Modern monetary theory created Silicon Valley Bank crisis

They say a week is a long time in politics. But after the past week, we now know that a week is a long time in financial markets.?

Last Friday saw a lynchpin of the US startup ecosystem–Silicon Valley Bank–crumble into dust as customers withdrew over $40 billion in a couple of days. The bank had a majority of its customers’ funds (deposits) locked up in long term bonds. When depositors panicked and withdrew large sums of money, the bank couldn’t sell those bonds without taking huge losses on its books.?

This came after the bank had booked some losses when there was a similar run by depositors and planned a fundraise to shore up its finances to meet withdrawals by depositors. This was a classic case of bank run due to short term liabilities (customer deposits) not having adequate short term liquidity (funds) to meet customer withdrawals. This led to the US federal government, FDIC, and Federal Reserve providing backstopping the deposits of Silicon Valley Bank’s customers over the weekend. On Monday, customers were able to withdraw their deposits from Silicon Valley Bank.

Customers of other regional banks like Signature and Silvergate and even First Republic in the US, rushed to withdraw deposits and park them in banks that were classified as ‘too big to fail’. For now, the contagion in the US seems to be under check.

Contagion Spreads to Europe?

Across the Atlantic Ocean in Europe, trouble was brewing in Credit Suisse. The second largest Swiss bank has been losing customers steadily over the past few years. Last week, it said there were deficiencies in its internal control systems.?

This is code for unreliability of the bank’s financial reporting. The bank’s stock tanked post this revelation and more customers withdrew their deposits. Credit Suisse sent an SOS to the Swiss National Bank (Switzerland’s central bank) for an emergency liquidity facility worth $54 billion to honour customer withdrawals.

In the case of Credit Suisse, it was denoted as a systemically important institution. This meant the central bank had to save it from crumbling. The turmoil at Credit Suisse also sent stocks of French banking giants BNP Paribas and Societe Generale and German Deutsche Bank tumbling.

The trouble that began in the US is now sending shivers across the financial world. Although stock markets globally have recovered, there are?murmurs of discontent among European regulators?about the way the US handled the collapse of a handful of regional banks. Essentially, the US has torn up the post 2008 playbook of designating certain key institutions as systemically important by backstopping Silicon Valley Bank, Signature Bank and other regional banks’ deposits.

But there is enough blame to go around both sides of the Atlantic ocean.

Modern monetary theory created this crisis

In their urgency to revive their economies from the economic shock due to the pandemic, western countries pumped in huge amounts of monetary and fiscal stimuli over the past few years. As these countries hadn’t experienced even moderate inflation after the 2008 financial crisis, they believed that no amount of stimulus would lead to runaway prices.

Now, this is where the proponents of?modern monetary theory?(unrestrained government spending backed by monetary stimulus) stepped in and justified the handouts to all and sundry. This is what led to rise in deposits in banks like Silicon Valley Bank, and fueled the crypto mania. Emergency stimulus measures became permanent, while supply chain issues were blamed for rising inflation initially in 2021.?

Then came the pivot towards higher interest rates in 2022. This meant that banks that had gotten used to nearly 14 years of easy money had to now adapt to rapidly rising central bank’s benchmark lending rates. This is when banks needed to have proper risk management measures in place along with asset-liability management. They had to make sure their short term and long term liabilities are synced with the term of the assets they hold on their books. This was not the case with #SiliconValleyBank because it didn’t come under the heightened supervision of the US Federal Reserve because of its status as a regional bank.

As the US Federal Reserve raised rates rapidly, long term bond prices crashed, which left banks like Silicon Valley with huge unrealised losses. Some estimates put the unrealised losses in the US banking system on their government bond portfolio at?$620 billion.?

No wonder the US Federal Reserve came up with an emergency liquidity facility of?$2 trillion?(if needed) for banks that may face liquidity crunch on their government bonds that they have marked as ‘held to maturity’. Held to maturity means these bonds aren’t available for trading and will be held till they mature.

Why you should care

The pandemic caused untold economic hardship across the world, including India. But some countries like India chose not to throw the kitchen sink at the problem by pumping in an unlimited amount of stimulus into their economies. That’s why you don’t find a banking crisis bubbling up in India yet.

This blow up in banks in the US and Europe also shows that it's better not to borrow from the future to assuage current hardship. The modern monetary theorists believed that countries could spend unlimited amounts of money to fuel economic growth without consequences.?

Countries like India dithered because of how the post Great Financial Crisis stimulus created a crisis in 2013 (dubbed the?taper tantrum) due to excessive debt piled on by the Centre. For now, the Indian startups that had over $1 billion parked in Silicon Valley Bank have moved nearly $200 million to Indian banks at GIFT City in Gujarat.

Now all eyes are on the US’ Federal Open Market Committee’s (FOMC) decision on raising its benchmark rates next week. The European Central Bank (ECB) has already raised rates despite calls for a pause. Will #JeromePowell follow ECB’s footsteps?

To get more updates on finance and current affairs,?subscribe to our Money Order Newsletter.