What happens to your money when you put it in a bank?
The bank does not simply keep your money there in a lump sum, for you to access it at any time – they would not make any money that way. The money you put in as a deposit is instead used by the bank to make money for itself – they might lend that money out as mortgages or consumer loans, in the case of a commercial bank. Or, in the case of an investment bank, they might invest it.
Silicon Valley Bank, which went belly up this week, is an investment bank.
The basic basics: Over the years Silicon Valley Bank piled up huge mountains of cash via deposits from tech startups and decided to use that money to make what they thought was a very safe investment on behalf of themselves: US Government Treasury long-term bonds.
What are long term bonds? They are US Government Debt – money owed by the US Government to the debt holder.
In terms of investments, you can’t actually get much safer than that: The US Government owes you the money, and will pay it, because otherwise the US would be in debt default causing a global economic crisis. As investments go, US bonds are gold plated.
But there are two problems: First, because the debt is so secure, the interest rates on it are very low. Second, these bonds can be traded on the open market, meaning that you do not necessarily have to buy 100 dollars of US debt for 100 dollars: You can buy it off somebody else for 70 dollars, or 80 dollars, or 190 dollars, depending on the market value of the particular bond. Normally, the variations in value are not so extreme, but the point stands: Treasury Bonds are tradable on the market, and their value can fall, as well as rise.
Now, here’s where the problem arises: What happens to the market value of a US Government bond when the US federal reserve puts up interest rates?
Your bond, remember, has a fixed interest rate that it pays over a 30 or 40 year term. But when interest rates are suddenly much higher than the interest rate on the bond, then the relative value of the bond falls.
And suddenly, if you had 50 billion dollars of your depositors’ cash invested in US Government bonds, the value of those bonds might only be 40 billion. Or 30 billion.
There’s a second problem: When interest rates rise, money becomes harder to borrow and investments become harder to secure: So your depositors – all those tech firms, remember – suddenly need more of their cash back.
And suddenly: You don’t have enough cash to cover your depositors who want their money back. When rumours of this spread, everybody wants their money back. And then, it’s…… game over.
That is what happened to silicon valley bank: A really good investment on paper by the bank became a nightmare investment because of inflation and higher interest rates.
There’s now a big question in the financial world: Was Silicon Valley Bank alone? The short answer is we do not know, but:
As Chancellor @Jeremy_Hunt gears up for his first Budget there are fresh fears for the financial system.
Credit Suisse shares have collapsed after the Saudi National Bank said they wouldn’t be putting any more funds in.
Down 18% today. Down 97% from their all time high… pic.twitter.com/9Uy0Y6Cx70
— Ed Conway (@EdConwaySky) March 15, 2023
In many ways this problem is a psychological one: A bank might well, as a result of changing prices of long term bonds, suddenly find itself in a position where it lacks the funds to cover all of its depositors. This might mean that a bank is theoretically insolvent, but this only becomes a problem if, like Silicon Valley Bank, all those depositors start panicking and demanding their money all at once. In other words, if depositors don’t believe there’s a problem, a bank could theoretically operate for years while not having the funds to cover the demands of every depositor at once.
If there’s a run on these banks, though – and it’s a good bet that some of them exist – then Silicon Valley Bank might not be the last to go boom.
The irony here is that many of these banks – if they are in trouble – are in trouble for making what were, on paper, very safe investments. Over the longer term, the value of a treasury bond is guaranteed – you get it back with interest. The problem has arisen because in the short term, the market value of those bonds has fallen because of higher interest rates.
As for you, an ordinary person: Chances are your bank is fine. This contagion seems mainly to be afflicting higher end investment banks whose money is tied up in things like bonds and shares. It’s not like the 2008 crisis, where money was tied up in bad mortgages, which suddenly could not be repaid.