Arshad Shaikh studies the recent collapse of the Silicon Valley Bank (SVB) in America. The spectacular failure of the 16th largest bank in the United States represents a systemic failure of the banking system. While analysts and media pundits debate the bank’s over-reliance on its held-to-maturity (HTM) portfolio, the lack of regulatory oversight, moral hazard and the tightening monetary policy by the Fed, very little is being said about the concept of conventional banking and the design of the global financial system. The American administration is intervening aggressively to avoid contagion and restore confidence in the depositors and investor community. However, the cracks in the banking system are openly visible and only its complete overhaul can prevent an impending apocalypse.
The American banking system is in a crisis. In the space of a few weeks, three banks in the US collapsed. The closure of Silvergate, Signature Bank and the Silicon Valley Bank (SVB) sent tremors in the banking industry and the global financial system. SVB was the preferred banker for many venture capitalists (VCs) and tech startups. Before “going bust”, SVB had assets (loans given) worth $209 billion and deposits of $175 billion. Its downfall is bound to result in salary delays, job losses and a drop in funding for the tech industry.
There are reports that US banks are sitting on roughly $620 billion of unrealised losses (loss in asset value on “paper” as the asset is still not sold). The US administration moved in quickly to calm tempers. President Biden assured the world that the American banking system is safe and SVB depositors would be able to access all their money. The Fed is signalling the provision of trillions of dollars in lending facilities to stressed banks feeling the heat after SVB’s collapse. So, what led to one of the second largest bank collapses in the history of the United States and the first major “tremor” since the 2008 financial crisis?
Talking to the media after the SVB crisis broke out, President Biden said, “There are important questions of how these banks got into the circumstance in the first place. We must get the full accounting of what happened and why those responsible can be held accountable. We must reduce the risk of this happening again. I am going to ask the banking regulators to strengthen the rules for banks to make it less likely this kind of bank failure would happen again.”
Research and investigation into the SVB balance sheets by analysts and pundits indicates an over-reliance on revenue through long-term bonds to boost its investment portfolio. The financial position of SVB quickly deteriorated after the Fed raised interest rates to counter inflation triggered by the Ukraine crisis. The disappointing role of regulators and moral hazard (engaging in risks when you know somebody else will pay the consequences) added fuel to the fire. However, one must dig deeper and find the root cause of the problem.
WHEN SAFE TURNS HAZARDOUS
Banks earn money on the difference between the interest paid for deposits and the interest earned against loans extended to their customers. It was the old idea of banking. Today, banks are publicly traded entities whose fortunes can plunge by market sentiment. Banks have moved far beyond their original mandate of looking after the credit requirements of their depositors and customers. They grapple for maximum profits and fuel the financial economy (100 times larger than the real economy) by investing the depositors’ money in a wide portfolio ranging from fixed-income products (government and corporate bonds, certificates of deposit) to loans, equities, and even real estate.
The money managers of Silicon Valley Bank made the fatal error of “putting all their eggs in one basket”. In 2021, SVB was flush with excess liquidity and riding on the back of an investment boom in tech companies. Their deposits surged from $102 billion to $189 billion. At a time of near-zero interest rates (courtesy of the Fed to stimulate the Covid-hit economy), SVB money managers relied on government-backed securities and fixed-rate mortgage bonds to get that elusive yield. However, this safe strategy turned hazardous as these long-term bonds fell in value after interest rates rose sharply following the Fed’s tightening monetary policy to rein record inflation after the Ukraine crisis.
As the majority of depositors were from a particular class (venture capitalists and private equity firms), the emergence of a “herd mentality” led to a surge in withdrawal demands. Finally, SVB’s unsuccessful bid to sell off some of its securities led to a run on the bank and sealed the fate of what was once touted as the “financial partner of the innovation economy”.
THE “MESSED UP” SYSTEM
Modern banking is another name for Fractional Reserve Banking. In this system, only a fraction of bank deposits resides in the bank. A large portion is loaned out or invested. It frees the banks to offer more and cheap credit that would otherwise be limited to the size of the deposits. However, it can result in disastrous bank runs and heat the economy. However, more than that, this system allows bankers to create new money (from nothing) and then charge interest on it.
This singular act is the cornerstone of capitalism and leads to the beginning of the concentration of wealth in a few hands. Those who managed the funds of SVB thought they were beating the system by investing in “safe” long-term bonds. The value of bonds is linked to the interest rates set by the country’s Central Bank. If the interest rate rises, investors are bound to dump those long-term bonds and scrape out the last “basis point” for their money.
Again, this concept of buying and selling loans (that are subject to market sentiment) is nothing short of “speculative” and akin to playing in a casino. Some experts have coined the term – “financialisation of the economy” for the increasing importance of financial markets, financial motives, financial institutions, and financial elites in the operation of the economy and its governing institutions, both at the national and international levels. It must be resisted if we care about preserving our economy.
THE PRICE FOR JUNKING ETHICS
The Qur’ān says, “As for those who devour interest, they behave as the one whom Satan has confounded with his touch. Seized in this state, they say: ‘Buying and selling is but a kind of interest,’ even though Allah has made buying and selling lawful, and interest unlawful.” (2:275).
Many argue that if the profit on money invested in a business enterprise is permissible, why should the profit accruing on loaned money be deemed unlawful? Hence, fixed-income financial instruments are ethical. They conveniently forget that any trade or economic enterprise (commercial, industrial, or agricultural) always carries some element of risk.
While credit at a fixed rate of interest is a transaction in which a profit at a fixed rate is guaranteed in all circumstances, protected against all possibilities of a loss. It is an unjust and imbalanced transaction, which is completely biased in favour of the creditor. The debtor is always on a sticky wicket. It is astonishing how the world has succumbed to the guile and duplicity of those who advocate interest-based banking as a legitimate economic activity.
On top of it, we allowed Wall Street to build a quadrillion-size financial world based on derivatives trade that controls the levers of power globally. Unless there is a drastic overhaul of the financial system based on ethics and justice, we will continue to see these “bailouts” and “fallouts” with calamitous consequences for the real economy.