New Delhi: Silicon Valley Bank, the 16th largest bank in the United States, became the largest bank to fail since the 2008 global financial crisis, sending global indices into a tailspin last week. The Nifty50 fell by 1% and the Sensex by 1.12% on Friday, March 10th.
SVB is a bank like any other but its client base is predominantly startups in the IT and pharma sectors. The startup ecosystem has hit a pause button. The firms have started burning more cash (incurring losses). With funding not keeping pace they had to dig into their savings/ deposits balances from the SVB. To meet the high withdrawal requirements, SVB had to sell their investments in government securities. However, due to rising interest rate regime in the USA, these securities were trading at lower prices.
The SVB, thus, had to incur losses. To recoup some of the losses, they decided to raise money through equity, but some of the large investors backed off at the last moment.
These two simultaneous developments created panic among the other deposit holders and investors, resulting in a bank run.
Treasury Secretary Janet Yellen said Sunday that the federal government would not bail out Silicon Valley Bank, but is working to help depositors who are concerned about their money.
How Banks Function And What They Do With Our Money
The primary role of banks is to take in funds — called deposits — from those with money (public, financial institutions, corporates etc.), pool them, and lend them to those who need funds (corporates, individuals, startups etc.).
As per the International Monetary Fund, “Banks are intermediaries between depositors (who lend money to the bank) and borrowers (to whom the bank lends money).”
The amount banks pay for deposits and the income they receive on their loans are both called interest. The banks normally charge a higher rate of interest from the loans they give out, and earn a net interest income.
The banks pay interest to depositors for their balances in savings account, fixed or recurring deposits. They charge a higher interest from borrowers for the loans or advances taken and thus make money.
Deposits are liabilities for the banks, which they owe to public and financial institutions.
The amount of money which banks are not able to lend is normally invested in government securities on which the banks earn interest.
Loans or advances and investments are assets of the banks.
At any given moment, only some depositors need their money, most do not. This enables banks to use shorter-term deposits to give longer-term loans, leading to an asset-liability mismatch risk.
If some individuals or corporates to whom loans have been given fail to pay, they are classified as non-performing assets. These losses are borne by the bank from their capital and profits, and by selling the assets of the defaulter.
Banks normally have a very large and diversified deposit base as well as borrower base. Borrowers are from various industries and majority of them are not expected to default at the same time.
The central bank has put in place regulations to avoid concentration risk, to prevent banks from giving out majority of their loans to one company or one group.
Banks cannot lend more than 20% of their capital to a single borrower and more than 25% of capital to a group of interconnected borrowers in India.
In the infamous PMC case, the Punjab and Maharashtra Cooperative Bank’s exposure to bankrupt Housing Development and Infrastructure Limited (HDIL) was pegged at over 73 per cent of its total assets, which led to its collapse.
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What Happens When A Bank Fails
If a bank fails in India, there is a bank deposit insurance cover of Rs 5 lakh per bank, which is available to depositors, and this amount has to be refunded within 90 days. Earlier, this limit used to be Rs 1 lakh and this was increased in the aftermath of the PMC case.
This ‘Deposit Insurance Credit Guarantee Scheme’ covers more than 90% of depositors in the country as most people have less than Rs. 5 lakh as deposits in a single bank.
As per the Government of India, the depositors of India are given the largest coverage available anywhere in the banking system in the entire world.
In case an individual has more than Rs 5 lakh deposit in a bank, and it fails, the regulator is likely to take over the bank and oversee sale of its assets and investments. These proceeds from sale will be returned to the depositors on a pro rata basis.
The Federal Deposit Insurance Corporation of the USA insures deposits up to $250,000, but many of the companies and wealthy people (80%) who used the SVB bank had more than that amount in their account, and their fate hangs in balance.
The key learning for depositors from the SVB episode is to avoid concentration risk. Don’t put all your eggs in one basket. If you have more than Rs 5 lakh to invest as Fixed Deposits, keep it in different banks to enjoy the insurance cover.
The authors are SEBI-registered investment advisors.
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