. The failure of SVB, Signature Bank, and First Republic Bank was not an isolated incident but rather a consequence of deeper vulnerabilities within the banking system, highlighting the need for continued vigilance and reform in financial oversight.