Banking Crisis – A Tale of Interest Rates & Depositor Diversification

April 1, 2023

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Banking Crisis: A Tale of Interest Rates and Depositor Diversification

Over the past month, the financial world has been shaken by the collapse of three major banks: Silvergate, Silicon Valley Bank (SVB), and Signature Bank. Unlike the 2008 financial crisis, this time around, the root causes are record interest rate hikes and a lack of depositor diversification.

How Record Rate Hikes Hurt the Banks

Silvergate, SVB, and Signature Bank experienced surges in deposits due to their connections to rapidly-growing industries like crypto and venture capital. SVB, for instance, tripled its balance sheet between late 2019 and early 2021. But the timing wasn’t ideal.

Flush with cash, the banks had to find something to do with it when “safe” assets like government bonds were at record-high prices. This was a result of the Fed cutting interest rates to stimulate the economy during the Covid pandemic.

SVB heavily invested in long-dated treasuries and mortgage-backed securities, only to see the Fed implement its largest rate-hiking campaign against inflation in four decades. As rates rose in 2022, the value of SVB’s bond portfolio plummeted.

When SVB had to sell $1.8 billion worth of bonds at a loss to meet withdrawal requests, investors realized that other banks might also be in trouble due to large bond holdings purchased during low-rate pandemic times. Estimates suggest that U.S. banks have over $600 billion in unrealized losses on bond holdings.

Depositor Diversification: A Crucial Misstep

Somebody holding a bitcoin
Silvergate and Signature’s overinvestment in crypto was a strong factor in their collapse

Silvergate and Signature were overexposed to crypto firms. When the crypto business boomed in 2021, these banks profited. However, as the Fed raised interest rates, the opportunity cost for owning speculative digital assets increased, since investors could get guaranteed 4-5% returns on government bonds.

This wiped out trillions of dollars in market value for digital assets and forced many crypto companies to spend down their cash balances held at these banks. In turn, the banks had to sell assets to provide depositors with their money.

For SVB, it faced a similar situation with venture capital (VC) firms. Though the bank serviced thousands of companies, making its depositor base appear diversified, it was heavily reliant on the VC sector.

The banking crisis serves as a stark reminder that even seemingly “safe” investments can be risky, and depositor diversification is essential to maintain a stable financial system.

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