Analysis. The Fed's restrictive plans were supposed to depress jobs. Instead they affected finance with the collapse of two banks last week.

The Federal Reserve’s earthquake: Rates rise till someone falls

It’s a story featuring cryptocurrencies and interest rates: fifteen years after the failure of Lehman Brothers, the U.S. is once again jittery about its banking sector.

Two banks are mainly at issue: Silvergate Capital and Silicon Valley Bank. In the space of two days, between Wednesday and Thursday, the stock price of the former fell 42 percent (after announcing it was shutting down its business) and the stocks of Silicon Valley Bank dropped by over 60 percent; the latter was shut down by California authorities on Friday. The country’s major banks (JPMorgan Chase, Bank of America, Citigroup, Wells Fargo, Morgan Stanley and Goldman Sachs) took an immediate hit as well, losing $54 billion off their stock value in 24 hours. Stock markets around the world were in turmoil, with Milan down heavily as well, weighed down by banking in particular.

For Silvergate Capital, a bank specializing in cryptocurrencies, the November collapse of FTX, the exchange founded by Sam Bankman-Fried, and the persistent bearish trend in the virtual currency market were important factors. But its case is a more narrowly circumscribed one. The collapse of Silicon Valley Bank, however, is much more of a systemic issue.

Let’s look at the events: on Wednesday, the historic bank based in Santa Clara, California, serving startups and among the largest in the United States, suddenly announced it was going to issue new shares worth $2.25 billion and sell them to raise capital to cover a $1.8 billion hole in its accounts. This news was received very poorly by investors. Customer flight began, spurred on by the advice of large investment funds and venture capital firms (Founders Fund, Coatue Management and Union Square Ventures in particular). The bank’s shares plummeted and panic ran rampant, and bankruptcy was the result.

Undoubtedly, the origins of this earthquake can be found in the effects of the Fed’s restrictive monetary policy. Higher interest rates result in a higher return on investment in government bonds. It works as follows: the central bank’s reference rate acts as a core support for all rates: when the “guide rate” goes up, bond yields go up with it. The problem is that there is an inverse relationship between the yield and the value of a bond. Thus, higher interest rates correspond to a devaluation of the latter.

This is a big problem for banks that own too many of these bonds. That was the case with Silicon Valley Bank, which, in order to repay its depositors (many of whom were companies with liquidity problems precisely because of the Fed’s tightening of credit), had to sell the bonds it held at a lower price than it bought them (resulting in the $1.8 billion capital loss).

And the rise in interest rates comes together with a risk of recession, which still remains a possibility. A recession looming is not good for the soundness of the U.S. or the global financial picture. Meanwhile, on Friday, new U.S. labor market estimates came in: 311,000 jobs were “created” in February compared to the previous month. This is too many, as analysts had expected 225,000 at most. More jobs means more income and therefore more consumption. This doesn’t look good with inflation remaining high.

Is another crackdown on rates coming, then? That would be the logical conclusion. But the fire started by the California bank should give pause for thought about the effects of further raising the cost of money – even more so if a sharp slowdown in the global economy is factored in. What about the risk of contagion? The New York Times pointed out that the failure of Silicon Valley Bank can be compared in some respects (e.g. the value of customer assets) to that of Washington Mutual in 2008.

Furthermore, we must not overlook the global dimension of the institution. SVB operated not only in the United States but also in Europe, Asia, and Israel. In Israel, hundreds of start-ups have withdrawn their money from their current accounts at SVB in the past few days. In short, no matter how much people are trying to downplay it now, the situation is inevitably concerning. The liquidity crisis of businesses may lead to new cases similar to SVB – not to mention the impulse towards speculation, which is already having a heyday.

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