Silicon Valley Bank (SVB)’s shares went to zero because there was a run on the bank. Depositors pulled their money and it suddenly became insolvent. 

The big two Irish banks’ shares are each down 16 per cent this week. The Eurostoxx index of European banks is down 9.8 per cent.

You’d be forgiven for drawing a straight line between the two stories. What’s going on with Irish bank shares?

Potted summary

Very quickly: SVB had two problems. In recent years, it got a big influx of deposits. Its deposits were particularly skittish, for reasons to do with its role as a bank to the tight-knit technology community.

A sensible bank would have looked at these skittish depositors and put the money into stuff that’s easy to turn into cash at short notice. But SVB got greedy and put it into 10-year bonds. When SVB’s bet on bonds went bad, skittish depositors did their thing, and the bank collapsed.

I wrote in more detail about how SVB collapsed on Friday, and yesterday I wrote about the regulator’s role. Stephen happened to find himself in Silicon Valley, meeting technology leaders, as the story was breaking. 

How does this fit with the drop in Irish bank shares?

The mistake

SVB apologists say it was doing the same thing as every other bank: borrowing short to lend long. This is known as maturity transformation and it is indeed the fundamental purpose of banks in our economy. Banks’ job is to borrow money from depositors and use it to fund longer-term, risker projects. This is how society funds big projects and it’s how banks make a profit. 

The problem with borrowing short and lending long is that it’s vulnerable to panics: if everyone calls in their deposits at the same time, the bank won’t be able to raise the funds by selling out of long-term projects, and the bank will go bust. 

This is not to let SVB off the hook. Society does lots of things that are fundamentally risky, like flying planes across the ocean. SVB blew up because it took irresponsible amounts of risk in the pursuit of profit. Most banks take a responsible amount of risk, and make a profit, without leaving them wide open to a run on the bank. Their capital stack doesn’t get wiped out by an admittedly fast rise in interest rates.

Regulation is an important part of the story. SVB was permitted to take big risks by US banking regulators, which go easy on “small” banks (SVB had $209 billion in assets, which would have made it comfortably the biggest bank in Ireland). 

SVB was the worst offender but not the only one. Another small, lightly regulated US bank called Signature was shut down by regulators alongside SVB. And this week, other US regional banks are in trouble: shares in First Regional bank fell 57 per cent, PacWest fell 37 per cent, and Zion Bank fell 25 per cent. 

Those banks might be in real trouble. They’re lightly regulated, like SVB. Most of them made big bets on interest rates staying low. And now that the word is well and truly out about the risk of bank runs, their depositors might take fright.

If SVB was the first domino to fall (shares down 100 per cent), and First Regional is the bank most at risk of falling next (shares down 57 per cent), does it follow that AIB and Bank of Ireland (down 16 per cent) are somewhere along the chain?

I don’t think that’s what’s happening with the share price of Irish banks — that investors are slightly worried about being liquidated in a global bank armageddon. There’s a more reasonable explanation.

Credit risk and rate risk

The Global Financial Crisis was a story of loans going bad. It was about banks underestimating the riskiness of their lending. 

The consequence of this was that regulators got very tough on lending. They cracked down on banks with non-performing loans and made them set aside extra capital for riskier loans.

What the Global Financial Crisis wasn’t about was rates. Banks didn’t blow up in 2008 because they owned a load of bonds that were sensitive to rising interest rates (as happened to SVB). 

And after 2008, central banks didn’t clamp down on interest rate risk. To put it another way: if SVB had responded to its influx of deposits by making lots of risky loans, the regulators would have stepped in. Instead it bought risky bonds, and the regulators gave it two thumbs up.

SVB and these other regional banks have found themselves vulnerable, not to their loans going bad, but to their bond portfolios going south as interest rates rise. 

Central banks have been raising interest rates to fight inflation. But this scenario would give any central banker pause. Runs on banks have a way of getting out of hand. Even if these US regional banks are small fry, a run on one or two of them has the potential to spark a panic. Central bankers might want to avoid that scenario by going a bit easier on the rate rises.

According to an analysis on March 13 by David W. Higgins, a research analyst at Carraighill, market expectations of interest rates for the first of November are 50 basis points lower than they had been one month previously. 

Now we’re getting somewhere: we know Irish banks are acutely sensitive to interest rates. That’s because, relative to other banks, they make a bigger proportion of their income from money lending. Higher rates make money lending more lucrative and vice versa. It’s why Bank of Ireland shares rose 577 per cent between September 2020 and last week. 

For Bank of Ireland and AIB, higher rates have meant more income from lending. For SVB, whose balance sheet was bloated with bonds (55 per cent of assets compared to 12.4 per cent for AIB and 6.4 per cent for BOI), higher rates crashed bond prices which wiped out its capital and led to the run.

Another hint that lower interest rates are what hurt Irish banks last week: whatever is happening is being felt across the economy, and not just by bank stocks. The S&P 500 is down seven per cent in the last week, and the Eurostoxx index was (until this morning) down four per cent. Stock markets like a Goldilocks level of inflation — not too high or too low.

So the good news is that the Irish banks’ share prices aren’t forewarning of a financial cataclysm. It’s more likely to do with interest rates. This SVB fiasco will result in fewer interest rate hikes in the near term. Everyone will have to live with higher inflation for a while because SVB’s chief financial officer got greedy.