<p>In Nobel House, the Hong Kong-based television series of the late 1980s, the character Quillan Gornt, in order to impress a visiting American businessman, demonstrates how he could enable a profitable mid-sized bank to collapse within days. He begins to short the stock and provokes rumours of a looming failure. His misinformation spreads like fire in a hay barn and depositors begin queuing up outside bank branches to hastily withdraw their money. A dominos effect occurs and within a few days, the bank crumbles, compelling the Hong Kong Monetary Authority to step in.</p><p>Banking is an assurance game and no bank can survive if depositors recall their money at the same time. The events leading to the collapse of Silicon Valley Bank (SVB) have similar overtones. When SVB announced it would issue fresh capital to cover certain bond losses, a scrutiny of its books revealed it had committed substantial sums to long-dated bonds. Unable to previously deploy cash in lending activities, SVB had chosen to invest it in US treasuries. As US interest rates jumped abruptly, from 0.25% to 4.5%, the value of these bond holdings began to tumble. If held to maturity, the impact may have been bearable. Some equity capital infusion could have done the job and then it might have been business as usual.</p><p>But things did not turn out that way. Short sellers dumped the stock and depositors began withdrawing their money in panic, presuming that a collapse was imminent. SVB had to sell its bond holding to generate the liquidity to honour deposit commitments. In two days, it was all over. But the saga did not end there. Customers in other small regional banks began withdrawing their deposits and a contagion, with damaging consequences for the American banking system and its economy, may have occurred. Signature Bank, a New York-based company also failed a few days later.</p><p>It was then that the Fed and the US Treasury Department stepped in. First, all deposits in SVB and Signature would be honoured whole, and straightaway. Second, the Fed would create a new emergency-lending facility, to allow banks to deposit high-quality assets, in exchange for a cash advance worth the face value of the asset, rather than its market value. Other banks that had stacked up on US treasuries and other bonds, which had fallen in price, would thus be protected from a SVB like tragedy.</p><p>All of this conceivably leaves the Fed in a dilemma. The need to curb inflation with higher interest rates is paramount. But on the other hand, the impact of higher interest rates, on bond values and consequently the asset book of banks, is equally worrisome. Oddly, the pricing of US equities suggested that markets were sitting smug on the assumption that interest rates had peaked. The recent hike of 25 bps must consequently have come as a shocker. Clearly, therefore, despite the failure of a couple of mid-sized lenders, the Fed believes that inflation is the bigger worry and rightly so. Long term stability can never be assumed if inflation continues to lurk. But this leaves the global economy in a state of turmoil. Collapsing bond prices destroy wealth, wobble even strong banks and over-flow into equity markets. Liquidity for corporations is bound to be affected. Failures have the onerous habit of spreading across national boundaries, as depositors and investors begin to panic. The months ahead will probably see more unrest.</p>
<p>In Nobel House, the Hong Kong-based television series of the late 1980s, the character Quillan Gornt, in order to impress a visiting American businessman, demonstrates how he could enable a profitable mid-sized bank to collapse within days. He begins to short the stock and provokes rumours of a looming failure. His misinformation spreads like fire in a hay barn and depositors begin queuing up outside bank branches to hastily withdraw their money. A dominos effect occurs and within a few days, the bank crumbles, compelling the Hong Kong Monetary Authority to step in.</p><p>Banking is an assurance game and no bank can survive if depositors recall their money at the same time. The events leading to the collapse of Silicon Valley Bank (SVB) have similar overtones. When SVB announced it would issue fresh capital to cover certain bond losses, a scrutiny of its books revealed it had committed substantial sums to long-dated bonds. Unable to previously deploy cash in lending activities, SVB had chosen to invest it in US treasuries. As US interest rates jumped abruptly, from 0.25% to 4.5%, the value of these bond holdings began to tumble. If held to maturity, the impact may have been bearable. Some equity capital infusion could have done the job and then it might have been business as usual.</p><p>But things did not turn out that way. Short sellers dumped the stock and depositors began withdrawing their money in panic, presuming that a collapse was imminent. SVB had to sell its bond holding to generate the liquidity to honour deposit commitments. In two days, it was all over. But the saga did not end there. Customers in other small regional banks began withdrawing their deposits and a contagion, with damaging consequences for the American banking system and its economy, may have occurred. Signature Bank, a New York-based company also failed a few days later.</p><p>It was then that the Fed and the US Treasury Department stepped in. First, all deposits in SVB and Signature would be honoured whole, and straightaway. Second, the Fed would create a new emergency-lending facility, to allow banks to deposit high-quality assets, in exchange for a cash advance worth the face value of the asset, rather than its market value. Other banks that had stacked up on US treasuries and other bonds, which had fallen in price, would thus be protected from a SVB like tragedy.</p><p>All of this conceivably leaves the Fed in a dilemma. The need to curb inflation with higher interest rates is paramount. But on the other hand, the impact of higher interest rates, on bond values and consequently the asset book of banks, is equally worrisome. Oddly, the pricing of US equities suggested that markets were sitting smug on the assumption that interest rates had peaked. The recent hike of 25 bps must consequently have come as a shocker. Clearly, therefore, despite the failure of a couple of mid-sized lenders, the Fed believes that inflation is the bigger worry and rightly so. Long term stability can never be assumed if inflation continues to lurk. But this leaves the global economy in a state of turmoil. Collapsing bond prices destroy wealth, wobble even strong banks and over-flow into equity markets. Liquidity for corporations is bound to be affected. Failures have the onerous habit of spreading across national boundaries, as depositors and investors begin to panic. The months ahead will probably see more unrest.</p>
