More Banks May Collapse If Fed Continues Raising Interest Rate

More banks could face the fate of Silicon Valley Bank (SVB) if the US Federal Reserve continues raising interest rates in order to stop runaway inflation, experts told Sputnik

MOSCOW (UrduPoint News / Sputnik - 14th March, 2023) More banks could face the fate of Silicon Valley Bank (SVB) if the US Federal Reserve continues raising interest rates in order to stop runaway inflation, experts told Sputnik.

SVB is the largest US lender to fail since Washington Mutual collapsed in 2008 at the height of the financial crisis. Investors at the California-based bank withheld $42 billion in deposits last week, triggering a 60% plunge in its share prices.

The bank provided financing for almost half of US venture-backed technology and healthcare companies. At the end of 2022, the bank said it had $151.5 billion in uninsured deposits, $137.6 billion of which was held by US depositors. Its total assets as of the end of last year were $209 billion. The bank's collapse is believed to be linked to the increase in interest rates by the Fed, which caused the impairment of assets on the balance sheets of many financial institutions.

Meanwhile, New York-based Signature Bank, known for courting the cryptocurrency industry, was closed by regulators on March 12 over alleged systemic risks. Signature Bank is placed 29th on the Fed's list of the country's large commercial banks, while SVB is 16th.

The United States has been forced to contend with rising levels of inflation due to supply constraints in the wake of the COVID-19 pandemic. The situation has prompted the Fed to keep introducing higher interest rates to quell the problem. This approach, however, presents its own set of risks, as high interest rates slow down economic activity and could potentially plunge the economy into recession.

John Bugnacki, the deputy general counsel and director of regulation and policy at legal-first crypto software company Tacen, noted that SVB was dependent on new capital inflows from the technology and venture capitalist industries. As the rising interest rates resulted in a decline in riskier ventures, including investing in new tech companies, such enterprises were more likely to withdraw funds from the bank rather than make new deposits, according to the expert.

"At the same time, many smaller regional banks in the United States, outside of the globally significant investment banks (GSIB) have faced increased pressure because they invested heavily in securities that carried a lower interest rate than the current federal funds rate. The banks, believing that the Federal Reserve would not increase (the interest) rate rapidly, invested heavily in long-term securities that carried this lower rate," Bugnacki observed.

When the Fed did rapidly increase the federal funds rate, rendering the investments by the regional banks unprofitable, SVB and other non-GSIBs tried to make up the deficit by securing additional investment, but when rumors about SVB's lack of funds began to circulate, many investors began to rapidly pull their money and transfer it to larger GSIBs,

Other experts, such as Marshall Auerback, a research associate at the Levy Economics Institute of Bard College, have also linked the Fed's actions to curb inflation to the SVB failure.

"The SVB collapse is a direct consequence of the Fed's misguided action on inflation, which has largely been a problem of supply constraints, not excess demand.

And now we have the collapse of SVB as a result of Fed interest-rate hikes," Auerback, said, suggesting that "this may force the Fed to pause on its plan to raise interest rates higher and faster."

The Federal Deposit Insurance Corporation (FDIC) took charge of SVB and Signature, promising to protect all deposits from both banks in a departure from the usual limit of $250,000 per depositor, per insured bank and per ownership category.

"The action to backstop all of the deposits at Silicon Valley Bank will likely reduce the risks of widespread bank runs, but if the Fed continues to raise rates, more small banks could be vulnerable to collapse," Auerback explained.

In the same vein, Auerback's Levy Economics Institute colleague Eric Tymoigne, noted that the recent statement by the FDIC, the Fed and the Treasury on protection of SVB and Signature deposits resolves the issue of panic.

"The problem of banks recording losses because of the (Federal Reserve Board Chair Jerome) Powell moves is another story. If he keeps going at it, then there will be more pain. I hope he does not repeat a full-blown Volcker experiment. We got a taste, it is enough," Tymoigne, who is also an associate professor of economics at Lewis & Clark College, said, referring to one of Powell's predecessors, Paul Volcker, whose aggressive interest rate hikes led to a recession in the early 1980s.

Bugnacki, for his part, pointed out that the fund that the Treasury has created to backstop bank deposits is only $25 billion, while the effective losses from the rapid increase in the federal funds rate are roughly $600 billion. He also noted that in the case a sufficient number of banks fail, dealing with the total number of losses could be difficult, despite the Fed's claims about deposit protection.

"As a result, many business depositors will either shift to banks that are too big to fail or have back-up accounts that can serve as a backstop in the event a run begins on their smaller bank. There are also concerns about moral hazard in the case of banks making risky bets. For example, a bank could offer a very high rate of interest for depositor accounts knowing that the Fed has stated all amounts even more than $250,000 will be protected. As a result, it may lead banks to engage in riskier investments and poorer risk management," Bugnacki said.

He also noted that one reaction from investors in the US and other countries was to start converting their fiat currencies into digital assets like Bitcoin and Ethereum, resulting in a substantial price hike over the weekend and the beginning of the week. The expert added, however, that the Joe Biden administration, known for its skepticism toward crypto, was unlikely to welcome this development.

"Many in the digital asset community have viewed the shutdown of Signature Bank as a part of a crackdown on the digital asset industry in the US. Entrepreneurs in digital assets and crypto are looking to reduce their presence in the US and move their operations to Europe, East Asia, and the Middle East," Bugnacki stated.