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The Fall of SVB Bank, Signature Bank - What Makes Banks Fail?
SVB was the first to fail on Friday, March 10th 2023, becoming the largest bank failure since the 2008 financial crisis. The size of the Bank is nearly USD 200 billion (nearly the size of HDFC Bank). SVB invested the majority of its funds in Long Term Government Bonds. When US Federal Reserve (similar to the RBI in India) raised interest rates by nearly 5% in the past one year, the value of long term bonds invested by SVB deteriorated. Majority of its clients are startups. These startups started withdrawing funds due to funding winter. To honor the withdrawal by startups, SVB had to sell these bonds at a loss of USD 1.8 billion. But this loss did not cause the collapse. Collapse happened when SVB announced that it needed to raise USd 2.25 billion to shore up its capital. This announcement led to Bank run which led to the collapse.
Signature Bank with balance sheet size of USD 100 Billion was the next to fall on Sunday, March 12th, ranking as the third-largest bank failure in U.S. history. Signature had a cryptocurrency business. While Signature didn’t have loans backed by cryptocurrencies or hold cryptocurrencies on its balance sheet, it had a payment platform for processing crypto transactions. But deposits associated with the crypto platform had been dropping, with the fall in crypto prices in the last one year. While this was not a big concern, collapse of SVB led to Bank run on Signature also which led to its collapse.
What Makes Banks Fail?
A Bank’s business model typically involves taking money in the form of deposits and giving the same in the form of loans to the public. Business model of a Bank is by default fragile as a Bank has an obligation to payback majority of liabilities as and when demanded. These liabilities are in the form of deposits from the public. More obligations means more fragility in the business model.
Both SVB and Signature Banks collapsed due to Bank run i.e. majority of depositors of these Banks have demanded for their money.
While a business model of a Bank is fragile, Banks at the same time are critical for an economy as they mobilize capital from depositors and lend the same to Borrowers which is in turn is deployed for setting up new businesses, capex, etc which in turn contribute for employment generation, economic development, etc. The other alternative to saving money in a Bank is keeping money in a safe locker which was the norm many decades ago. Money in a safe locker does not contribute to the economy.
To build trust in the Banking system, Governments & Central Banks across the world introduce various measures. For example FDIC insures deposits upto USD 2,50,000 in USA i.e. depositors receive back money upto USD 2,50,000 even if a Bank collapses. Similarly, in India, Deposit Insurance and Credit Guarantee Corporation (DICGC), which is a fully owned subsidiary of the Reserve Bank of India, insures deposits upto Rs 5 lakhs per depositor.
Apart from Bank run, there are other risks which a Bank faces. Some of these are:
As explained above, a Bank takes money from depositors and lend the same to various Borrowers. What if Borrowers do not pay back the money? Then a Bank will not be able to pay back depositors. To mitigate this, a Bank needs to maintain % of liabilities in the form of Equity Capital. Equity Capital is shareholders money and is a lability which a Bank is not obligated to pay back unlike depositors money. The minimum capital to be maintained depends on the riskiness of the lending i.e. if a Bank lends to risky borrowers, then the capital requirements increase. Further, RBI mandates Banks to invest part of depositors money in safe instruments like SLR and CRR.
A Bank takes money from depositors at a lower interest rate say 4% and lends to borrowers at a higher interest rate of say 6%. The difference of 2% is the profit earned by a Bank. The collapse of SVB started due to loss incurred in its long term bonds due to an abrupt increase in interest rate by the Federal Reserve. To mitigate this risk, RBI introduced MCLR linked lending and Repo linked lending which better manages this risk as compared to earlier benchmark rates of Base rate or PLR based lending.
Loss incurred by PNB due to Nirav Modi fraud is primarily an operational risk. Details can be found in this economic times article How Nirav Modi cheated PNB of Rs 14,000 crore through fraudulent LoUs. Other forms of operational risk are accidentally sending Rs 10 Crs instead of Rs 1 Cr requested by the customer due to manual entry error. Each Bank continuously works towards identifying and mitigating such risks. Central Banks regularly audit Banks to identify such risks.
A depositor generally opens a deposit for 1 to 2 years. Whereas a Borrower takes a loan for 5 to 7 years. Further, a depositor might deposit only Rs 1 to 2 lakhs whereas a borrower might take a loan of few Crores, This mismatch is ALM risk. Banks have dedicated teams to monitor and mitigate this risk.
Investors Point of View
Even if we are aware of these various risks, the difficulty an investor faces is that these risks cannot be easily identified/measured by analyzing financial statements of a Bank. SVB and Signature Banks had Buy ratings by the majority of equity analysts prior to both Bank’s collapsing.
While many Banks have been wealth creators for their shareholders and many Banks will continue to be wealth creators, an investor should be aware that there are always unmeasurable risks involved.
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