Markets remain nervous following recent news that two U.S. banks had collapsed including the Silicon Valley Bank (SVB) – the country’s 16th largest. Even as American government agencies worked to ensure depositors get their money back, share prices of U.S. regional banks and mid-sized lenders, like the ones that had failed, remain volatile.
A classic bank run
In the case of Silicon Valley Bank (SVB), it was a classic bank run that led to its collapse. A bank run happens when most depositors lose confidence and demand their money be returned at the same time. But a typical bank can’t return a majority of its depositors’ money all at once. That’s because much of the depositors’ funds was lent to borrowers or was invested in financial instruments that mature over time.
SVB’s longer term bond investments were losing value. When some depositors discovered these losses, they demanded their deposits back from the bank. When other depositors followed suit, the bank collapsed as it couldn’t meet all the withdrawal demands.
An isolated incident or a system-wide risk?
Bank failures can be scary and lead to instability. One bank failure can trigger a panic that can bankrupt other perfectly solvent banks. It pays to solve bank runs early. This is why the U.S. Federal Deposit Insurance Corporation (FDIC) acted quickly and committed to protect both insured and uninsured deposits of the two recently failed banks.
While SVB’s collapse is the largest bank failure since 2008, its concentrated customer base in the tech industry may not lead to a 2008-style financial crisis.
SVB – the first fatality of higher rates?
Monetary policy, or actions that central banks take, often take effect with a lag. Between March 2022 and now, the U.S. Federal Reserve (the Fed) has raised interest rates by over 4.5%, one of the fastest rate hike cycles in U.S. history. It appears that SVB is one of the early casualties of this aggressive tightening. Much of SVB’s long-term bond investments were profitable when interest rates were low. But they lost value with rapidly rising interest rates. Now that SVB’s failure has raised concerns about financial stability, the Fed has to walk a tight rope between fighting inflation and not damaging the financial system.
What does this all mean for Canada?
Compared to the U.S, Canadian banks are not as exposed to risky tech and start-up industries. But if broader borrowing conditions for customers and corporations freeze in the U.S. due to problems in the banking industry, Canada will likely feel the chill too.
Canadian markets fell in the past week because of volatility in the U.S. Our base case does not see the U.S. bank runs turning into a systemic event primarily because of swift U.S. government actions. We encourage Canadian investors with exposure to U.S. markets to remain calm. While we do see potential fallout for smaller banks with balance sheet concerns, few took as much risk as the banks that have so far suffered. Markets have also swiftly priced in these problems.
Looking forward, the most important signal for the market will come from the Fed later this month. If it signals a less aggressive interest rate move because of the SVB fallout, markets will interpret that the era of accelerated rate hikes are likely behind us. However, if the Fed continues its aggressive rate hiking policy to fight inflation, we expect volatility ahead not just for the U.S. but also for Canada.