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The turmoil at US’ Silicon Valley Bank in 10 Points

The sudden catastrophic collapse of US-based Silicon Valley Bank (SVB) and its seizure by the US regulatory authorities has caught the interest of ‘We—the Mango People’ of India also, and has frayedsome nerves, too.

But in view of the very limited or negligible exposure of the Indian economy and banking system to the repercussions of the fallout of a US banking system failure, this collapse hopefully will not have any direct financial impact on us.

However, this SVB crisis imparts critical lessons. But before learning these, it becomes essential to first know and understand what led to this massive banking system failure in the US.

So, here is a simple explainer on the turn of events:

1. It all started on a very promising and bright note, with majority of the US Silicon Valley’s big tech-startups, raising huge funds in a funding spree from venture capitalists and big investors and depositing their surplus/unutilized fund raises with SVB.

2. SVB, instead of keeping these deposits in liquid form (cash), invested in US Treasury bonds. It is pertinent to mention here that these US Treasury bonds were adequately backed by the US government, with minimalistic default risk.

3. The time bomb started ticking when the Fed increased federal interest rate (US Central Bank lending rate like Repo Rate in India) in a continuous series, in order to curb inflation in the US.

4. There is an inverse correlation between the interest rate and the bond prices. So, the increase in the US Federal interest rate, resulted in the decline in the US Treasury Bond prices, which constituted the major chunk of the investment portfolio of SVB.

5. The market value/net realizable value of these US Treasury Bonds, forming the investment portfolio of SVB, became less than the carrying value/ book value of these investments, in the balance sheet of SVB.

6. At the same time, Silicon Valley start-ups started incurring cash losses and faced a funding freeze and stopped getting funds from investors.

7. This liquidity crunch forced these Startups to ask for their money/deposits.

8. In order to honour such deposit withdrawal demands of the Silicon Valley start-ups, SVB was forced to sell its investments in the US Treasury Bonds at a loss of around $1.8 billion, due to rising federal interest rate and declining bond prices. To compensate for this loss, SVB announced the selling of its equity. This created panic among the Silicon Valley startups, and further accelerated the process of withdrawal of their deposits from SVB.

9. Fresh deposits also became more expensive for SVB, with a federal interest rate’s hike.

10. All this led to a crash of share price of SVB by 60% in the US capital market, and ultimately the collapse of SVB, and the Federal Deposit Insurance Corp. (US regulatory body) assuming the regulatory control of the bank.

Lessons learnt: The SVB crisis didn’t happen due to its bad loans or its advances becoming non performing but it happened because SVB failed to foresee and assess the timing of serviceability/repayment of the deposits taken by it from the Silicon Valley startups and instead of keeping these deposits in liquid or short-term investment instruments, invested them in long-term US Treasury bonds.

In India, there the cash reserve ratio (CRR). It is a specified fraction of the total deposits, which commercial banks have to hold as reserves either in cash or as deposits with RBI to ensure banks do not run out of cash to meet payment demands of depositors. CRR is a crucial monetary policy tool and is used for controlling money supply. Currently CRR is at 4.50%.

Secondly, SVB was caught off-guard and it ran out of cash as it failed to foresee the very basic correlation between rising US federal interest rates and the declining US Treasury bond prices, constituting its investment portfolio and, consequently, its mark-to-market loss (book loss), suddenly converted into actual loss, on forced selling of its investments in US Treasury bonds, below their acquisition costs, in order to service the withdrawal demands of deposits by the Silicon Valley startups.

Mayank Mohanka is the founder of TaxAaram India, and a partner at SM Mohanka and Associates.

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