This ‘run on the bank’ was a combination of a few different events that created a perfect storm: the bank’s fixed income portfolio, mismanagement of duration, and liquidity crunch caused panicked customers, all combined with the Federal Reserve’s quantitative tightening.
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One of the most significant impacts of quantitative tightening on fixed income portfolios is changes in interest rates. When central banks tighten monetary policy, it can lead to an increase in interest rates. We have been seeing consistent, yet swift, interest rate hikes by the Federal Reserve, starting at the beginning of last year.
These interest rate hikes impact the value of fixed income securities, as the present value of future cash flows decreases when rates rise. As a result, investors holding fixed income securities have been experiencing unrealized losses and a significant decline in their portfolio values.
Additionally, the process of quantitative tightening can increase the risk associated with duration in fixed income portfolios. Duration risk is the risk that changes in interest rates will impact the value of fixed income securities. Fixed income securities with longer maturities typically have a higher duration, meaning they are more sensitive to changes in interest rates. Therefore, when central banks tighten monetary policy, it can increase the duration risk of fixed income portfolios that hold longer-term bonds.
Now in the case of SVB, as the Guardian explains, “The seeds of its demise were sown when it invested heavily in long-dated U.S. government bonds, including those backed by mortgages. These were, for all intents and purposes, as safe as houses. However, as aforementioned, bonds have an inverse relationship with interest rates; when rates rise, bond prices fall. So when the Federal Reserve started to hike rates rapidly to combat inflation, SVB’s bond portfolio started to lose significant value.”
Like any other fixed income portfolio, if the bank was able to hold on to its investments, longer-term bonds or other fixed income securities, until their maturity, then it would have received the entire principal back. However, the perfect storm was created with its clients—especially tech companies, including startups that typically burn through cash relatively fast—started drawing on their deposits. In the case of SVB, the bank didn’t have enough cash on hand to meet customer demand and had to sell its fixed income holdings at hefty losses; the unrealized losses, due to quantitative tightening, turned into realized losses for the bank.
“It took just 48 hours between the time it disclosed that it had sold the assets and its collapse.”
At the banking level, many local governments, their employees, and their vendors may have their banking relationships with SVB. As the FDIC took over the bank, these people didn’t have access to their accounts. Initially, it was unclear as to how much of their deposits would be covered by FDIC insurance; the standard limit is $250,000 per customer. The long-term impacts of the bank failure are yet to be seen. However, depositors for all other regional to large banks are cautious about potential cascading impacts on other financial institutions.
One potential solution is to diversify fixed income portfolios by investing in a mix of different types of bonds, such as government, corporate, and municipal bonds paired with shorter maturities, which typically have lower duration and are less sensitive to changes in interest rates.
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