Lessons from SVB Shut Down

 Lessons from SVB

I. SVB (Silicon Valley Bank) meltdown: 

1. Wholesale deposits did it in: Major portion of its deposits/liabilities were demand and callable deposits, which were payable immediately/ on short notice.

2. Deployment of funds in long term assets: Such deposits were invested in the long term mortgage backed securities and treasury bonds, both in the 10 year plus bracket, in the belief that the stimulus package rolled out and low fund rates introduced during the COVID period might not be reversed all at once. 

3. No Provisions created from revenue to meet asset price decline: The bank never thought it prudent to make provisions to meet emergencies, that may arise as the liabilities were fixed in amount and payable on demand while the long term assets, were cashable but the value is marked to market (MTM). Even after FED started raising the rates aggressively and took  consistent hawkish stances, the bank did not seem to have brought in/succeeded in its efforts to infuse capital funds to cover the unrealized /notional losses (USD 16 billion) in its HTM portfolio, which far exceeded its equity base.

4. Whether the Regulator alone is to be blamed?: Some may argue that the bank is not at fault as the regulator has to be blamed for increasing the fund rates by more than 400 bps in a very short span of six months. And they advocate that this was responsible for the MTM notional losses in respect of an asset portfolio, predominantly filled with risk free/ low credit risk assets. It is conveniently forgotten that a banker has to manage credit, operational and market risks together. SVB got it alright in looking at the credit risk while investing, but forgot the market risk associated with the investments and the operational risk that arises, if losses are made due to operations/ sale of such assets.  

II. A few lessons to the banks in India and RBI: Though Indian Banks operate on a different planet, with retail deposits holding the fort on the liabilities side, the bankers in India and RBI still can take away a few points from this episode.

• Increase in Bulk Deposits: In terms of growth in FY 2022-23, unsecured personal loans, corporate advances, gold loans, housing and auto loans, in that order, have scored over the other loans. The deposit growth picked up since October 2022, after the banks were forced to increase their deposit rates due to dry down in  liquidity (RBI restored CRR to 4.5% from 4% introduced during COVID times) and the depositors also started moving the funds towards debt funds, equity and Mutual Funds. Even now, the growth in CASA is sluggish and the bulk deposits form the majority of the growth in term deposits in some of the banks. The strength of Indian Banking system is that retail deposits contribute in a major measure to the growth in advances, with borrowings and bulk deposits accounting for a miniscule, except a select few, which were traditionally dependent on bulk deposits. However this trend has changed recently. RBI should bring back its measures to down size the growth in certificate of deposits, which is on the rise, in a majority of the banks in the current FY.

• Increase in Investment portfolio, nearly 50% more than regulatory levels:  The regulatory prescription for SLR is a minimum of 18.5% of NDTL and RBI has further permitted the banks to hold SLR eligible securities up to 23% of NDTL in their HTM portfolio. However the SLR securities held by commercial banks in India is consistently higher and varies between 27-35% of their NDTL.. This has created problems for the banks in the scenario of raising repo rate since April 2022. As the yield moved up by 135 basis points in the 10 year G-Sec since April 2021, (prices of the securities are inversely proportional), only a few banks could report positive figures under sale of investments in FY 2022-23. The banks also had to account for depreciation in respect of their HFT/AFS portfolios as the securities were marked to market. Luckily, the banks need not value their HTM investments on MTM basis.  Though Indian Banks are fairly insulated, due to the fairly well spread retail deposits, let us remember that except the benchmark  10 year g-sec and the one issued as benchmark prior to that, the volume traded in the other long term securities is always thin, especially when the price of the securities are at a discount. Secondary market for State Development Loans (SDLs), accounted as eligible SLR security, has not yet developed and most of them are illiquid. Hence, there is an urgent need to create a reserve in the books of the banks (to be created as a percentage of annual net profit), which will serve as a buffer against  the market risk arising out of notional losses in HTM portfolio. (SVB episode is mainly attributed to the notional losses in HTM portfolio).

• Need to constantly increase capital in tune with the growth in assets: CAR ratio of the banking system as a whole is much above the regulatory prescription of 11.5%. While internal accruals, (mainly on account of the growth in advances resulting in a better net interest income), and capital infusion played their roles in the banks reporting a healthy CAR, the regulator has also played its role by reducing the risk weight in respect of retail advances and home loans in 2020. The relaxation in risk weight is expected to continue till the quality of assets in the said sectors is maintained at current levels. Any increase in NPA levels in these sectors in future may force RBI to review the risk weights assigned to these sectors. Probably, it is for this reason that RBI Governor, in all his speeches drive home the point that banks should continually infuse equity and other capital funds to guard against delinquencies, slow down in economy etc.

III. MPC should look at 'pausing' the repo rate: ECB increased their policy rates by 50 bps.  FOMC meeting in the third week of March 23 will decide whether the fed fund rate will continue to be on the upward curve or  the episodes in SVB, Signature Bank and the crisis in Credit Suisse deserves consideration, while keeping inflation target in mind. Monetary Policy Committee of RBI meets in the first week of April 23. Whatever be the decision of the FOMC or the realities now prevailing in the CPI/Core CPI inflation front in India, I am of the view that MPC will do well to pause the rate for the following reasons.

1. Costs to borrowers in production and Services: The policy rate increased by 250 basis points in less than nine months. Assuming that the average loan rate for the MSME/corporate customer was 7.5 to 9.5% prior the increase in repo rate, the average lending rate should now be in the range of 9.0 to 11.0%. The increase in financial costs is  20-25% more in 2022-23 than what they were paying in 2021-22. As the interest costs is to be paid in time, to keep the standard asset status, from the internal accruals only, there are chances that payment to creditors/ salary to employees are delayed and consequent decline in purchases of materials as well. It is a cycle and the decline in net profit is not far away in this situation. Though dues to the banks may be well received initially, this is bound to face challenges after a lag. 
2. Repo rate is only one of the tools to control inflation: Monetary Policy is only one of the tools to control inflation and increasing interest rates alone may not bring back price stability. For example, the crude oil prices are on a downward path since June 2022. The share of oil imported from Russia, at huge discounts, has gone up substantially. However, petrol and diesel prices, which shot up between Rs.15 and Rs.20 in almost all the states ill June 2022, remain unchanged, though the import costs for the oil companies has come down appreciably. The reduction of Rs.8 for petrol and Rs.6 for diesel in May 2022 were due to reductions in excise duty by the central government. Reduction in the retail fuel prices may help in  achieving core inflation, remaining sticky, to come down faster. 
3. Effect on Government Borrowings: Every increase in repo rate has a direct effect on the money market and loans linked to external benchmark. 10-year G-Sec is pricier by 135 bps since April 2021 and 364-days Treasury Bills have gone up by more than 250 bps since May 2022. The increase in cost of borrowings* for the government is likely to push the inflation still further, as the borrowings are decided based on estimated fiscal deficit and not on the cost prevalent for raising such borrowings in the market. 

Regards

V.Viswanathan

17th March 2023

*In the fiscal budget presented for 2023-24, out of every one rupee to be spent, 20 paisa goes towards interest on government borrowings