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You may have seen the recent news that an American Bank, Silicon Valley Bank, collapsed. This raises two important questions: what happened? And, could something similar happen here?

What Was Silicon Valley Bank?

Silicon Valley Bank was the 16^th largest bank in the USA. As its name suggests, it was a favoured bank of the IT industry, especially start-ups and new entrants. As it’s name also suggests, it was headquartered in California.

What Happened?

Regulators stepped in on March 10 to take control of the bank. The bank had become insolvent, which meant that it could no longer repay its debt because those debts now exceeded its assets. As the market had become aware of this, a ‘run’ had started whereby a lot of depositors started to ask for their money back. Money that a bank holds in a customer’s account is a liability for that bank, and so if too many people ask for their money back all at the same time, there is a risk that some people will not get their money back.

(As it happens, the US Government has guaranteed deposits in all US banks, so there was no actual risk of a depositor losing their money. But try telling that to people who hear that their bank is insolvent!)

Why did this Happen?

The short answer to this is rising interest rates, although the impact came via a slightly circuitous route. According to media reports, during the pandemic years, the SVB continued to receive customer deposits but the amounts that it was loaning out started to fall. This meant that it was accumulating ‘spare cash’ on which it was not earning a return.

Apparently, the bank invested an unusually high amount of its deposits in US Government Bonds. To understand what happened next, you need to know a little bit about how bonds work.

A bond is essentially a promise from the Government (our Government issues them as well) to pay a series of interest payments and then a final payment at the end of a specified term. A five year $100 million bond with a coupon rate of 2%, for example, will pay the holder 2% of $100 million, or $2 million a year, for five years. At the end of the fifth year, the holder will receive $100 million.

We don’t need to go into how a bond is issued here. For now, we need to know that once a bond has been issued, the payments that flow from it are fixed. What’s more, once a bond has been issued, it can be sold in an open bond market. Because the payments attached to a bond are fixed, the value of a bond in the market will change as the payments that can be received on other types of investment change. Those other payments tend to change when interest rates change.

Put simply, what usually happens is that, when interest rates fall, the value of an existing bond will tend to be higher. This is because the fixed money repaid under the bond will be relatively higher than what an investor can get if they invest in something that pays the new rate of interest.

Similarly, if interest rates rise – and in particular if people think interest rates will continue to rise – then the value of an existing bond will fall, because the fixed revenues coming from that bond are now comparatively lower compared to the revenues that an investment in something else will pay.

This is exactly what happened to the SVB. They bought their bonds during the pandemic, when interest rates were low (and bond prices were high). Interest rates have since risen dramatically, and the head of the US Reserve announced on March 7 that he expected rates to continue rising. This caused a further, sudden and sharp drop in the value of existing bonds, such as those being held by the SVB.

Remember, SVB still had to give its depositors the same amount of money as they deposited. But it had lost a lot of that money because the value of its bonds had crashed. It could not sell the bonds to access sufficient cash. And when depositors started to want their money back, this became a particular problem.

This is why, in a roundabout way, the dramatic rise in US interest rates caused the SVB to become insolvent. (Although some pretty crappy management was obviously at play, too).

Could this Happen Here?

Almost certainly no. While our bond values also rise and fall as interest rates change, we have a very well-regulated system that stops banks from putting too much of their asset holdings into a single type of asset as SVB did. It has been reported that SVB put more than half of their total assets into Government bonds. Any Australian bank wanting to do this would fall foul of our regulators.

What has been the Impact?

Share prices fell about 3% in the US in the week following SVB’s collapse. Interestingly, markets that relate more to interest rates have responded in ways that suggest that this event might see an end to interest rate rises and maybe even some reductions between now and the end of 2023. The idea of raising interest rates is to reduce economic confidence – and there is nothing like the collapse of a bank to do that! Interest rates may no longer need to rise.

Of course, whether rates really do stop rising will depend on what comes next. Interesting times!