Dangers of Wrong Economics
On 10th March regulators declared Silicon Valley Bank (SVB), a 40-year-old bank set up to cater to the tech companies of America, had failed.
This crisis was the direct result of repeated increase in the interest rate by the Federal Bank of US. This hike in interest rates was to contain high inflation in America due to disruption of economy during and post Covid-19. The classical theory of controlling inflation in all the countries is to enhance the interest rate by the central banks to make the loans more expensive. This ensures that less money (liquidity) is taken from banks for investment in business, thereby reducing the money supply in the market. The reduction in money in the market suppresses the prices of commodities to control inflation. The action by the Federal Bank of US was a big mistake, because it failed to see the nature of the inflation. This inflation was not the result of the increase in demand, but it was due to the disruption in the global and domestic supply chains during and after the pandemic. RBI should get wiser.
Amid rising interest rates and a slowing economy, a funding scarcity set in and startups started finding it difficult to raise funds. They began falling back on their deposits. Typically when interest rates rise, bond prices fall and vice-versa.
SVB couldn’t stop depositors from withdrawing their money. So, it had to sell some of the bonds it had bought, even if it meant incurring a loss. In crisis SVB said it had sold $21 billion worth of bonds at a loss of around $1.8 billion. Its share price was falling and more people had started withdrawing their deposits from the bank. The regulator shut the bank down to avoid a contagion. However, 3 US banks have collapsed and a fourth bank has received help of $30 billion from a consortium of banks. In Europe, Credit Suisse had to borrow $54 billion from the Swiss central bank.
Every bank works on the trust and confidence the depositors have in it. No bank can survive if enough depositors want to be repaid at the same time. The trick, therefore, is to ensure that customers never have cause to whisk away their cash. The managers of Silicon Valley Bank, formerly America’s 16th-largest lender, failed to maintain trust at this moment. After public scrutiny of bank accounts deposits worth $42bn were withdrawn, a quarter of the bank’s total. The bank failed.
There was repercussion in the global markets. Indian stock exchanges also felt the pressure but fortunately India and the world in general for now, unlike 2008, seem to have escaped the catastrophe of recession.
