MAHESH PAI reflects on the important points that one can learn from the setback faced by a leading bank in the US.
In March 2021, Silicon Valley Bank (SVB), a leading financial institution based in California, found itself caught up in a major controversy. SVB was a key lender to technology and innovation startups which landed itself in a liquidity crisis giving a shock to the entire startup ecosystem. It was alleged that the bank had gotten itself into trouble because of its Asset Liability Management (ALM) mismatch concerns, which manifested solvency issues for the bank, leading to a widespread investigation by regulatory authorities.
So how did this crisis begin?
In February 2020, when the pandemic began, the entire world’s economies were startled, a recession was about to begin but before that, The Federal Reserve reduced its interest rate to almost 0%.
What is Zero Interest rate policy?
During any economic downturn or recession, the central bank reduces its lending rate; in US, the Federal Reserve reduces its lending rate to almost 0% during the pandemic. The logic of reducing the interest rates is that borrowing becomes cheaper which encourages businesses and individuals to take loans from banks at bare minimum interest rates. This is done to increase the money supply in the market which can help stimulate economic activity by encouraging borrowing and spending, but this always has a negative effect, too. When there is more money in circulation it can lead to inflation as people have more money and are willing to pay more eventually increasing the prices of commodities. So, during the period of zero interest rate (2020) SVB invested billions in the US government bonds which are usually considered a safe investment with low returns and fixed interest rates which makes it risk-free. These bonds have a fixed interest rate and investors get their money back after a specific period of time.
In 2022, the Federal Reserve started increasing interest rates aggressively to combat inflation, and the value of bonds purchased by SVB started decreasing (because the new bonds that were issued had higher interest rates and were more attractive to investors). The tech companies that had their deposits with the SVB started losing the value of their investments, this led to panic selling in the market, and the tech companies were not being able to raise capital from the market due to which they were forced to withdraw their money from the bank. The bank had to sell off its bonds at a loss to repay its investors and depositors. Due to their inability to repay, the FDIC (Federal Deposit Insurance Corporation) had to take over the control of SVBs assets and operations and sell the bank’s assets to pay off its creditors and investors.
This crisis has impacted India as well where SVB has been operating since 2005. The major reason for SVB’s failure was its wrong investment strategies and the rise in interest rates by the Federal Reserve, SVB did not improvise and adapt to the market situation which resulted in this crisis.
SVB is known for its focus on providing financial services to the technology and innovation sectors. Its clients include startups, venture capital firms, and technology companies, many of which are based in India. SVB has deposits worth 1 billion from Indian startups and over the years, it has played a crucial role in supporting the growth of the Indian startup ecosystem, providing funding, mentorship, and other resources to promising companies. However, the recent crisis has raised concerns about the bank’s operations in India. As regulatory authorities crack down on SVB’s activities, there are fears that Indian companies may be caught in the crossfire. Startups and small businesses that rely on SVB for funding and other financial services may face significant challenges in the coming months.
What are the lessons that investors can take away from this crisis?
1. The most important lesson is whatever the asset class may be, it is essential to diversify your investments. Investors should not keep all their eggs in one basket, the purpose of diversification is to mitigate risk and not lose the invested capital. This also reduces the impact of all the market shocks and sentiments.
2. For our savings, our deposits need to be spread across different banks and for equities; our investments need to be spread across different stocks in various sectors across market capitalisation. This diversification in sectors helps as different sectors behave differently depending on the Indian and global economies.
3. Diversifying the investments will help keep away from extreme drawdowns and loss of principle amount. An investor should allot a few of his funds systematically that are risk-free and capital protected, there should be a balance between equity and debt in one’s portfolio.
4. In terms of the Indian Banking system, deposits of only up to 5 lakhs are insured with DICGC (Deposit Insurance and Credit Guarantee Corporation). This means a depositor with a crore in a fixed deposit will get only 5 lakhs if the bank fails.
In conclusion, SVB forgot the basics of banking and their asset and liability management (ALM), leading to disruption in the market and for the investors as well. The SVB crisis has the potential to have a significant impact on India, particularly on the country’s startup ecosystem. Every bank where people keep their hard-earned money invests it in financial markets where there are chances of a financial mess. The failure of SVB highlights the importance of sound investment strategies, proper allocation of funds, and risk management especially in the financial sector where one mistake can hamper the lives of a lot of people and the economy as a whole. Investors have now learned the importance of portfolio management, diversification of investments, assessing financial and legal strategies and securing organisation’s capital and earnings.
