Silicon Valley Bank: a cautionary tale of rising interest rates and financial stability 

On 13 March, the Bank of England and HM Treasury announced that the UK subsidiary of Silicon Valley Bank (SVB) had been sold to HSBC, to protect depositors’ money and stem potential repercussions for the UK tech sector. This incident shares a root cause with other recent crises, such as the LDI crisis in the UK last September: rising interest rates. In this blog, we discuss the repercussions of higher interest rates for the macroeconomic environment and financial stability and the potential implications for supervision and regulation.   

Significant parts of the economy used to low-interest rates, face business model challenges 

In the last 12 months, we have seen one of the fastest cycles of monetary tightening since the 1980s, with the Bank of England’s Bank Rate rising from 0.1% in December 2021 to 4% in February 2023, while the US Federal Funds Rate has increased from 0.25-0.5% to 4.50-4.75% over the same period.  

The end of the low-interest rate environment has caused havoc in many sectors accustomed to ‘easy money’ and triggered steep revaluations and volatility in financial markets. We’ve seen the market cap of the cryptoasset market come under steep pressure, whilst the share prices of tech firms have fallen significantly following years of growth. Even the safest asset classes, such as US Treasuries, have come under increased strain. On 13 March, two-year Treasury yields recorded their biggest one-day drop since 1987. This raises the risk of further disorderly repricing.  

Market liquidity has been challenged by these rapid changes. Compared to the wider banking sector, SVB was particularly exposed to rising interest rates: its depositors (mostly tech companies with a broadly homogenous investor base) withdrew deposits as interest rates rose, while the asset side of its balance sheet suffered significant losses as a direct, mechanical result of interest rate rises. However, SVB is by no means the only bank subject to this dynamic. In the US, similar developments were seen at Silvergate and Signature Bank. Liquidity crises can rapidly develop into solvency crises, especially where business models centre around long-term, speculative or highly illiquid assets.  

Central banks need to avoid exacerbating systemic risk as they tackle inflation 

Policymakers face a challenging environment. Central banks have signalled the need to raise interest rates further, lest inflationary expectations become entrenched. Whilst monetary tightening has to date had a limited impact on the wider macroeconomy, risks are now crystallising in pockets of the banking sector. The transition away from the low-interest rate environment could be a trigger for potential financial stability risks in the short term.  

Authorities could find themselves in a position where they face trade-offs between managing inflation and preventing the materialisation of systemic risk. For example, following the UK Government’s disastrous “mini-Budget” in September 2022, the Bank of England was forced to intervene with quantitative easing – buying up bonds to stabilise gilt markets as pension funds were forced to sell their assets to meet margin calls. Leading figures from central banks have highlighted how quantitative tightening will need to be carefully calibrated (and may even move in the opposite direction to interest rates) to take into account its effect on financial stability as interest rates rise.  

Central banks will need to focus on holding the line on rate hikes while preventing the materialisation of financial stability risks. Since the SVB crisis, interest rate expectations have fallen as market participants expect central banks to act to steady the financial system. However, policymakers have been resolute in tackling inflation and previous predictions of softening in monetary policy have repeatedly been proven wrong.  

Implications for central banks, financial regulators and governments 

In response to the crisis, the Federal Reserve (Fed) announced it will make additional liquidity available, on unusually loose terms (e.g. with pledged securities valued at par, not market, value) to minimise the risk of runs on other banks following the failure of SVB. US authorities have also moved to guarantee all deposits of Silicon Valley and Signature Bank, despite concerns around moral hazard. This is driven by fear of potential contagion across the banking industry, which has been reflected in banks’ stock prices across all major jurisdictions.   

The failure of SVB raises obvious questions about the fragmented oversight of banks in the US. The scale of concentration of risk in long-dated bonds, which SVB piled into in its search for yield, is a catastrophic failure of risk management. The liquidity mismatch which arose is even more striking as interest rate expectations have been well-signalled by the Fed. It is well-known that corporate deposits are flighty: SVB’s clients used their deposits as working capital and drew them down as the tech sector faced a downturn. This raises significant concerns about the quality of supervisory oversight, which may be toughened in light of the collapse of SVB.  

In the US, deregulation in the Trump era meant that banks with a balance sheet below $250bn faced fewer prudential requirements, particularly on their liquidity and funding positions. This is a particularly high ceiling compared to other jurisdictions (it is notable that SVB, Signature and Silvergate all fell into this category). The full panoply of Basel rules only applies to a few internationally active banks, a point of contention that the EU has raised in the past. Authorities in the US may look to roll back some of the Trump-era reforms. Further, the subsidiaries of US banks may come under greater regulatory scrutiny in the EU, UK and APAC. 

However, the regulatory landscape outside the US is unlikely to significantly change. Tighter banking standards following the financial crisis have led to a more resilient financial sector – demonstrated by the fact that contagion to the mainstream banking system remains limited. At the same time, authorities, led by the Financial Stability Board, have been looking to tighten standards in the non-bank sector, which we discuss in another blog post. 

A related perspective on how regulators are approaching non-bank risks highlights the growing concern about over-correction and unintended consequences.

In the UK, authorities have come under pressure in recent years to develop more tailored regulatory regimes for smaller, domestically-oriented banks. This incident shows that such ‘proportionality’ is not without risk and will be front of mind for the UK PRA as it works to develop its ‘strong and simple’ prudential regime for smaller banks. Regulators previously under political pressure to roll out the red carpet for challenger firms may now feel the need to demonstrate that they are not compromising on the fundamental building blocks of the regulatory regime – particularly to avoid the risk of blame for any eventual failure. 

Furthermore, the sale of SVB UK to one of the UK’s leading retail banks consolidates an already concentrated sector, creating a trade-off between competition and financial stability. There is a risk that customers turn away from smaller or newer financial institutions, in the fear that legacy ‘too big to fail’ banks are a safer store for their assets. The managed sale of SVB UK has been justified on the basis that it reduces risks to the UK tech and life sciences sectors (and taxpayers) from one small bank, which could have been catastrophic for many businesses. However, there are questions over whether SVB will retain its unique and tailored offering to the sector, a particularly significant issue given the government’s focus on investment for early-stage tech in the UK.  

As authorities consider whether prudential or supervisory standards need to adapt following this failure and whether the deposit insurance framework is due for a review in the digital age, they must balance these concerns with the costs which tighter prudential and liquidity standards impose on the financial sector, impacting lending, competition and wider economic growth. It is important that firms engage with policymakers to ensure policy proposals are sensible, and proportionate and address the risks which led to the crisis in the first place. 

Businesses facing similar uncertainty are now being advised to understand the political backdrop behind economic decisions and regulatory change.

Conor Sewell is a Manager at Flint and supports clients on global financial services policy and regulatory issues. Before joining, he worked on financial services at HM Treasury and within the Bank of England’s Capital Markets Division. Prior to joining Flint as a consultant, Tamim Kalaji worked on wholesale financial markets issues at the Financial Conduct Authority. They are both based in our London office. 

To find out more about how Flint can help you navigate the risks and opportunities of these developments, get in touch.