Sunday 19 May 2024
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This article first appeared in Forum, The Edge Malaysia Weekly on March 20, 2023 - March 26, 2023

Although Silicon Valley Bank (SVB) is among the top 20 banks in the US, it is not regarded as one of the pillars of the economy that are too big to fail.

SVB’s clients are concentrated in one segment of the capital markets — technology start-ups. The bank itself behaves like a tech company and positions itself as a financial industry innovation that will disrupt the status quo.

While the bigger names such as JPMorgan Chase and Goldman Sachs have insisted that their employees go back to the office, SVB’s employees still largely work from home. 

The most significant difference between SVB and established financial institutions, however, is that the former does not go through the rigorous regime of supervision that a normal financial institution is subjected to.

This is thanks to former president Donald Trump, who signed off a regulation that eased the risk management requirements for banks with assets below US$250 billion in 2018. The rules, known as the Dodd-Frank Wall Street Reform and Consumer Protection Act, were put in place in the aftermath of the 2008 US financial crisis.

The changes in the regulations effectively allowed smaller banks to evade close scrutiny of their liquidity risk management. Essentially, banks such as SVB did not have to go through a vigorous “stress test” that determined the diversity of the liquid assets they had to cover the deposits placed with the banks during a period of stress.

SVB’s deposits were from tech start-ups, which got their money from venture capital (VC) firms. It is a small industry where everyone knows what is happening. When SVB was in trouble, word soon reached the VCs, which then told their investee companies to pull out their money.

The lack of a diversified pool of liquid assets exacerbated the run on SVB. News spread quickly among the tech companies and finally, SVB was taken over by the state.

SVB’s failure led to the fall of two other banks and forced the Swiss National Bank to assure depositors that it would provide Credit Suisse with money should there be a run on the bank.

Although the fear is that the fall of SVB will have a contagion effect across the globe, this is highly unlikely because the current crisis is more a crisis of confidence than a credit crunch. 

In 2008, banks stopped lending to each other, causing a liquidity crunch. They were holding mortgage-backed securities with properties as the underlying asset. When there was an economic downturn, property values, which were inflated in the first place, slumped.

Essentially, the quality of the assets that banks were holding was not good and values deteriorated quickly.

Today, the banks are holding high-quality bonds, including Treasuries, whose value deteriorated because of the rise in interest rates. But if held to maturity, the bonds can be redeemed at full value.

Depositors are concerned that banks may not have adopted the best risk management practices to hedge the bonds against interest rate movements. As such, the worry is that the banks may take a hit if they are forced to liquidate their assets earlier than the redemption dates to meet withdrawals.

Faced with massive withdrawals, SVB was forced to sell US Treasuries at a loss.

Regulators and the more established banks probably see the difference in the asset quality in the previous situation and now. That is likely one of the reasons why seasoned bankers on Wall Street led by JPMorgan Chase CEO Jamie Dimon have put together a package to place deposits of US$30 billion (RM134.6 billion) into First Republic, a bank that is facing a run.

One way to handle a crisis of confidence is to provide emergency funds for banks that are experiencing a run on their deposits. This is what the Swiss central bank did for Credit Suisse and what the Wall Street banks did for First Republic.

The risk management of financial institutions encompasses several facets.

Apart from having adequate capital, the risk management analysis looks into the banks’ client profile, the industries they service, their hedging strategies against interest rate movements and the amount of provisioning set aside for the assets whose value may have deteriorated.

In the case of SVB, its concentration of clients in the tech sector, particularly start-ups, was of no help. The bank was more interested in playing a disruptive role in the highly regulated financial services industry.

Prudent measures that conventional banks place so much emphasis on, such as risk management, cash management and capital management, took a back seat. 

One of the biggest fears of conventional banks is interest rate hikes. That is why they place so much emphasis on the risk management of their assets and their diversification. Conventional banks hedge their risk by going into interest rate swaps, which reduces their profit margin but mitigates risk. 

This is an area where SVB failed.

In most countries, including Malaysia, it would not have been allowed to happen. Bank Negara Malaysia has issued licences for digital banks, but the requirements for these banks to manage their risk are the same as for conventional banks. 

For instance, Bank Negara is strict in not allowing Malaysian banks to have too much exposure to one sector. There was a time when property companies had difficulty in obtaining loans. 

The central bank also makes sure that the banking sector as a whole does not have too much exposure to one particular group of companies.

That is why it has agencies such as the Corporate Debt Restructuring Committee to ensure the orderly restructuring of debts of large corporations.

The positive development that is coming out from the collapse of SVB is that the US Federal Reserve is almost certain to retreat from its path of aggressive interest rate hikes. The market is expecting a 25-basis-point hike at its meeting next week, which will inch the federal funds rate closer to 5%.

As for Malaysia, Bank Negara did the right thing in not raising interest rates. The ringgit took a hit but the developments in the US suggest that the dollar is probably at its peak against other currencies.

So, without raising rates, the ringgit could strengthen relative to the dollar once fears over the health of the global banking sector diminish.

Technology helps reduce the cost of operating a bank. For instance, banks do not need an extensive branch network as automated teller machines are equally effective. But SVB’s collapse shows technology cannot replace the art of managing risk that conventional banks adhere closely to.

M Shanmugam is a contributing editor at The Edge

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