Silicon Valley Bank’s foibles don’t threaten India’s financial stability

   2023-03-16 17:03

An accident waiting to happen — that’s how veteran banker Uday Kotak has described the run on Silicon Valley Bank and the subsequent 4.1% drop in the S&P 500 Financials Index on Thursday.  The contagion spreading to Asian markets by Friday. In all probability the panic is unwarranted, especially as financial regulators have presumably learned their lesson from not bailing out Lehman Brothers, triggering the global financial crisis of 2007-09.

When interest rates go up in the range of 500 basis points from zero over just a few months, banks are bound to be caught with lots of low-coupon securities whose current price would be a steep discount over their acquisition cost (the coupon, or periodic payments serving as interest payments to the holder of the security, is specified as an absolute amount, and the capital required to generate an amount equivalent to the coupon goes down as interest rates go up, depressing the value of the coupon-bearing security as the Fed raises rates to combat inflation).

If banks holding plenty of such securities are forced to liquidate them at short notice to service panicky depositors, they will book steep losses and need plenty of additional credit to stave off an asset-liability mismatch, insolvency, and disaster.

If the US financial regulatory system does not provide Silicon Valley Bank with a lender of last resort, it could go under and feed the panic set off by the shut down of Silvergate, a traditional bank that, in 2013, decided to specialise in supporting the cryptocurrency ecosystem with traditional finance.

When cryptocurrency poster boy Sam Bankman Fried’s crypto exchange FTX collapsed last year, the crypto universe went into a tailspin. That invited short-sellers to trigger a self-fulfilling prophecy that Silvegate would collapse. Attempts to raise capital from crypto exchanges and wallets did not succeed and Silvergate had to shut down.

It had generally been assumed that the regulatory reform initiated since the Global Financial Crisis had fortified the banking system against fragility of the kind that took down Lehman Brothers. Capital adequacy norms were raised. Additional loss-absorbing capital buffers were instituted, such as the Additional Tier 1 Bonds of the kind that are in focus following the bailout of Yes Bank.

Globally, systemically important banks were required to have yet stronger capital buffers. The kind of speculation that creates additional risk, rather than mitigates existing risk, was tightly controlled. Regular stress tests are carried out to ensure banks were in good nick. In the US, pure merchant banks like Goldman Sachs started taking customer deposits to secure access to low-cost funds.

While all this is true, it applies more to large banks than to smaller ones. Given the inherent interdependence of banks and other elements of the financial system, the chain is only as robust as its weakest link.

In retrospect, the error of letting cryptocurrencies thrive in a regulatory vacuum should have been obvious at the outset. When ordinary people started seeing bitcoin and other cryptocurrencies as viable saving instruments, alarm bells should have been clanging. While Indian regulators put very tight regulations around cryptos, the US authorities took a more lenient view. Cryptocurrencies flourished as embodiments of libertarian freedom beyond the reach of the state.

While sharp swings in the value of cryptocurrencies destroyed value frequently, it was only after the collapse of FTX that the vulnerability of the crypto ecosystem became obvious to anyone who cared to look. Yet the notion that investors were investing in cryptocurrencies exercising their inalienable right to lose their shirts as they deemed fit has burst like the bubble it was, and people started blaming governments for failing to protect them.

The sensible thing to do now would be listen to voices such as that of Bill Ackman, billionaire and activist investor, who suggests an official bailout for Silicon Valley Bank. Just fixing one weak link would not suffice, however. Cryptocurrencies should also be brought under ambit of regulation and supervision.

Indian banks are relatively insulated from American ones. While stock markets take cues from one another, the real economy will be affected by developments in American finance only if Indian regulators lose their focus on financial stability. That is not a serious prospect.

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