In a matter of 48 hours, two big US banks have collapsed – the Silicon Valley Bank (SVB) on Friday and the Signature Bank (SB) on Sunday. This raises the specter of a broader systemic crisis that may engulf other economies, particularly the UK and India. In an interconnected world of globalised finance, such events tend to travel quickly and harm many economies. The 2007-08 financial crisis is a good example of this.
The US Treasury Department and other bank regulators may be claiming that “no losses will be borne by the taxpayer” in their efforts to save these banks but another public bail-out may just be around the corner. After all, these are the second and third-largest failures in US banking history. The risks to these banks were greater because they focused on start-ups (SVB) and real estate and digital (crypto) assets (SB) – all of which are under stress in recent times.
One of the most striking aspects of the bank runs, however, is the overnight change – which gave no time to the regulators to take preventive measures. Clearly, this points to intrinsic flaws in the US banking practices and oversight mechanisms.
Nevertheless, the development is shocking because there have been plenty of advance warnings, in fact, for more than a year: (i) US witnessed a technical recession with two consecutive quarters of negative output growth in 2022 (January to June 2022), pointing to the weakened economy and fragile post-pandemic recovery (ii) ‘inversion’ in the yield curve first noticed in May 2022 (long-term or 10-year treasury yield falling behind the short-term or one-year treasury yield), pointing to further recession in waiting (iii) ‘funding winter’ for start-ups since the first quarter of 2022 (January-March 2022) and its continuation (iv) crypto crisis with the collapse of the biggest crypto exchange FTX in November 2022 and (v) deep stress in the US housing sector, which is likely to worsen in 2023 due to the rising interest rates.
Why the bank runs in the US?
There are two sets of factors here, one of which is proximate.
In the case of SVB, the collapse happened as (i) its main client, the Silicon Valley start-ups, are in trouble for more than a year. They withdrew money to meet their liquidity needs because of (ii) the rising interest rates for the past year which shut down the market for IPOs for many of them and made private fundraising more costly (‘funding winter’). This forced the bank to sell a bunch of securities at a loss last week and the announcement that it would do more of it to meet the withdrawal demands and the sale of its shares to raise funds ended up pulling down the (share) price by 60%. The last factor sparked a panic withdrawal, resulting in the bank’s overnight collapse.
At this time, (iii) the US banks also lost more than $100 billion in market value. Both developments impacted the SB, a quarter of whose deposits come from (iv) the cryptocurrency sector, which is already in deep stress after the collapse of the crypto exchange FTX) and also deeply invested in (v) the US housing sector, which too is under stress.
There is yet another proximate factor, which is (v) change in US regulatory practice. Following the 2007-08 financial crisis, the US brought the Dodd-Frank Act in 2010 to tighten regulatory oversight and resolution plans and which required all banks with more than $50 billion in total consolidated assets to submit resolution plans providing for their rapid and orderly resolution under the US Bankruptcy Code. This threshold was raised to $250 billion in May 2018 by the Trump administration.
The result?
At the end of 2022 (more than two months ago), the SVB had an asset base of $209 billion and the SB $110.36 billion – more than $50 billion – and hence, no trigger went off.
Realising this, the Biden administration is now contemplating lowering the threshold again but this is easier said than done. After the midterm elections, the Republicans (Trump’s party) took control of the House of Representatives in January 2023 and the US Congress stands sharply and deeply divided.
There are two not-so-proximate factors: (vi) the start-up culture which, until the ‘funding winter’ set in in 2022, ignored bottom-line (profit) and sound financial fundamentals to grow (most need venture capital at different stages of growth) and (vi) cryptocurrencies which are without legal backing or “permanent value” (as Raghuram Rajan said, predicting that most of them won’t survive). Staying invested in these sectors (start-ups, cryptocurrencies and housing) may not be a sound business decision.
One consolation is that most of the proximate factors would go away when the US inflation eases to herald the lowering of interest rates and the global economic outlook improves; President Biden may produce magic by reversing Trump’s threshold too.
But this can’t be said of the set of fundamental factors that keep the risks to global financial stability perpetually alive.
Built-in risks to bank-run and other financial crises
The fundamental risks to financial stability arise primarily out of the existing global economic order which seeks to promote: (a) de-regulated or lightly regulated flow of capital (FDIs and FIIs) (b) low-interest regime high on liquidity infusion (c) complex financial instruments bringing high vulnerabilities (d) dominance of the stock market, its speculative activities highly prone to emotional reactions (irrational exuberance or panic) and the disconnect with ‘real’ economy (e) debt-driven entrepreneurship in which capital/investment rides more on debt, less on equity (or promoters’ money) which is encouraged by (f) taxation system in which (i) returns on equity (dividend) is taxed but returns on debt (interest) is tax-exempted (ii) global flow of FDI/FIIs is tax incentivised and (iii) corporate tax is low (below individual income tax level in India, for example).
None of these is likely to change anytime soon as these are the official policy of the US and pushed by the World Bank-IMF in the rest of the world (for more than four decades).
For India, all these factors are at play; it is connected to the global economy more than ever and hence, the US development is likely to impact.
Besides, India has its own vulnerabilities.
For one, its start-up ecosystem is already reeling under a long spell of ‘funding winter’ and the SVB’s collapse has already caused serious apprehensions even if the exposure is limited. For another, for the first time, India witnessed the US-type yield inversion earlier this month – the yield of one-year treasury bills at 7.48% (highest since October 2018) surpassed that of 7.41% for the 10-year benchmark 7.26% 2033 bond. In normal times, the yield for longer-duration treasury bills or bonds is more than the shorter-duration ones. The US studies have shown, when such yield inversion happens, recession follows in the next 6-24 months.
The fear of recession was expressed in January 2023 by Union Minister Narayan Rane, who told a G20 meeting in Pune that it was likely hit India after June 2023, primarily because of the global recessionary trend. He said he “gathered (this) from the discussion in the meetings of the Union government”. The economy is on the downswing, after a recovery in FY22. From 9.1% in FY22 (revised upward last month) the GDP growth is estimated to go down to 7% in FY23 (RE) and 6.4% in FY24 (mid-point of 6-6.8% projected in the Economic Survey of 2022-23).
These are pointers to worsening economic conditions which make India vulnerable to any adverse financial developments in the US and other advanced economies. The impact of the US bank runs has already been witnessed in the stock market upheaval on Monday and may continue to bleed.
Then there are other factors.
As it is, India is passing through a critical stage because of the Hindenburg-Adani episode. The Adani group may have denied allegations of being overleveraged (high debt burden), price manipulations, financial and accounting irregularities and unknown source of funding involving shell companies and tax havens, but its listed companies have taken a big hit, forcing it to suspend future investment plans and shed debts instead. Given that India’s infrastructure story rides on the Adani group (it already runs 30% of freight through a dozen shipping ports, 23% of airline passengers through seven airports, operates the biggest generators of private electricity and holds 30% of grains in its warehouses, besides building highways, developing real estate and investing big in green energies.), any negative impact on this has serious consequences for India’s present and future growth prospects.
India has just come out of multiple failures and frauds involving banking and non-banking financial institutions (PMC Bank, Punjab National Bank, ICICI Bank, Yes Bank, Lakshmi Vilas Bank, IL&FS, HDIL, DHFL) and the NPA crisis. India’s regulatory system is far from robust. Its big businesses are debt-ridden. Its bankruptcy and insolvency mechanism (IBC Code) is less effective than the earlier regime (haircuts under the IBC are over 80%, against 75% under the BIFR).
It is unlikely that India will delink from the global order and charter its own economic policies and hence risks of bank runs and other financial crises remain.
