Silicon Valley Bank (SVB): The tip of the iceberg of a major crisis?

Ashleay: Welcome to iA Financial Group's “In Your Interest” podcast, where we aim to share the essentials of economic news and its impact on your finances. My name is Ashleay, and this week we're taking a look at the latest economic news with Sébastien Mc Mahon, our Chief Strategist and Senior Economist. The successive flash bankruptcies of Silicon Valley Bank and Signature Bank are the talk of the town. And now it's European banks that are scaring the market. So Sébastien, hi, welcome.

Sébastien: Hello, Ashleay.

Ashleay: I was personally looking forward to hearing about this, about your view on this subject. So, Sébastien: what's happening with the banks?

Sébastien: I was also really looking forward to talking to you, my friend, about banks. But first we need to say that it's March 15th, in the afternoon. So this morning we woke up to the news that Crédit Suisse in Europe was in turmoil. And, you know, these situations can always move quickly. So I just wanted to start with that and to also say that we are not talking about Canadian banks here. Canadian banks are solid. Canadian banks are very well diversified, have a lot of capital in hand. So they have the cushion necessary to face dire environments and they are very well regulated. So we're not talking about Canadian banks. That's the first point. And we're also not talking about a 2008 kind of situation at all. Remember that in 2008, we were at the end or let's say post the bursting of the housing bubble. And—mostly in the US—banks had started the practice of lending money for a mortgage to households that had no business getting these mortgages or that size of mortgage, because everyone was thinking that housing prices could never go down. So they were just lending money and then they were taking those mortgages, putting them in products, selling them off in the market so that there was no risk for the bank anymore. And everyone was loading up on these products—the banks especially put that in their capital to have a cushion in case the economy turned sour—and then when the housing bubble burst, the capital of the banks evaporated. So we realized that the banks are filled with toxic products. That was 2008. This is really not the case now. We're talking, for now, about a few specific examples. And Silicon Valley Bank is going to be going down in the history books as a poster child for bad risk management. The name says it, it's in Silicon Valley, so they were lending money to tech start-ups and to people that were involved in this sector, and they were taking deposits from them. So technology is a sector that does well when interest rates are low and when the economy is thriving. Now, when interest rates rise and the economy slows down, these sectors, they need their money to make payroll and all of that. So they started taking their deposits away and the bank said, “All right, we can pay you back”—but whoops, the assets are all in long-term Treasury Bonds, which are supposed to be very safe. But when you have rising interest rates—and we won't do math in a podcast here, but we did that in an Economy Finance 101 video—when interest rates rise, which was the case in 2022, the market value of these products go down. So, they had a mismatch. And with illiquidity doing its magic, the bank was out of business in about 24 to 48 hours. So that was that specific story. Now the question is, are other regional banks in the US at risk of something similar? Because, you know, in Canada we have the Big Six banks and a few small regional banks like Western Canadian Bank and Laurentian Bank and banks like that. But in the US, there are over 4,550 regional banks. And some are very, very specific, like you can have a bank in the Midwest that loans and takes deposits, let's say only from farmers. So if the stars align, you can have issues there. That’s why I think it's always prudent to consider that when it affects banks you need to be careful, you need to maybe expect things to get worse before they get better. But we do have lots of regulation: the Fed came out, the Treasury came out; they acted quickly. But for us, it seems too early to say that this is off and done and we're moving on from this topic.

Ashleay: Absolutely. And so by now, we all know about Silicon Valley Bank, which recently failed within days—were its problems limited to its business model or can it be generalized?

Sébastien: Well, you can maybe generalize it if you think that other banks—the regional banks—maybe did not manage their risks correctly (because some of these banks are pretty small). But the point here is more that when people put their money in a bank, they expect to get it back.

Ashleay: Yes.

Sébastien: And when you have money in the bank, the government in the US guarantees your deposits with one financial institution up to $250,000. So if you have $1 million in one bank, $250,000 is guaranteed and $750,000 is not guaranteed. So it's better to spread your money around. And in Canada, this number is $100,000. So if you have more than $100,000 in a bank, well, it's only a part that is guaranteed by deposit insurance. So people expect to have their money back. And if they think that, well, maybe there's a risk with my bank—well, that’s how bank runs happen. It used to be that everyone would line up in front of the bank, yelling “give me my money back.” There was some of that last weekend, but now you can do all of that with your smartphone: you can take your smartphone, you can open a bank account in another institution—maybe a larger bank—and take your money out of the small bank and put it there. And we've started to see that this morning: it was the Bank of America, a bank that was saying that, in the last few days there was $15 billion of deposits that came in. So we are seeing that. It’s likely that before we're done, we could see some other regional banks have some issues, but likely we'll see that many isolated cases made up for all that kind of [unclear speech].

Ashleay: I see. And so we sometimes hear the term “black swan” used. Can you explain what this term means and if it applies here?

Sébastien: Sure. So a black swan by definition is something that we don't see coming, but which after the fact you can always turn back to, and so it becomes obvious that this thing was burnt, but no one was looking at it at the time. So it's a surprise and it's hard to measure the magnitude of the impact. And now the black swan, let's say, could be that there was a lot of interest rate risk on the bank's balance sheet. So they had a lot of deposits, but they invested in long-term Treasuries. So it's borrowing in the short run and investing for the long-term. This is a big mismatch in liquidity. That was the black swan. And, you know, interest rates rising quickly just flipped this story over. Investors sell first and then think; depositors take their money out and then think. And, as I said when we started today, we heard that in Europe, it's Crédit Suisse that has some issues (and it seems to be specific to them: they are not a poster child for risk management either, they're not the favourites, the students of the regulators). And now they're having problems raising equity. And the market is looking at all the other banks, saying “well, maybe you have ties to that bank? Maybe you have some counterparty risk with Crédit Suisse? Maybe you're also hiding a few things? So just sell the banks.” The market reacts strongly. So that's the kind of impact of a black swan. It’s behavioural-finance-land; it's not rational, it's very emotional.

Ashleay: Right. And so should we understand that monetary policy has tightened too quickly? Like will central bank policy rates start to fall now?

Sébastien: Well, I think now with hindsight, it's clear that monetary policy tightened too quickly. We always thought every economist was saying that this is a very fast pace, something someday will likely break. But what, when—nobody knew. Now it seems that maybe this is the beginning of this or maybe it's just a one off. But I always advise that we stay careful there. But rates falling now, I think that would be difficult. Remember the central banks need to target inflation, they need to favor maximum employment and they need to achieve financial stability. So right now inflation is high and it's stubborn, and the financial system is having some issues. Of course, they have multiple tools, multiple programs, but starting to cut rates now to help the financial system would maybe fuel inflation. So it's a hard situation. I'm glad I'm not the chair or the governor of any central bank right now.

Ashleay: Absolutely. Thanks, Sébastien. I understand a lot better, and I hope listeners enjoyed listening to you as well. Thank you for being here and if you enjoyed it, please feel free to share with your friends. Love this podcast? Want to know more about economic news? Follow our “In Your Interests” podcast available on all platforms. Visit the Economic News page on ia.ca or follow us on social media.