Why did a regional US bank failure lead to financial market turmoil?

Financial markets had a rough week as the banking crisis in the United States spread to Europe. Two banks failed in the US, but the Fed quickly acted as it provided a lifeline over the weekend. Stocks rallied from their lows as the risk of contagion seemed very small.

After all, a quick look at the SVB (i.e., one of the banks that failed)’s balance sheet shows that the bank did not hedge against the interest rate risk.

What is the interest rate risk?

The world was caught in a period of low inflation for a long time. Even deflation (i.e., negative inflation) appeared in some countries. 

Economists agree that stable inflation around 2% is optimal for stable economic growth. But for many years, inflation was close to zero or below.

As such, central banks have cut interest rates to their lowest boundary. In some cases (e.g., Switzerland, Euro area), central banks moved the interest rate into negative territory and held it there for years.

All central banks sang the same song – low interest rates are here to stay. So commercial banks bought bonds because the price of bonds is inversely correlated to the yields. Lower yields meant higher bond prices, so buying bonds was an appealing strategy.

The COVID-19 pandemic amplified this phenomenon. Central banks and governments further eased monetary and fiscal policies through various innovative programs and incentives offered to companies and households.

But all fired back recently.

The pandemic is over as the world moved on. Only now, the world sees the effects of all the actions taken in the past decade or so.

Inflation soared worldwide. To tackle it, central banks did what they were supposed to do – raise the interest rates.

Remember the inverse correlation between the yields and bond prices? As interest rates rose, bond prices collapsed.

SVB did not hedge against the interest rate risk or the risk that the interest rates may rise. As they did, the bank was under pressure to meet withdrawals and had to sell its fixed-income holdings (i.e., bonds). But because the price of bonds collapsed due to the rise in interest rates, it sold the bonds at very low prices and with huge losses.

The perfect storm was in place, and there was no way to get out. So the next question investors had is – what if this is the start of a new banking crisis? What if this is similar to the housing crisis that started in 2008 in the US and quickly spread around the globe?

Attention turned to Credit Suisse and the European banking system. And this is why we are in the current financial crisis.