On March 10, the California government announced the closure of Silicon Valley Bank and the transfer of it to the Federal Deposit Insurance Corporation (FDIC). The once-little-known small and medium-sized American bank suddenly thundered, causing market vibrations. Around the same time, two U.S. banks serving companies in the cryptocurrency space, Silvergate Bank and Signature Bank, also collapsed, adding to concerns about the U.S. economy.
US President Joe Biden responded on Monday (March 13) that the overall US banking system remains robust and taxpayers will not bear the losses. However, fears still appear to be creeping in, with U.S. bank stocks tumbling on March 13, with First Republic Bank down 62 percent. Ratings agency Moody's then placed First Republic Bank and five other banks on negative watch list.
How bad is the Silicon Valley banking crisis? Will Silicon Valley Bank become another Lehman Brothers? What lessons should China on this side of the Pacific take from this? The Observer interviewed Cao Yuanzheng, Vice President of the China Macroeconomic Society and Chairman of BOCI Research.
[Interview, Collation/Observer Network Gao Yanping]
Why Silicon Valley Bank?
Observer.com: In the second half of last year and the beginning of this year, many institutions and economists, including you, predicted that the world economy, including the US economy, would fall into recession in 2023.
Cao Yuanzheng: Silicon Valley Bank is different from ordinary commercial banks in that it is a bank that specializes in serving the special financing needs of technology and pharmaceutical startups.
Silicon Valley Bank has no bank counters, no personal savings business, no public deposits, and the funds on the liability side come from deposits called by loan customers and venture capital institutions at any time. Most of these deposits are in demand, and the cost of funds is relatively low.
The bank's core business is bridge lending, lending to VC/PE investors (FOFs) and also to start-ups. Because high-tech start-ups are not profitable, risky, and generally have higher interest rates, Silicon Valley banks can benefit from interest rate spreads, and at the same time, obtaining option earnings from start-ups is also one of the sources of profit for Silicon Valley banks.
According to Silicon Valley Bank, after 40 years of accumulation, 50% of the software and hardware, life sciences and medical industry companies backed by venture capital funds in the United States are Silicon Valley Bank customers. 44% of tech and healthcare startup IPOs backed by VC funds in 2022 were clients of Silicon Valley Bank; 88% of Forbes' "Next Billion Dollar Startups" in 2022 are Silicon Valley Bank customers.
Before the epidemic, the debt-side deposits from loan customers and venture capital institutions were sufficient, asset-side loans were relatively normal, and Silicon Valley Bank operated without problems. But after the epidemic, there was a very serious maturity mismatch between the liabilities and assets of Silicon Valley Bank.
When the epidemic broke out in 2020, the United States offered a large-scale quantitative easing policy to stimulate the economy, and the deposits of Silicon Valley banks increased sharply, jumping from $61.76 billion in 2019 to $189.2 billion in 2021. At this time, VC/PE financing costs are low and investment activities are extremely active.
Silicon Valley banks have accumulated huge deposits that are used to invest in long-term U.S. Treasury bonds and MBS and other assets, and by the end of 2022, Silicon Valley held as much as $120 billion in long-term bonds, accounting for more than half of total assets ($211.8 billion). (See figure below)
By the end of 2022, SVB asset-side long-term bonds accounted for more than half, and loans accounted for less than one-third. Data from SVB2022Q4 financial report
However, affected by the epidemic, the economies of various countries have been hit hard; There are also sanctions and small courtyards by the United States and its allies after the conflict between Russia and Ukraine, for example, China was a major investor in US high-tech companies, but it has been greatly reduced in the context of decoupling; Moreover, the Fed's interest rate hikes since 2022 have worsened, and the investment and financing activities of venture capital companies have contracted sharply in 2022. Tech companies are no longer as easy to access to funds as they used to be, and in order to stay afloat, they need to go to the bank to withdraw money, which has led to a massive outflow of deposits from Silicon Valley banks since 2022. (See figure below)
Since the first quarter of 2022, VC investment enthusiasm has declined, while deposits have flowed out significantly. Data from SVB2022Q4 financial report
The problem was that Silicon Valley Bank didn't have the cash to handle the sheer volume of withdrawals and had to start selling up to $21 billion in U.S. bonds and MBS assets, while also raising $2.25 billion through additional stock issuance to raise liquidity.
The maturity mismatch of Silicon Valley banks has been exposed: on the liability side, depositors are in dire need of money, but long-term investments on the asset side cannot be repaid in the short term. Against the backdrop of a dollar hike, selling bonds necessarily means losing money.
The reason is simple, a bond purchased in 2021 with a face value of 100 yuan has an interest rate of almost zero, assuming 1%. After the interest rate hike, assuming that the interest rate fluctuates by 3%, the 100 yuan bond can only sell 98 yuan after selling.
This is how Silicon Valley Bank's $1.8 billion after-tax loss after selling long-term debt assets arose. Coupled with the impact of stock issuance on stock prices, investors are worried about the liquidity problems of Silicon Valley banks, further exacerbating stock sell-offs and bank runs. And so the crisis erupted.
It can be said that the collapse of the Silicon Valley Bank has a lot to do with the particularity of this bank's business, which is a liquidity crisis.
Why was the U.S. bailout so fast?
Observer: We review the following timeline of the Silicon Valley Bank crisis: On March 8, Silicon Valley Bank announced that it had raised $2.25 billion, triggering a wave of withdrawals; on March 9, the stock price of Silicon Valley Bank's parent company plummeted and the bank ran down; in the early morning of Friday, March 10, Silicon Valley Bank executives were still raising funds, and at noon, the California Department of Financial Protection and Innovation announced the closure of Silicon Valley Bank and handed over to the Federal Deposit Insurance Corporation (FDIC) to take over, and announced that it would provide insurance for depositors with deposits below $250,000. Since you think that the collapse of Silicon Valley Bank has its own peculiarities, why did the US government act so quickly this time?
Cao Yuanzheng: Although I said that the collapse of the Silicon Valley Bank is special, the bank is the bloodline of the economy and an interconnected system.
The most important lesson from the 2008 financial crisis for the United States is that immediate measures should be taken to bail out the first signs of crisis.
If you look back at the 2008 financial crisis, the United Kingdom and the United States handled the crisis differently.
The first is the speed of reaction of both countries. After all, Britain is an old capitalist country, its handling of the financial crisis is more sophisticated, as soon as there was a run on Northern Rock Bank on September 14, 2007, the Bank of England, as a lender of last resort, directly provided capital, bought the bank, and avoided the collapse of the financial system.
The United States is different. After the collapse of the subprime mortgage market in the United States in July 2007, the United States has been discussing for a long time whether and how to save it.
It was not until March 14, 2008, that the Fed provided $30 billion to support JPMorgan's acquisition of Bear Stearns. On September 7, 2008, the U.S. Treasury Department announced that the government would take the "two rooms" under trusteeship. However, after the collapse of Lehman Brothers in September 2008, there was no rescue.
The more important difference is the rescue method. Everyone knows that banks are leveraged and the capital adequacy ratio must not be less than 8%, which means that making up 8 yuan of capital can stabilize 100 yuan of debt. This is the British approach.
The US approach is to buy bad debts, that is, to buy 100 yuan of debt, which is obviously not as effective as the British method.
The Americans did not remedy the situation according to the British method, because they feared that if they bought these banks, they would be tantamount to nationalizing the banks, a policy adopted only by socialist countries, and the Americans could not accept it conceptually. So the US bailout was later than the UK, and the bailout was not immediate, causing the crisis to accelerate its spread around the world.
In dealing with the Silicon Valley banking crisis, I think the United States has learned the lessons of the past. As soon as there is a problem, intervene in advance to help.
According to news reports, the Federal Reserve, the Treasury Department and the Federal Deposit Insurance Corporation pledged to secure all depositors' deposits on March 12 and pay in full for deposits above the $250,000 deposit insurance protection limit. At the same time, the Fed launched a new emergency financing instrument, the Bank Term Financing Program (BTFP), which provides loans of up to one year to banks that pledge U.S. Treasuries, agency debt, mortgage-backed securities (MBS), and other qualifying assets. The $25 billion loan, backed by the Treasury, was backed by the Treasury to avoid contagion.
In this sense, this shot is relatively fast.
Observer: Obviously, the U.S. government bailed out on March 10, but Secretary Janet Yellen said in an interview with Face the Nation on March 12, "We're not going to bail out [Silicon Valley Bank] like we did in 2008." The reason is that after 2008, the United States adopted new measures conducive to monitoring capital and liquidity; And the early days of the pandemic in 2020 also tested the resilience of the U.S. banking system, so she said Americans have confidence in the safety and stability of the banking system. What do you think of Yellen's statement?
Cao Yuanzheng: First, it should be said that after the 2008 financial crisis, the lessons learned by US financial institutions, so the balance sheet of the financial system has been repaired.
In a March 12 interview with Face the Nation, Yellen said that we will not bail out banks as we did in 2008, and that Americans have confidence in the safety and robustness of the banking system
In 2020, I wrote in "Will the Pandemic Trigger a New Global Financial Crisis?" After the 2008 crisis, the US balance sheet recovered to some extent, which was reflected in the fact that the leverage ratio of household households began to decrease and became relatively stable.
However, it should also be noted that while household and financial institutions' balance sheets are being repaired, the U.S. government's balance sheet is expanding, as is the balance sheet of non-financial corporations. The opposite trend of the leverage ratio of the government, non-financial enterprises and households and financial institutions objectively forms a leverage wall.
This is not the same as in 2008. The 2008 financial crisis started with a recession on the household balance sheet, and then all balance sheets fell into recession. In this sense, Yellen is right when she says that there have been new advances in risk management due to increased oversight of financial institutions' balance sheets.
But I would like to point out that this is only one side of the coin.
The most important thing is that banks are a system of creditor's rights and debts linked to each other, and the systemic risk that banks are most afraid of is runs. No matter how robust the banking system is, as long as any bank is run, no matter what reason it appears, real or unreal, there is no point, and failure to bail out in time will inevitably lead to systemic risk.
From the current situation, after the Silicon Valley Bank, there have been three more banks such as Silvergate Bank, Signiture Bank, and Frontier Bank going bankrupt, and many banks' stocks have fallen sharply, and in the case of this market panic, the risk of failure of small and medium-sized banks in the United States is increasing in the future.
In this sense, Yellen's speech may have warned these banks that the government will not save the problem of individual cases and must be responsible for itself. But in the end, it was decided to save it, because the banking business is interconnected, and in the end, through the government, it is the depositors who are saved, and the confidence of the market.
So we see that not only are US deposit insurance institutions the first to take over Silicon Valley banks, but the Treasury Department is also providing $25 billion in real money to help a possible liquidity crisis and avoid a systemic collapse.
This is probably an important lesson learned from the 2008 financial crisis.
Will it become another "Lehman Brothers"?
Observer.com: Many people are comparing the Silicon Valley banking crisis with the Lehman banking crisis in 2008, what do you think are the similarities and differences? Some scholars believe that this is similar to the crisis of the American Savings and Loan Association in the 1980s, what do you think?
Cao Yuanzheng: Silicon Valley Bank is not Lehman Brothers, but it is Lehman Brothers.
Not Lehman Brothers means that Silicon Valley Bank is a relatively special bank for financing high-tech enterprises, similar to the crisis of long-term capital failure in the United States in 1998, and its crisis has certain particularities.
Not Lehman Brothers also pointed out that the nature of the crisis is different, and we will also see that the crisis of the Silicon Valley bank is not the same as the financial crisis of 2008. The 2008 financial crisis was a balance sheet recession crisis, before the crisis broke out, the real economy went wrong, no one bought the house, this is not injected liquidity can be solved, but requires a profound adjustment of the entire balance sheet.
Lehman Brothers means that the cause of the crisis is the failure of financial institutions, and then the market fears that there will be a chain reaction, because the failure of banks will trigger the collapse of the creditor-debt chain, thus bringing systemic risks. This fear has exacerbated stock sell-offs and bank runs.
But this time Silicon Valley Bank is a liquidity crisis, which only appears on the income statement and cash flow statement, and has not yet affected the balance sheet.
If governments or regulators intervene in time to replenish liquidity, there will be no recession on the entire balance sheet, and then there will be no systemic financial crisis. However, it must be noted that these three tables are interrelated, and if not handled well, they will be transmitted into a balance sheet crisis.
It is not Lehman Brothers that in 2008, the US government did not save Lehman Brothers and went bankrupt and liquidated. And this time the Silicon Valley banking crisis not only came to the rescue of the government, but also the rescue method is different from the past.
The rescue of the Silicon Valley bank crisis is that insurance companies directly take over the business of original customers and banks, and bankruptcy liquidation and other matters are put aside. This is a temporary transitional measure. This kind of rescue method has also appeared in the restructuring of the mainland banking system, with assets being zeroed, retaining the original customers and brands, and re-injecting capital.
If the Silicon Valley banking crisis is similar to any kind of crisis, I think it is similar to the bankruptcy crisis of long-term capital management companies (LTCM) in the United States during the 1998 Asian financial crisis, which also faced liquidity difficulties.
The management of long-term capital in the United States includes Nobel economists such as Robert Merton and Myron Scholes. At that time, because the interest rate differential between U.S. bonds and emerging market bonds was large, they predicted that emerging market bonds would stabilize, so they sold U.S. bonds and bet on emerging market bonds, especially Russian bonds. In general, the default of national bonds is a very small probability event. But that year, there was an economic crisis in Russia, which announced the cessation of trading in government bonds, and as a result, LTCM's liquidity collapsed.
It was the time of the Hong Kong financial crisis, and our battle to defend Hong Kong's exchange rate had just ended. The Americans invited Donald Tsang, then Hong Kong's chief executive, to the United States to ask what was going on, and prepared to criticize why the Hong Kong government intervened in Hong Kong's exchange rate. But after arriving in the United States, Americans discovered that long-term capital also had an accident. So the Treasury secretaries began urgent discussions to raise money to save America's long-term capital. LTCM was eventually acquired by Merrill Lynch and Morgan.
Through this case, I want to say that the crisis of long-term capital in the United States is the same as the crisis in Silicon Valley, which is a liquidity crisis.
The crisis of the American Savings and Loan Association in the 1980s, similar to the crisis of long-term capital in 1998, we call the crisis on the income statement and cash flow statement, this crisis can be called a financial crisis in a sense, it is not systemic. But this financial crisis, if not bailed out in time, can also lead to systemic risks.
The United States may fall into a vicious circle of interest rate hikes-recessions-stimulus-inflation
Observer Network: Some people point out that if the crisis spreads badly, it will force the Fed to end the interest rate hike cycle early? What do you think?
Cao Yuanzheng: This view makes sense. Because from a macro perspective, the trigger for Silicon Valley banks is the Fed's interest rate hike.
The Fed has raised interest rates eight times in a row since March 2022, accumulating 450 basis points, from almost zero interest rates (0-0.25%) before March last year to 4.5-4.75%. As mentioned earlier, raising interest rates means selling the bonds you bought before, and there will be losses, eventually causing investors to panic and flee, and stocks to plummet.
In addition to the fuse of interest rate hikes, the second background is the epidemic, and the world economy has changed from economic globalization in the past to geopolitical economy and value supremacy. This has led to a drastic change in the investment environment for VCs, with both VCs and start-ups facing increased liquidity pressures and increased market uncertainty.
Looking at the rate hike cycle, the Fed expects to raise the federal funds rate to a peak level of 5%-5.5% in 2023. After the rate hike in February this year, the market is discussing whether to raise the rate again in March this year, and if it does, at most once or twice, by 50-75 basis points.
In any case, the rate hike cycle has come to an end, which is what the market has already expected. At present, raising interest rates is no longer the most concerned issue for the market, and the market's biggest concern is whether the global economy will enter a recession in 2023.
Observer Network: After the outbreak of the Silicon Valley crisis, some domestic institutions analyzed that the US economy may have a "hard landing", what do you think?
Cao Yuanzheng: The International Monetary Fund believes that in 2023, one-third of the world's economies will experience at least two consecutive quarters of negative economic growth, that is, a recession in the typical sense, and many other economies will also experience technical recession.
The fact is that since the third quarter of last year, Japan took the lead, followed by the United Kingdom, there has already been negative economic growth, and the Eurozone's GDP in the fourth quarter of 2022 grew by 0.1% month-on-month, close to zero growth.
The U.S. recession is likely to be a little later, and the market generally expects the U.S. to enter a recession in the second half of the year. So will the crisis caused by the Silicon Valley bank trigger a recession earlier, such as entering a recession in the first half of this year?
At the end of last year, the Fed's monetary policy faced a dilemma, it had to choose between recession and inflation: if it continued to raise interest rates, recession would come sooner; If interest rates are not raised, inflation will remain high.
Before the Silicon Valley Bank incident, many people were still concerned about whether the Fed would raise interest rates. Now everyone is concerned about whether the recession will be brought forward? If there is a significant recession, the economy may have a hard landing.
But at present, we cannot predict, because of this Silicon Valley banking crisis, the US government is taking action. A new question arises, who will pay for the $25 billion bailout? This time it was clear that taxpayers' money could not be spent to bail out, Yellen said that the Ministry of Finance should be at the bottom, and then in the end, it must be rescued by issuing national bonds, which will increase inflationary pressure.
Raising interest rates leads to a recession, and in order to save the economy, the Fed issues Treasury bonds again, which in turn leads to inflationary pressures, and the US economy falls into a vicious cycle.
Implications for China
Observer: What are the implications of the outbreak of the Silicon Valley banking crisis for China?
Cao Yuanzheng: After the epidemic, the United States adopted an extremely loose monetary policy, the Federal Reserve started printing machines to buy government bonds, the widening deficit was used to fight the epidemic, and residents found gold. Therefore, the unemployment rate is increasing during the epidemic in the United States, and the savings deposits of residents are growing. Household savings are growing, so consumption has been good, and China's exports have increased sharply.
At the beginning of the outbreak of the epidemic in 2020, there was a debate in China about whether China could follow the example of the United States in monetizing the fiscal deficit, that is, the central bank issued money to finance the fiscal deficit to stimulate the economy.
However, America's problems soon became apparent. After the excess quantitative easing, the US economy looks good, but this is supported by "helicopter money". Since 2021, prices in the United States have begun to rise sharply, frequently refreshing historical records, which is why the Fed later raised interest rates. The problem is that the Fed raised interest rates too sharply, and those companies that relied on ultra-loose monetary policy transfusions during quantitative easing periods, after raising interest rates, the blood transfusions stopped, and funds quickly went wrong.
The collapse of Silicon Valley Bank came against this backdrop. The Silicon Valley banking crisis was ostensibly caused by interest rate hikes, but behind it was actually the consequences of US fiscal monetization.
If there is any inspiration for China, monetary policy should still be conservative. What ticket is printed too much will be hairy, now it will not be hairy, one day it will become hairy; Although prices may not rise in the short term, they will definitely be reflected in prices in the long run; In China, it is not reflected in prices, but in asset prices such as housing prices.
I think this is the most important revelation for China. Our country has been relatively cautious, and in recent years has implemented a proactive fiscal policy and a prudent monetary policy, not allowing the central bank to purchase government bonds through the primary market to directly finance the fiscal deficit, and making clear limits at the institutional level. So although we also adopted fiscal expansion policies during the pandemic, inflation did not appear.
Observer: If the Silicon Valley banking crisis spreads and the global economy falls into recession early, what risks do you think are China-related to our vigilance?
Cao Yuanzheng: The US interest rate hike has pushed the global economy into recession ahead of schedule, and I am worried that there will be a situation similar to the Asian financial crisis in 1998 in developing countries.
The 1998 Asian financial crisis was a currency crisis caused by a large outflow of international capital and difficulties in the balance of payments. The crisis first erupted in Thailand and later spread throughout Asia. As we can see, this coincides with the Fed's rate hike cycle.
Interest rates and exchange rates are parity, and the Fed's interest rate hike means that the dollar index rises, and dollar investment becomes profitable, thereby attracting global capital outflows from emerging Asian countries such as Thailand, Indonesia and South Korea, causing serious difficulties in the balance of payments of some financially vulnerable countries, and eventually breaking out of crisis.
The crisis brought about by this round of dollar interest rate hikes has already broken out, and since last year, Sri Lanka, Turkey and Pakistan have successively experienced such balance-of-payments crises.
Countries that have erupted currency crises have one thing in common: twin balance-of-payments and fiscal deficits. They rely on imports to maintain the national economy, and even the daily lives of ordinary people, such as India and Pakistan, ordinary people's lives are inseparable from onions, these daily necessities need to be imported. Once the dollar index rises, funds flee, there is a balance of payments crisis, there is no foreign exchange to import onions, and the daily life of ordinary people will be greatly affected.
There have been many crises in history due to the rise in interest rates in the US dollar, each time accompanied by a recession for relatively weak economies.
The first was in the 1980s, when the United States raised interest rates 12 times in a row from 1983 to August 1984 to control inflation. Rising interest rates led to the return of the dollar, and from Brazil to Argentina, Latin American countries could not make ends meet their balance of payments, and eventually a debt crisis broke out. Since the debt crisis, Argentina has not recovered and is still frequently affected by the fluctuations of the US dollar.
Second, in 1985, after the signing of the Plaza Accord between the United States and Japan, the depreciation of the dollar led to a reduction in the trade deficit between the United States and Japan, and economic recovery and rising inflation. The Fed raised interest rates aggressively again, starting in March 1988 and raising rates 26 times from May 1989. The yen also raised interest rates, causing the economic bubble to burst and plunge into the "lost twenty years".
Since last year, everyone has been discussing the fluctuation of the RMB exchange rate, and in just 8 months, the exchange rate of the US dollar against the RMB has risen from a minimum of 6.3 to 7.3, and the essence behind it is not the appreciation or depreciation of the RMB itself, but the fluctuation of the US dollar index, which triggers the passive appreciation or depreciation of the RMB.
Therefore, today we see that this round of dollar interest rate hikes has brought about a disorder in international capital flows, and developing countries are likely to have a crisis similar to the Asian financial crisis. Following Sri Lanka, Turkey and Pakistan, some financially vulnerable countries, such as India, Vietnam, and some countries in Latin America, are likely to be hit in the future.
Many of these countries are partners of our Belt and Road Initiative, and we will not be able to survive the crisis alone. Therefore, the threat of international capital flows brought about by the US interest rate hike to the "Belt and Road" countries is also one of the events that we must guard against and be vigilant against.
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