US financial regulators have rolled out emergency measures to arrest the aftereffects of the crisis. The bank depositors will now get access to their money. Other banks will also be able to borrow from the Federal Reserve for 2024, as long as the loans are matched by safe government securities.

US Treasury chief and veteran economist Janet Yellen, however, decided not to compare the situation with the 2008 financial crisis, when the collapse of large banks threatened to bring down the global financial system.

Understanding The Gravity Of The Crisis

Silicon Valley Bank had assets valued at USD 212 billion and these were primarily lent to tech start-ups.

The bank has been placed under the Federal Deposit Insurance Corporation (FDIC) control, with the latter guaranteeing deposits of up to USD 250,000 for the affected parties.

Silicon Valley Bank’s woes have also resulted in the downfall of the values of other US regional financial institutions. New York-based Signature Bank has been shut down by the FDIC. The regulatory body has also taken control over the bank’s USD 110.36 billion worth of assets and USD 88.59 deposit storage (as per December 2022 stats).

First Republic Bank, Western Alliance and PacWest too have been affected by the crisis.

In the United Kingdom, HSBC will take over SVB’s operations in the country. This will override the Bank of England’s initial decision to place the entity into insolvency, apart from protecting the finances of the bank’s 3,500 customers, including hundreds of tech start-ups.

Crypto company Ripple Labs had “business exposure” to Silicon Valley Bank but remains in a strong financial position, clarified CEO Brad Garlinghouse. Ripple, currently engaged in a lawsuit with the United States Securities and Exchange Commission (SEC) over the status of the cryptocurrency XRP, had reportedly stored some of its cash reserves at the Silicon Valley Bank.

What Went Wrong For SVB?

As the world went into COVID lockdowns in 2020 and 2021, remote working became a part of the mainstream economy. This resulted in the rise in the fortunes of tech start-ups, as companies bet big on technology to keep their operations going amid business disruptions.

The tech companies used Silicon Valley Bank for payroll and other monetary services and the bank received an influx of deposits. SVB used the investors’ money in US government bonds, including those supported by mortgages. The prices of these bonds generally go down when the Federal Reserve hikes interest rates. As the Joe Biden government started its monetary policy tightening in 2022 beginning, it resulted in SVB’s bond portfolios undergoing value losses.

The only feasible option for the bank would have been to hold onto these bonds till their maturity stage, in order to get the capital back.

As the tech sector went into a financial bloodbath in 2022, SVB’s customers reportedly started drawing on their deposits. The bank sold some of its bonds at massive losses.

On March 8, 2023, it announced a USD 1.75 billion round of capital raising, while informing its investors about the need to ‘plug a hole’ caused by the sale of its loss-making bond portfolio.

However, aware of SVB’s mess, its customers started withdrawing money en masse, which was reportedly stored in larger accounts.

On March 10, the collapse finally happened. It is now the largest bank failure in the United States since the 2008 global financial crisis.

Revisiting The 2008 Mess

In 2007, global financial markets started showing signs of the negative fallouts of the cheap credit binge. Not only did two Bear Stearns hedge funds collapse, but BNP Paribas also warned investors that the latter might not be able to withdraw money from the bank’s funds. British bank Northern Rock reportedly mulled emergency funding from the Bank of England.

However, only a few investors could anticipate the onset of the worst crisis in nearly eight decades, which brought Wall Street’s giants, triggered the Great Recession and cost people their jobs, savings and homes.

The 2008 financial crisis began with cheap credit distribution and relaxed lending standards, along with years of low interest rates, fuelling the creation of a housing bubble. As it burst, banks were left holding trillions of dollars of worthless investments in subprime mortgages.

The Federal Reserve lowered its rates from 6.5% (in May 2000) to 1% (in June 2003), in order to boost the US economy by making money easily accessible to businesses and consumers.

The move resulted in an upward spiral in home prices. Subprime borrowers, those with poor/no credit history, were also able to buy homes.

The lenders then sold these loans on to Wall Street banks, which, in turn, packaged these entities into low-risk financial instruments such as mortgage-backed securities and collateralized debt obligations (CDOs). The whole chain created a big secondary market for originating and distributing subprime loans.

The US Securities and Exchange Commission (SEC) in October 2004 relaxed the net capital requirements for Goldman Sachs, Merrill Lynch, Lehman Brothers, Bear Stearns, and Morgan Stanley, thus freeing the latter to leverage their initial investments by up to 30/40 times.

Eventually, interest rates rose and homeownership reached a saturation point. In 2006, the Fed rate was revised at 5.25% and it remained as it is until August 2007. By 2004, US homeownership peaked at 69.2% and by 2006, home prices started going down. The US homeowners couldn’t sell their properties, as they owed a high amount of money to their lenders. Subprime borrowers were stuck with mortgages beyond their payment capacities.

In 2007, subprime lenders went into a bankruptcy spree. Bear Stearns stopped redemptions in two of its hedge funds, prompting banking giant Merrill Lynch to seize USD 800 million from the funds. Northern Rock had to approach the Bank of England for emergency funding due to a liquidity problem. In October 2007, Swiss bank UBS announced losses worth USD 3.4 billion from subprime-related investments.

By 2008, the United States and world economies entered the recession phase, and financial institutions’ got surrounded by liquidity struggles. Northern Rock got nationalised. Bear Stearns collapsed and was taken over by JPMorgan Chase. IndyMac Bank too failed. Two of the United States’ biggest home loan lenders Fannie Mae and Freddie Mac, were seized by the government. The crisis reached its zenith with the downfall of Lehman Brothers in 2008 September.

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Following the 2008 crisis, central banks, regulators, and decision-makers were compelled to adopt exceptional measures. As a result, banks are now more capitalized, and the global financial system is experiencing less money sloshing. But new threats have also developed, as well as some old ones. The article will draw on ten years of financial markets research to examine what has changed and what hasn’t happened in the banking sector since the crisis.

Banks are safer but less profitable

Following the crisis, authorities and policymakers all around the world took action to fortify banks against potential shocks. For US and European banks, the average Tier1 capital ratio increased from less than 4% in 2007 to more than 15% in 2017. According to Jerome Powell, all banks now keep a minimum level of liquid assets. He stated that the largest systemically significant financial institutions must hold an additional capital buffer.

Scaled back risk and return

Most of the biggest international banks have scaled back their trading activity during the last ten years, including proprietary trading for their own accounts, which has decreased risk exposure. However, despite the extremely low-interest rates and new regulatory frameworks, many banks with headquarters in industrialized economies have been unable to develop new, viable business models. Since the crisis, the return on equity (ROE) for banks in advanced economies has decreased by more than half. For European banks, the pressure has been the strongest. They had an average ROE of 4.4% over the previous five years as opposed to US banks’ 8%.

Banks are only modestly valued above the book value of their assets by investors, who have a pessimistic view of growth prospects. The price-to-book ratio of banks in advanced nations was at or slightly below 2% before the crisis, reflecting expectations of rapid development. However, most advanced economy banks have had average price-to-book ratios of less than one since 2008. (including 75% of EU banks, 62% of Japanese banks, and 86% of UK banks). Nonperforming loans are a burden on the banking system in several emerging economies. More than 9% of all loans in India are non-performing. The recent currency decline in Turkey may increase the number of defaults.

In the post-crisis era, the best-performing banks have been those that have drastically reduced operational expenses while also hiring more risk-management and compliance personnel. In general, US banks have reduced more drastically than their European counterparts. But unless the sector revives revenue growth, banking might turn into a low-margin, commoditized enterprise. The industry’s average annual global revenue growth from 2012 to 2017 was only 2.4%, a sharp decline from the euphoric pre-crisis years of 12.3%.

Digital disruption

New digital players are posing a threat to established banks, just like they are to incumbents in every other industry. Platform firms like Alibaba, Amazon, Facebook, and Tencent threaten to snatch up some market share; this is already happening in the world of mobile and digital payments. According to predictions made by McKinsey’s Banking Practice, the banking sector’s ROE might reach 9.3% in 2025 as interest rates rise and other favorable factors come into play. However, if retail and business consumers transfer to digital providers at the same rate that people have in the past for new technologies, the industry’s ROE may decline much lower.

However, technology threatens more than just banks. It might also provide them with the boost in productivity they require. For increased efficiency, several institutions have already begun to digitize their consumer-facing and back-office activities. They can also improve how they employ big data, analytics, and artificial intelligence in risk modelling and underwriting. By doing this, they may be able to avoid the kinds of bets that went wrong during the 2008 financial crisis and increase profitability.

Global banks retrench

Banks in the Eurozone have taken the lead in this decline in global activity by becoming more regional and less national. Since 2007, their total foreign debts and other claims have decreased by $6.1 trillion, or 38%. Reduced intra-eurozone borrowing accounts for about half of the drop (and especially inter-bank lending). German banks, for example, had two-thirds of their assets located outside of Germany in 2007, but that number has since dropped to one-third.

The amount of business conducted abroad has decreased for some US, Swiss, and UK institutions. Since the financial crisis, banks have sold more than $2 trillion worth of assets worldwide. Global banks’ cutbacks are a result of a number of factors, including a new assessment of country risk, the realization that doing business abroad is frequently less profitable than doing business at home, national lending policies that favor domestic lending, and new capital and liquidity regulations.

The biggest international banks have also reduced their correspondent links with local banks abroad, particularly in emerging nations. Banks can conduct different types of business in nations where they do not have their own branch operations because of these connections. These services have been crucial for remittances, trade financing, and providing underdeveloped nations with access to valuable currencies. However, due in large part to a new evaluation of risks and regulatory complexity, global banks have begun adopting a tougher cost-benefit analysis of these connections.

A few banks, most notably those from China, Japan, and Canada, are diversifying their international operations. Due to the saturation of their domestic market, Canadian banks have expanded into the United States and other markets in the Americas. Japanese banks are expanding their footprint in Southeast Asia and increasing syndicated lending to US corporations, albeit as modest investors. Banks in China are increasing their loans internationally. They used to have almost no overseas assets, but today they have more than $1 trillion. The majority of China’s loans go toward supporting Chinese companies’ outbound foreign direct investment (FDI).

FDI is now a larger share of capital

From a peak of $3.2 trillion in 2007 to $1.6 trillion in 2017, global FDI has decreased, but this decline is less dramatic than the decline in cross-border financing. In addition to reflecting a substantial fall in cross-border investment in the eurozone, it also represents a decline in the number of firms using low-tax financial hubs. However, FDI accounts for 50% of cross-border capital flows in the post-crisis period, up from the average quarter before the crisis. Contrary to short-term funding, FDI shows enterprises adopting long-term business expansion initiatives. It is unquestionably the least erratic form of money movement.

According to Ben Bernanke, the “global savings glut” produced by China and other nations with sizable current account surpluses is what is causing interest rates to drop and the real estate bubble to expand. Interest rates were pushed lower because a large portion of this capital surplus was invested in US Treasuries and other government bonds. The result was a reallocation of portfolios and ultimately a credit bubble. This pressure has now decreased, along with the danger that unexpected withdrawals of foreign cash will plunge nations into crisis.

The reductions in China’s current account surplus and the US deficit are the most notable improvements. China’s surplus peaked in 2007 at 9.9% of GDP but has since dropped to just 1.45 of GDP. The US deficit peaked at 5.9% of GDP in 2006, but by 2017, it had dropped to 2.4%. Large deficits have similarly decreased in Spain and the UK. There are still some imbalances. The previous ten years have seen Germany maintain a sizable surplus, while certain emerging nations, such as Argentina and Turkey, have deficits that put them at risk.

Corporate debt danger

There is a risk associated with the increase of corporate debt in developing nations, especially if interest rates rise and the debt is issued in foreign currencies. Companies may become trapped in a vicious cycle that makes it impossible to repay or refinance their debt if the local currency depreciates. At the time of writing, a sharp depreciation in the Turkish currency is causing market tremors that expose international and EU banks.

Credit quality has decreased as the market for corporate bonds has expanded. Non-Investment grade “junk” bonds have seen significant growth. Even investment-grade quality is no longer acceptable. 40% of the country’s outstanding corporate bonds have BBB ratings, which are one step above trash status. We estimate that 25% of corporate issuers in emerging markets are already at risk of default; if interest rates increase by 200 basis points, that percentage may increase to 40%.

A record number of corporate bonds will mature globally during the following five years, and there will be a $1.6 trillion to $2.1 trillion yearly requirement for refinancing. It is reasonable to anticipate more defaults in the years to come given that interest rates are rising and some borrowers already have precarious financial situations. The significant increase in collateralized loan commitments is another issue that merits close attention. These instruments, which are related to the collateralized debt obligations that were popular before the crisis, use loans to businesses with poor credit ratings as collateral.

Mortgage risk

One of the lessons from 2008 is how challenging it is to spot a bubble as it inflates. Real estate prices have increased dramatically since the financial crisis in high-demand real estate areas including San Francisco, Shanghai, and Sydney. Contrary to 2007, these run-ups are typically confined, and crashes are less likely to result in widespread collateral damage. But sky-high urban housing costs are also a factor in other problems, such as a lack of affordable housing options, financial strain on families, restricted mobility, and rising wealth disparity.

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10th September

In this article International Finance Magazine explains what is a toxic asset,fall of Lehman brothers, misuse of Repo 105 and its implications on the world.

An article from Bloomberg stated, Citigroup Inc., the third biggest U.S. bank by assets, reported that its first half costs at a unit holding some of the lender’s most toxic loans and securities multiplied by almost 10 times compared to the last year on account of higher legal expenses. The Special Asset Pool’s operating expenses climbed from $ 1.25 billion from the first six months of the year from $ 129 million in the same period last year.

“One of the legacy issues that we’ve got is continuing litigation coming out of our business in holdings,” said its Chief Financial Officer (CFO) John Gerspach. Private label mortgage backed securities are not guaranteed by government sponsored securities such as Fannie Mae or Freddie Mac. Investors can force banks to repurchase the underlying mortgages if they are faulty.  Many banks have managed to cut down their toxic assets, Citigroup for example, cordoned off its troubled assets in January 2009 with its creation of Citi Holdings. In the last two quarters the bank has managed to unload $ 56 billion in bad debt, including complex investment products like collateralized debt obligations, or CDO’s. Other banks have also taken the initiative of off loading their toxic assets by deploying teams of individuals called “special asset groups” who have been tasked with clearing out loans and other securities. AIG, the insurance giant which succumbed in the 2008 financial crisis has been given a fresh lease of life by the Federal Reserve which has bailed out the company by spending $ 31.5 billion and buying the troubled insurance company’s assets.

“The truth of the matter is many financial institutions are in much better shape than in February of March 2009” said Edwin Truman, senior research fellow at the Peterson Institute of International Economics.

Investopedia defines Toxic assets as “ An asset that becomes illiquid when its secondary market disappears. Toxic asset cannot be sold, as they are often guaranteed to lose money. The term “toxic asset” was coined in the financial crisis of 2008-09, in regards to mortgage backed securities, collateralized debt obligations and credit default swaps, all of which could not be sold after they exposed their holders to huge losses.

A toxic asset can be described by this example:

If Jonathan buys a house and takes out a $ 500,000 mortgage loan with a five percent interest rate through Bank “A”, the bank now holds an asset – a mortgage backed security. Bank “A” is now entitled to sell the asset to another party Bank “B” is entitled to the 5 percent mortgage interest paid by Jonathan. As long as the house prices go up and John continues to pay his mortgage, the asset is a good one. However, if Jonathan defaults on his mortgage, the owner of the mortgage (Bank “A” or Bank “B”) will no longer receive the payments to which he is entitled. The value of the house would have gone down and only a portion of the money can be recovered. As, a result the securities based on this mortgage would not sell in the market as no one would pay for an asset that is guaranteed to lose money. In this example, the mortgaged backed security becomes the Toxic Asset.

Collapse of Lehman Brothers

Founded in 1850 by three immigrants from Germany, Lehman Brothers had been a prominent investment bank in Wall Street for decades, it operated at a wholesale level, dealing with governments, companies and other financial institutions, employing 28,000 people worldwide, with 5,000 employees in the U.K. The scandalous part of the Lehman brothers collapse was uncovered when they tried to cover up their abysmal financial situation. The bank sold $ 50 billion worth of toxic assets (mortgage backed securities) to different banks in the Cayman Islands with the promise that they would buy them back within a short time,(which is legal) this promise to buy them back makes the transaction a loan, not a sale. But Lehman Brothers used a combination of illegal and sneaky accounting to make their companies cash balance appear to be $ 50 billion greater than it actually was and made their toxic asset balance lesser by $ 50 billion than they were actually. Therefore it appeared that the bank had made sales of $ 50 billion when in fact they had borrowed $ 50 billion from different banks in the Cayman Island and showing them as a Repo 105 transaction. A “Repo 105” (a kind of window dressing) is a short term loan that is classified as a sale.

For example: If Lehman owned a bond that was worth $ 105, it would sell it on the repo market for $ 100. The investment bank would then take the money it got from selling the bond and settle some of its debts. After it had issued the quarterly report, the company would borrow more money to repurchase the bond.

The bank which was dubbed as the “The Real Estate ATM” said in August 2007 that it would make write downs to the extent of $ 700 million to adjust the value of its investments in residential mortgages and commercial property, a year later the figure soared to $ 7.8 billion, it also admitted of having $ 54 billion worth of hard-to-value mortgaged backed securities. It’s over exposure to the U.S. real estate market, huge investments in subprime mortgages and innovative but risky investments such as collateralized debt obligations and credit default swaps also contributed to its downfall. Lehman which once employed more than 28,000 employees, 5,000 in U.K alone, traded at a value in the NASDAQ at $ 85 at its peak and with a 158 year history it failed because it traded on Toxic assets and taking too much risk on a booming market. Its share value had plummeted by 95 percent

On 15^th September 2008, it was curtains for the bank as it filed for Chapter 11 bankruptcy protection, which allows a company to reorganise and devise a plan to pay back its creditors. The fall of the investment banking giant precipitated the financial crisis worldwide and a loss of confidence among major banks and a major financial crisis throughout the world.

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