Silicon Valley Bank has gone belly-up as has the Signature Bank in the U.S. in the last few weeks. Another bank, First Republic, seems to be heading the same way. Why does a bank run happen?
Every bank has two sides — liabilities and assets (Table 1). We deposit our money in a bank for safe-keeping or to earn some interest because cash is a barren asset otherwise. But we do so under the assumption that we can withdraw our money any time we like. A bank run usually happens when a significant number of depositors believe that the bank cannot honour its commitment. After all, banks do not sit with liquid deposits; instead, they use them to create assets — loans — and to buy government bonds. If, however, the bonds lose value or the loans become non-performing, the banks may not be able to honour its commitment to the depositors.
Table 1
Charts appear incomplete? Click to remove AMP mode
Charts 1A and 1B show the extent of the unrealised losses that Silicon Valley Bank and First Republic Bank have been making of late as a result of a dramatic fall in bond values. One way of understanding the negative bars is to think of them as the proportion of the total deposits the banks cannot honour. Even this may not necessarily lead the depositors to withdraw en masse provided their deposits are insured i.e. the state promises to honour the deposits even if the banks cannot. Further, the banks could allay the fears of the depositors if they had either cash or short-term assets in significant amounts. Unfortunately for these banks, neither was a significant share of the deposits insured nor did the banks hold near-cash assets in adequate amounts.
The next question to ask is, why were these banks losing on their assets side? And the reason is simple — a rise in the interest rate by the U.S. Federal Reserve. Any asset holder has a choice of holding assets of differing maturities. If these returns are arranged term-wise, which is called a yield curve, an asset of 30 years of maturity should give a higher annual return compared to, say, one with a one-year maturity; otherwise, nobody will hold the former.
Chart 2 plots the yield curve for the U.S. before and after the steep rise in the Fed Funds Rate (the policy rate that Fed controls). When the Fed increases the interest rates, the returns for new assets of all maturities rise. But the old assets are still fetching lower yields, so those holding the old assets lose value notionally as we saw in Chart 1. Additionally, this rise may not be uniform. In fact, the yield curve can even get inverted with the shorter-term assets giving higher returns than longer ones, as is the case in the U.S. currently. For the depositors, it makes sense to move away from such risk-ridden deposits with very low yields towards short-term risk-free treasuries, which the Fed will always honour. Both these reasons feed into a bank run.
The Fed is in a Catch-22 situation. If it increases the interest rates, more such failures may happen and if it decreases it, it will lose credibility. Chart 3 shows why this is a tightrope walk. Despite a fall in headline inflation, the Fed has stayed the course by increasing the interest rates perhaps because the core inflation (inflation for commodities other than food and energy) has not been controlled as yet. And if the core does not come under control, the Fed will have to weather it out. But in weathering the storm, it may bring in a tsunami.
Rohit Azad and Indranil Chowdhury teach Economics at JNU and PGDAV College, Delhi University, respectively
rohit.jnu@gmail.com, chowdhury.indranil@gmail.com
Source: Union Bank Performance Reports, U.S. Department of Treasury, Economic Research Division of the Federal Bank of St.Louis
Also read:Explained | Will the SVB collapse impact Indian start-ups?
Listen to our Data podcast | When sky has a limit: The looming space debris crisis | Data Point podcast
