Bank deposit insurance scheme avoided US financial system collapse

NEW YORK, 14 March 2023:

Recent sharp hikes in interest rates by the US Federal Reserve to contain inflationary pressures resulted in two major banks crashing over the past week – but contagion that could have led to a widespread financial system collapse was averted by authorities using the Federal Deposit Insurance Corporation (FDIC).

What made the US financial system rescue more remarkable was that FDIC funds provided enough of a stopgap despite the US$250,000 cap on coverage of individual depositor accounts. The situation is still evolving, but the panic situation seemed to be contained for now.

Panic set in from last Wednesday and the situation unravelled on Friday morning with the abrupt end of Silicon Valley Bank (SVB), the go-to bank for US tech startups since its founding in 1983. According to the FDIC, SVB was among the top 20 American commercial banks, with US$209 billion in total assets at the end of last year.

Though relatively unknown outside of Silicon Valley, SVB specialised in banking for tech startups – providing financing for almost half of US venture-backed technology and health care companies.

SVB’s demise was triggered by a series of US Fed rate hikes – as higher borrowing costs more than offset returns provided by long-term bonds.

These bonds were issued during the era of ultra-low, near-zero interest rates and SVB’s US$21 billion bond portfolio was yielding an average of 1.79% — while the current 10-year Treasury yield had risen to about 3.9% —  meaning that SVB’s return was already losing 2.11% on its funds.

At the same time, fresh venture capital began drying up as such money shifted to take advantage of higher interest rates — forcing startup firms to draw out funds they’d deposited at SVB.

The result was the bank sinking fast under a mountain of as-yet-unrealised losses in bonds while its cashflow was being pressured with customer withdrawals.

Since SVB’s financial status could no longer be sustained, the bank had to find ready money to keep its cashflow liquid. So on Wednesday, SVB announced it had sold a bunch of securities at a loss, and that it would also sell US$2.25 billion in new shares to shore up its balance sheet.

Instead of assuring clients this move was simply another normal operational matter, the cash-raising announcement triggered panic among several venture capital firms, who reportedly advised companies to withdraw their money from SVB.

With SVB’s stock plummeting Thursday morning, with many seeing it poised to become the largest failure of a US bank since Washington Mutual in 2008, other bank shares also slipped as investors began to fear a repeat of the 2007-2008 financial crisis.

When SVB abandoned efforts to quickly raise capital or find a buyer by Friday morning, California regulators intervened, shutting the bank down and placing it in receivership with the FDIC.

Meanwhile, HSBC — Europe’s biggest bank — yesterday announced a £1 deal taking over SVB units in UK effective “immediately.”

The acquisition should “end the nightmare thousands of tech firms had been experiencing over the past few days,” Susannah Streeter, head of money and markets at investing platform Hargreaves Lansdown, said in a statement.

The HSBC deal has secured the future of thousands of British tech firms that hold money at the lender and had a buyer not been found, SVB UK would have been placed into insolvency by the Bank of England. In a statement, the UK central bank said it “can confirm that all depositors’ money with SVB UK is safe and secure as a result of this transaction.”

Meanwhile, Sunday saw regulators close Signature Bank in New York, marking the third-largest bank failure in US history. Signature Bank suffered billions in rapid cash withdrawals following SVB’s collapse and ran out of liquid cashflow.

Signature Bank was one of the few banks to accept cryptocurrency deposits, with large exposures due the cryptocurrency industry exploding in size and prominence throughout the late 2010s and the start of 2020s. But Signature Bank took a serious hit as US Fed rate hikes caused a meltdown in cryptocurrency values.

The state-chartered commercial bank had over US$110 billion in assets and nearly US$89 billion in deposits as of the end of last year, according to the FDIC. But over US$79 billion of those deposits were not insured with the FDIC — forcing the New York Department of Financial Services to step in to forestall panic.

Both banks coming under the FDIC administration guarantees cash up to US$250,000 per account for depositors at both failed banks, drawing from the Deposit Insurance Fund (DIF).

While both banks’ shareholders and certain unsecured debtholders will not be protected. a joint statement by the US Treasury, US Fed and the FDIC assured no losses will be borne by American taxpayers.

Further, to address continued fears, the US Fed announced an additional line of credit known as a Bank Term Funding Program — offering loans of up to one year to banks, credit unions, and other types of depository institutions.

For collateral, the US Fed will take US bonds and mortgage-backed securities, and the line of credit will be backed up by US$25 billion from the Treasury’s US$38 billion Exchange Stabilization Fund.

American authorities have taken pains to avoid describing the rescue as a bailout as the DIF money used comes from insurance premiums that banks are required to pay into it as well as interest earned on funds invested in US bonds and other securities and obligations.

In Malaysia, a similar financial protection scheme is run by the Malaysian Deposit Insurance System (PIDM).