Smartphone age poured petrol on Silicon Valley Bank bonfire

‘Even if a wider banking crisis is averted, there will doubtless be knock-on implications’

Money may make the world go round but fractional banking and maturity transformation determine the speed of the revolutions. This arrangement works extremely well right up to the point at which it doesn’t – as we’ve just discovered with the collapse of Silicon Valley Bank in the US.

The inflection point revolves around the nebulous concept of trust. Unfortunately, it’s a commodity that is in rather short supply these days, a situation that may have implications with which regulators have not yet started to grapple.

Banks are required to hold only a small portion of the money deposited by customers as reserves. The rest can be used to make new loans. Short-term liabilities are therefore funding long-term assets.

You could make the argument that this is a kind of confidence trick; a sleight of hand that, to all intents and purposes, enables banks to magic new money out of thin air. It works because we are prepared to believe that our money is safe and sound in the bank even when it’s not really.

The danger is that if, for any reason, customers start to worry about the financial health of a bank, they may pull their deposits. If enough do this at the same time, there won’t be sufficient money at hand and the bank will suffer a liquidity crunch.

This is what has happened to SVB, which has just gone pop in the second biggest failure in US banking history and the largest since the financial crisis. Yesterday, HSBC, at the behest of the Bank of England, bought SVB’S UK arm to prevent it happening here, too. Do SVB’S travails presage a broader banking crisis? As it stands, that looks unlikely. For starters, SVB didn’t do a lot of business with other banks and therefore the systemic risk as a result of its collapse is low. There is little sign of stress in the interbanking market. It also seems that the bank’s focus on the technology sector made it particularly vulnerable in a number of ways.

The first problem started out as a blessing. The tech scene grew so fast, especially during the pandemic, that SVB ballooned in size. Deposits tripled in the two years to the end of 2021. Unfortunately, the bank was unable to make loans fast enough and instead invested in supposedly safe Treasury bonds and mortgage-backed securities.

At one point its investment portfolio had swelled to 57pc of total assets. SVB started to look less like a bank and more like an investment firm with a massive unhedged position in US government debt. It was at this point that the US Federal Reserve started raising interest rates at pace in order to battle raging inflation. This hit SVB in two ways. Start-ups found it harder to raise money from investors and began burning through their cash. And the value of SVB’S bond holding fell. The result was that both sides of the bank’s balance sheet were hammered at the same time.

Most banks usually do better when rates are higher, as the gap between what you earn on loans and mortgages compared to what you pay for deposits gets larger. Not so SVB. On Wednesday, the bank revealed it was selling some of these investments at a loss to raise cash. Its shares promptly went into freefall.

At that point “Slack and Whatsapp groups lit up across the start-up scene”, according to The Wall Street Journal. A mild panic turned into a stampede.

By the close of play on Thursday, depositors had withdrawn $42bn (£35bn) from SVB. That night the Federal Deposit Insurance Corporation stepped in and seized the bank before it reopened on Friday morning.

Over the weekend, the US Federal Reserve wheeled out the big guns and announced it will make liquidity available to any bank facing a rush of withdrawals. The hope is that giving banks access to such a facility should mean they won’t need to use it.

But, even if a wider banking crisis is averted, there will doubtless be knock-on implications. European bank shares were down an average of 5pc yesterday. The concerns are less about contagion and more a general wariness that other banks might also have nasties hiding on their balance sheets.

Investors are also betting that the Fed might rein in future rate rises to give the financial system time to find its equilibrium before anything else breaks. Yesterday, two-year US Treasury yields experienced their biggest one-day drop since 1987, as investors calculated the Fed will now leave interest rates unchanged at its next meeting later this month.

More broadly, there will be concerns about the manner of SVB’S demise. Silicon Valley Bank, as the name suggests, provided services for some of the most crypto-savvy and hyperconnected people on the planet.

But it’s not alone in being buffeted by these trends. In October last year, Credit Suisse, a doyenne of European banking, was the subject of a swirl of internet rumours about its financial health, which began to circulate on Reddit and resulted in the bank trending on Twitter and being given the moniker “Debit Suisse”.

Analysts noted that the dynamic was similar to when retail investors had banded together online to drive up the share price of so-called memestocks, such as Gamestop, to stratospheric levels. The bank had certainly suffered its fair share of self-inflicted mishaps, but it was clear its share price was being buffeted more by fast-spreading internet rumours than technical analysis of its fundamentals.

The worry is that, in such a febrile atmosphere, banks may have to over-correct. Part of the reason why share prices have fallen is that there’s a general expectation lenders will have to set more money aside to prove they won’t succumb to the same fate as SVB.

This may mean they make fewer loans and therefore less profit. But it would also result in credit drying up and companies finding it hard to access financing. That’s about the last thing we need when so many economies are flirting with recession.