LAST month saw much volatility and uncertainty surrounding the US banking sector, precipitated by the failure of Silicon Valley Bank (SVB), the 16th-largest bank in the US at the time. At the end of 2022, SVB recorded assets of US$209 billion and provided financing and banking services mainly to technology start-ups. Based on its main client type, deposits held there were typically above the maximum. US$250,000 insured by the Federal Deposit Insurance Corporation (FDIC). While there is a narrative of mismanagement, the effect of interest rate increases on the mismatch of assets on the balance sheet will be explored.

Central banks use monetary policy to control the supply of money, mainly through influencing interest rates. On the back of high inflation, central banks globally have been raising interest rates to curtail the inflation monster. By now every Jamaican should be familiar with the term “inflation” from the many advertisements the Bank of Jamaica (BOJ) has put out: “Inflation the monster”; “Inflation not the enemy, if we control it, if it’s too high the people will cry, if it’s too low the country nah grow!”

Inflation is a measure of the general change in price levels. If prices increase, purchasing power decreases. How does this affect the prices of bonds and the capital of financial institutions, and what role did this play in SVB’s downfall?

There is an inverse relationship between bond prices and interest rates. That is, as interest rates increase, the prices of bonds fall. How does this work? Let us say ABC Financials issues a JMD bond for 10 years at a coupon rate of five per cent in 2018. The bonds were issued at par, so the coupon rate and yield are the same five per cent. In 2018, this would have been an attractive paper.

DEF Bank bought $250 million of this bond at issuance. In December 2022, DEF Bank decided to sell the bonds in the secondary market. By this time, the central bank had raised the policy rate to seven per cent. That is, commercial banks could now borrow from the central bank overnight at seven per cent. This made the ABC Financials bond less attractive because it pays a coupon (five per cent) that is lower than market rates (seven per cent). Because of this fall in attractiveness, its price falls below par and it is trading at a discount.

XYZ Investments wants to purchase these bonds from DEF Bank, but they need to be compensated for the risk they will incur for holding an asset with a low coupon relative to what’s being offered in the market. XYZ Financials offers to buy the bonds from DEF Bank at a discount, which translates into a yield of 12 per cent (seven per cent from the coupon and an additional five per cent yield from the discount in price).

SVB invested predominately in held-to-maturity assets, US Treasuries and mortgage-backed securities. In a high interest rate environment, these can be problematic for financial institutions because it would be difficult to sell these instruments at attractive prices to fulfil liquidity needs. Between 2022-2023 the Federal Reserve raised interest rates from 0.25 per cent to 5.00 per cent. Recall that we established that there is an inverse relationship between interest rates and asset prices; therefore, bonds bought prior to the rate hikes would have experienced a fall in their prices.

Given that SVB’s assets were reduced and its liabilities did not move proportionately, SVB’s capital was shrinking. The capital of a bank is the difference between its assets and its liabilities. To supplement its capital, SVB attempted to raise over US$2 billion in the capital market. However, by this time, the issue was not well received. This failed attempt was one of the drivers of depositors running to withdraw as much cash as possible from the institution. To compound matters, in pursuance of meeting the demand of cash to satisfy depositors, the bank had to sell assets for liquidity, crystallising a reported loss of US$1.8 billion.

As an investor, one might be asking: If interest rates are high, why buy bonds that will decrease in price to have a loss? A high interest rate environment allows investors to earn more on their investments as well as buy assets at more attractive prices. The reality is that every investor, whether retail or institutional, has a different goal, that includes expected return, investment timeline, risk appetite, among others. It’s always good to speak to your advisor about the economy and the impact this may have on your portfolio.

Kerice Gray is assistant manager for bond equity and digital asset trading at VM Wealth Management Ltd.