What the Failure of Silicon Valley Bank Means for Bitcoin

You may never have heard about this bank, but until recently it was the 16th largest bank in the US and went bust. This is the single biggest bank failure since Washington Mutual hit the wall in 2008. As the name of this bank suggests, its focus was providing banking and lending services to start-up ventures in Silicon Valley. It was founded in 1983 and quickly grew in the 2000s with the rise of Silicon Valley. So what went wrong? How is it possible that a bank so carefully niched in one of the world's fastest-growing sectors and operating in one of the richest valleys in the world had to close its doors, and what does this mean for Bitcoin?

The answer can be found in mistakes made by the bank and an environment that worked against the bank and exposed these mistakes. We all know how banks make money. They take money from depositors in the short term and lend it out over the longer term. Most banks face this duration mismatch. Depositors invest for days, weeks, or months, while borrowers tend to borrow for months or years. This is the nature of modern banking and the risk managers that operate within the banks pay close attention to this mismatch. 

SVB found themselves in a situation where they are battling to originate loans. They had taken money in deposits but they were unable to lend the money out at a similar velocity. Unable to find ways to put depositors' money to work, they decided to invest in United States Treasury bonds - the lowest-risk investments known to man. When people sing the praises of treasury bonds and hail them as risk-free, they are only telling part of the story. Yes, they are risk-free from a credit point of view. When you buy a United States Treasury bond you are effectively lending money to the federal government of the United States. You can do that for a day, one week, one month, one year, three years - even up to 30 years with numerous time increments in between. It is highly unlikely that the US government will fail to pay you back your money and that is why treasuries are labeled as risk-free. The problem is that there is another risk that the majority of people do not understand and that is duration or interest rate risk. 

In order to understand the collapse of this bank, and why this is important for the global financial markets, you need to dive down the rabbit hole of duration risk. Silicon Valley Bank invested its excess cash in Treasury Bonds. Bonds tend to trade at a par value of 100. For every $100 invested in a bond, interest will be paid which is fixed periodically. For the sake of this example let us assume it is every year. We will also assume that the coupon or interest rate is fixed at 1 percent per annum. So every year, SVB would receive $1. So far so good. This is where things get a little complicated. The price of that bond does not stay fixed at $100 - it moves around and this is what caused problems for the bank. The reason why bond prices move is simple to understand because it is based on the simple laws of supply and demand. Let's say SVB bought one bond at $100 paying a coupon of 1 percent. As you can imagine, that is not a very attractive interest rate but was the interest rate at the time. What happens if interest rates suddenly spike to 4.7 percent (this is what happened between January 2022 and March 2023)? This creates a headache for SVB. They own a treasury bond that pays a coupon of 1 percent which they bought in January 2022. If they wanted to sell that bond in March 2023, they have to sweeten the deal for potential buyers. Buyers are able to buy freshly minted treasuries paying a coupon of 4.7 percent. If the bank wants to sell its bonds, it needs to discount the price to such an extent that the effective yield to maturity of the bond is 4.7 percent. That price is close to $94. A $6 decline does not sound like much, but there are two things to consider.

Firstly, banking margins are razor-thin because the yield curve is flat. The rate at which you pay depositors and charge lenders is not that different. Let's say SVB was paying 0.5 percent on deposits and 1 receiving 1 percent on treasury bonds. The profit is therefore 0.5 percent. When the bond price declines from 100 to 94, that is a decline of 6 percent effective. SVB had invested hundreds of billions in these treasuries so the losses were astronomical, especially given the fact that the money they were investing did not belong to them and could be called on at any time. 

This mismatch in duration that all banks face is what keeps bankers up at night. Given that depositors invest in the short term and borrowers lend over the medium term, the bank's worst nightmare is when all the depositors suddenly demand their money back at the same time. This is known as a bank run. If a bank has lent out all the money it has taken in deposits, the only way in which it can pay back all the depositors is to call the loans they have made. Silicon Valley Bank had lent money to the US government through the treasuries market. Luckily, it is easy to call your loans back. All you need to do is sell the treasury bonds. The problem for the bank is that by selling these bonds, they had to realize billions of dollars in losses which meant there was not enough money to pay back the depositors. 

So why did Silicon Valley Bank depositors suddenly all ask for their money at the same time? To understand this, we need to go back to the pandemic. The one sector that benefitted the most from COVID was the tech sector as businesses migrated online. People were working from home, buying online, meeting through Zoom, upgrading their hardware and software, and spending their lives on social media. Given that the bulk of SVBs clients were technology companies, and venture capital companies funding these tech companies, billions flowed into the bank. At the start of the pandemic, they boasted $60 billion in deposits.  Two years later, this number ballooned to $200 billion.

You will remember that higher interest rates affected the value of the securities into which the bank was investing. It also hit the tech sector hard. Tech companies live off funding. When money is cheap, they can borrow, expand, and live it up. When money gets more expensive, the party starts to slow down which means they started to withdraw their deposits in SVB. If the bank had been more diversified and had lent money to a wider range of sectors, this concentration of withdrawals may have been avoided.

The withdrawals started at a manageable pace, but then rumours started to surface that the bank was in trouble and this is when the panic started. Venture capital firms advised their clients to withdraw their funds as soon as possible, and pretty soon SVB was not able to keep up with the withdrawals and the bank had to close its doors. 

What does this mean for depositors? At the end of the day, depositors should not suffer significant losses. You need to remember that the bank made a few mistakes. It made an unhedged bet on interest rates and the market turned against them. The losses in the bonds into which they invested could have been avoided if the bank had been given the time by its depositors to mature in a couple of years. The bank was not being fraudulently managed. It was actually being run quite prudently but it was the duration mismatch that hurt them thanks to the sudden increase in interest rates by the Federal Reserve. 

So what does this mean for the US banking system, the global banking system, and the global economy. The SVB collapse highlights the danger of massive interest rate hikes. Consider this simple calculation. Interest rates in the United States have increased by over 4 percent in the last 12 months. Let's say you had a loan of $1 million at an interest rate of 4 percent in 2022, and assume the interest rate on that loan is variable. Last year, you were paying $40,000 in interest. Today that interest charge has doubled to $80,000. Regardless of how profitable your business is, this doubling of interest has to hurt. Given that global indebtedness as a percentage of gross domestic product has more than tripled over the past fifty years, we know that this level of pain by higher interest rates is being felt by a very large segment of the global economy. This poses a clear and present danger to economic growth. When people and businesses are heavily indebted, they consume, spend, and invest less.

A company that was planning on opening a new plant and hiring 100 new people may postpone the project. Consumers might decide to drive their car for another 2 years instead of replacing it. Travelers may think twice about that 2-week vacation to Europe. This reduced velocity of spending is bad for the economy. Add to this an inherent distrust of the banking system (after all, if the 16th biggest bank in the US could go bankrupt, maybe I should be worrying about my bank) and you have a massive headache for politicians, central bankers, and policymakers. This may force them to take their foot off the gas in continuing to increase interest rates. 

So let's go back to why interest rates are going up in the first place. Interest rates and inflation tend to move in the same direction. To understand this you need to understand the concept of Goldilocks economics. Governments want their economies to grow steadily and consistently. They don't want them to run too fast and they don't want them to be too cold - they want them to be lukewarm - much the same as the porridge in the fairy tale of Goldilocks and the Three Bears. There are two forces that cause economies to grow - supply side and demand side forces. This is where we need to take a crash course in economics.

Prices are set at the interaction between supply and demand. For most goods, when demand increases, the price goes up. For example, in winter the demand for firewood goes up. You can therefore expect to pay more for firewood in the winter than in the summer. But there is another way in which prices go up, and that is when there is a decrease in supply. When there is a drought in wine growing region that destroys all the vines, the supply of grapes will decline, and it is this relative scarcity that will increase the price. 

We are currently experiencing inflation which is broadly defined as an increase in prices. You now need to ask the question of whether this increase in prices is driven by supply or demand factors. To answer this question, we need to go back to the 1970s which is the last time we saw mega inflation was in the 1970s where it peaked at 12 percent at the beginning of the decade and then retraced only to end the decade at 14 percent. There were numerous reasons for this shift in prices depending on who you talk to. Demand-side economists said it was due to the entry of the baby boomers into the workforce.

After the second world war, the world celebrated by having copious amounts of sex. This led to the largest population explosion. In the United States alone, almost 80 million baby boomers were born between 1946 and 1964. By the mid-1970s a large portion of the boomers was entering the job market. They were buying cars, houses, appliances, clothes, and other consumer goods. The entry of baby boomers into the workforce in the 1970s had a complex and multifaceted impact on inflation, shaped by a variety of economic and demographic factors.

On one hand, the large influx of baby boomers into the workforce increased the supply of labor, which put downward pressure on wages and reduced labor costs for businesses. This effect tended to be deflationary, as it helped to moderate the overall rate of inflation.

On the other hand, the baby boom generation was also a significant consumer group, with high levels of purchasing power and a preference for certain goods and services. The growing demand for these goods and services, combined with a tight supply of certain goods and labor, led to inflationary pressures in certain sectors of the economy. For example, the demand for housing, which was fueled in part by the entry of baby boomers into the housing market, contributed to rising housing costs and inflation.

Moreover, the entry of baby boomers into the workforce also had implications for government policies and spending. As this generation began to enter the workforce and pay taxes, it put pressure on government spending to increase, particularly in areas such as education, health care, and social security.

Overall, the entry of baby boomers into the workforce had a mixed impact on inflation in the 1970s. While it helped to moderate wage inflation by increasing the supply of labor, it also contributed to inflationary pressures in certain sectors of the economy and put pressure on government spending.

The supply-side economists said that inflation was more a function of the Arab oil embargo. The Arab Oil Embargo of 1973 had a significant impact on inflation in many countries around the world, particularly those that were heavily dependent on imported oil. The sharp rise in oil prices caused by the embargo led to higher production costs for businesses, which in turn led to higher prices for goods and services. This phenomenon is often referred to as "cost-push inflation."

In the United States, the embargo led to a significant increase in inflation, with the annual inflation rate reaching double digits in 1974 and 1975. The rise in oil prices contributed to higher transportation costs, which led to higher prices for many consumer goods. Additionally, the higher costs of energy production led to increased costs for businesses, which were passed on to consumers in the form of higher prices.

The impact of the embargo on inflation varied by country and region, depending on factors such as the level of dependence on imported oil, the strength of domestic economies, and the effectiveness of government policies to mitigate the impact of the crisis. In general, countries that were less reliant on imported oil and had more diversified economies were better able to weather the inflationary pressures caused by the embargo.

Overall, the Arab Oil Embargo of 1973 had a significant and lasting impact on inflation in many countries, highlighting the interconnectedness of the global economy and the importance of energy policy in shaping economic outcomes.

Regardless of whether you are a supply-side or demand-side economist, one thing that we have learned about inflation is that it is transitory, and in a modern financial world that is so heavily indebted, it is unlikely that the current levels of inflation will remain high. This means that in order to protect the global banking system, monetary authorities are going to use the failure of SVB as a wake-up call to the necessity of rethinking their interest rate hikes and potentially putting them on hold. So what does this all mean for Bitcoin?

Firstly, lower interest rates are good for risk assets like Bitcoin and stocks. Secondly, any bank failure further legitimizes Bitcoin. It needs to be remembered that Bitcoin was born out of the 2008 financial crisis. It provides the building blocks for a world without banks. Bitcoin and other cryptocurrencies have disrupted the financial industry in significant ways and have forced traditional banks to adapt to changing customer preferences and technological advancements. It is possible that Bitcoin and other cryptocurrencies will continue to grow in popularity and become more mainstream over time, which could further disrupt the traditional banking industry.

#bitcoinusa#cryptocurrencies#binary#bitcoinminning#forexlifestyle#investing#binaryoptions#bitcoincash#crypto#cryptotrading#bitcoin