U.S. Banks Are in Big Trouble. What Has Happened, and What Can We Expect?

Chaos, panic and uncertainty. These are the three words to describe the current situation of the banking sector in the United States. Last year, when Fed and other central banks embarked on a path of tightening monetary policy to tame the highest inflation in America since the 1980s, it was clear that this would not go unchallenged forever. That is exactly what happened, and the sharp rise in interest rates brought its first casualties.

It all started just last week when U.S. bank Silvergate, known for its pro-crypto orientation and cooperation with many companies from the world of cryptocurrencies, including Coinbase, Paxos and Microstrategy, got into financial trouble. The uncertainty surrounding Silvergate kicked off with the bank announcing a delay in issuing a comprehensive 10-K report to the U.S. Securities and Exchange Commission (SEC). This document is known for containing a comprehensive overview broader than, for example, a company’s annual report, which is sent to shareholders before the annual meeting.

A few days later, specifically last Wednesday, Silvergate, in agreement with the Federal Deposit Insurance Corporation (FDIC), announced that it was winding down its operations and sending the bank into liquidation. According to the information available, all deposits will be fully repaid pursuant to the plan of liquidation, which was also made public on Wednesday. However, the company did not indicate exactly how it plans to resolve the claims of shareholders and bondholders.

Silvergate’s fall, however, was just the trigger for the so-called snowball effect. The end of last week brought something few would have expected. Silicon Valley Bank, a base of technological advancement and a bank of startups, came under scrutiny from U.S. regulators on Friday, with the FDIC saying that federal regulators had decided to shut down Silicon Valley Bank altogether. It is the largest bank failure in the US since the collapse of Washington Mutual in 2008, with Silicon Valley Bank currently the 16th largest bank in the United States with more than $20 billion in assets.

For four decades, the bank focused on financing startups and venture capital funds. It has become a major provider of banking services to companies such as Circle, Roku, Rocket Lab and the game studio Roblox.

There are several reasons why such an important bank fell. Firstly, the Fed’s raising of rates in an attempt to fight inflation is making investors more risk averse, as money is more expensive and less available to them due to high rates. This has also affected the behaviour of technology companies and startups – the primary clients of this bank – who have invested much less and have been more risk averse.

Second, as the high rate environment made it significantly more difficult for startups and early-stage firms to raise new funds, and private fundraising was also significantly more expensive, many of the bank’s clients began to gradually withdraw their money from the bank in an attempt to cover their liquidity needs. This has put the bank in significant trouble and forced it to look for ways to cover the cumulative withdrawals by clients.

To fund the redemptions on Wednesday, Silicon Valley Bank sold its $21 billion bond portfolio, which consisted mainly of U.S. Treasury bonds. The portfolio had an average yield of 1.79%, well below the current yield on U.S. 10-year Treasuries, which is currently around 3.5%. This forced SVB to realize a loss of $1.8 billion, which it needed to cover by raising capital. 

Therefore, SVB announced a day before the close that it would sell $2.25 billion of shares to cover the loss from the bond portfolio divestment. However, the reaction of investors was different than the bank expected. The bank’s shares plunged more than 60% that day as investors feared massive withdrawals by bank customers.

However, the spread of the financial contagion continued over the weekend and into Monday. On Sunday, everyone was shocked by the news that Signature Bank, a New York bank with a large real estate lending business, closed its doors after regulators said the bank’s continued operations could threaten the stability of the entire financial system.

Signature Bank, which had a quarter of its deposits coming from the cryptocurrency sector and more than $110 billion in assets at the end of last year, came under scrutiny from the Federal Deposit Insurance Corp. as a result. The bank’s closure marks the third-largest fall in the U.S. banking system in history.

Signature Bank is, to some extent, a victim of the panic surrounding the failure of Silicon Valley Bank and a victim of the situation currently facing small and medium-sized banks focused on niche areas of the business. As with Silicon Valley Bank, regulators said in announcing the closure that Signature’s customers would be covered for the full amount of their deposits, regardless of how much they had in their accounts. By default, however, the FDIC insures deposits only up to $250,000.

Signature Bank (NASDAQ:SBNY) stock price over the past 5 days:

Other banks also ran into trouble after the markets opened on Monday. Trading was suspended at dozens of regional banks on Monday morning as the banks’ share prices fell by tens of percent. Regional bank Western Alliance saw its shares drop by more than 50 percent, while First Republic Bank’s shares fell as much as 64 percent. 

Major US banks have also been partially affected as fears of a spreading contagion in the banking space continue to grow. On Monday, shares of banking giant Wells Fargo were down 7.5%, Bank of America shares were down 7.4%, and Citigroup shares were down nearly 6%.

What Will Be Fed’s Response?

U.S. President Joe Biden addressed the nation from the White House yesterday shortly after the opening bell. He attempted to defuse panic and avert a wider catastrophe that could befall the financial system following the collapse of several banks. “The American people can have confidence that the banking system is safe,” Biden said. But he refused to answer questions and left the conference room after a few minutes.

In the current situation, experts see a solid chance that the Federal Reserve could slow or stop its aggressive monetary policy altogether at next week’s meeting. The high level of rates and the failure of several banks raises fears of a possible collapse of the financial system, which probably no one wants to admit.

In particular, the failure of Silicon Valley Bank has shown that the Fed must change course on raising interest rates if it does not want to plunge the country into a huge financial crisis and an imminent recession. In response, on Sunday and Monday, there was a significant adjustment in the probabilities associated with rate hikes. While as recently as last week, the probability of a half-percentage point increase in the base rate was more than 80 per cent, experts now say the chances of such an increase are zero.

Thus, a 25 basis point rate hike with a probability of 79.7% is currently in play. The probability of the Fed not raising the rate and leaving it at the current level increased from zero to 20.3% on Monday.

While these are all just predictions, a still strong labour market coupled with a rise in inflation in January indicates that the Fed may move to raise rates by 25 basis points. However, the sudden instability and fragility of the financial system may significantly affect the Fed’s final decision, as may the U.S. inflation data for February, which showed that inflation fell year-on-year from January’s 6.4% to the 6.0% recorded in February. The Fed meeting to decide on an interest rate hike is scheduled for Wednesday, 22 March.

How Did Bitcoin and Cryptocurrencies React to the Whole Situation?

The prices of the two most popular cryptocurrencies, Bitcoin and Ethereum, plunged to nearly two-month lows on Friday in reaction to the fall of pro-crypto-oriented bank Silvergate.

However, sentiment in the cryptocurrency market quickly reversed after the Silicon Valley Bank crash. Since Sunday, Bitcoin’s price has risen more than 30% from Sunday’s $20,000 high to the $26,000 recorded on Tuesday afternoon.

The surge in interest in Bitcoin came after U.S. regulators announced covering all deposits for customers at failed banks and making additional funding available to banks. Crypto investors are also betting that the Fed will be less aggressive in raising rates so as not to further damage the already currently disrupted traditional financial system.

“A lower pace of rate hikes and a lower terminal rate, plus a likely injection of liquidity to support banks struggling to meet withdrawals (through the Bank Term Funding Program), mean more liquidity in the market, though this could be partially offset by higher volatility,” said Noelle Acheson, economist and author of the newsletter “Crypto is Macro Now“. 

“Bitcoin is one of the most liquidity-sensitive assets in the market because its risk profile is not weighed down by yield or rating concerns,” Acheson added.

Is the Decorrelation of Bitcoin a Possibility?

During the course of Monday, it was possible to observe an increased interest in risky assets. However, it was interesting to note that Bitcoin and traditional gold traded in a similar uptrend during the troubles of the traditional financial sector, with the stock market not reflecting these movements much.

The Dow Jones Industrial Average and the S&P 500 fluctuated significantly on Monday, eventually ending the trading day in the red. The Nasdaq Composite technology index was the only one to end Tuesday with a modest gain.

Correlation of BTC vs. S&P 500 vs. Nasdaq Composite vs. Gold

A chart from The Block website shows the evolution of Pearson’s Bitcoin correlation to the S&P 500, Nasdaq Composite and traditional gold. Over the past month, Bitcoin’s correlation to the S&P 500 and Nasdaq has declined from a value of 1 (strong positive correlation) to a value of approximately 0.19. If the correlation value was 0, it would mean that correlation doesn’t exist.

It is very difficult to predict whether the problems of the banks and the financial sector will mean a release of Bitcoin from its correlation to stock indexes. However, many experts have noticed yesterday’s phenomenon, which hasn’t been common until now. Nevertheless, only time will tell whether we will actually see Bitcoin decorrelate.