Fragile Arrangements

Silicon Valley Bank went bankrupt on Friday. That means that anyone who lent money to that bank will find it hard to get it back, and anyone who did business with it will have to take their business somewhere else.

The consequences of this will be seen as early as this coming Monday, and we will learn how fragile or robust our current financial system really is.

The challenges for anyone who did business with SVB are multiple, so its bankruptcy serves as a good test case. First of all, a large number of businesses were dependent on the bank for their operations. Many had the bank taking care of salaries for their employees, either through credit lines or from deposits.

A bank deposit is a loan to a bank, and any amount above $250,000 is uninsured. A company with a bank deposit above that figure isn't going to get access to all its money. If the money is required for salary payments, it's going to fail its legal obligation to pay. Those dependent on credit lines for paying salaries won't be able to pay either. If they cannot find an alternative to their SVB services by Monday, or early next week at the latest, employees will have to be furloughed.

SVB specialized in venture capital, with a large number of its clients being start-ups. These companies were typically doing all their banking with SVB as part of their deal to get funded in the first place. A large number of start-ups are therefore likely to be wiped out unless some other bank steps in as an alternative, but with financial conditions now tight due to central bank tightening, we're not likely to see anyone step into the vacuum left by SVB. Many well paying jobs are therefore likely to be cut as early as Monday morning.

But a bank like SVB isn't an island. Banks trade in loans among themselves, and any bank that owned SVB bonds or had deposits at SVB must now write that money off as as a loss. There's also the sudden awareness among depositors that deposits aren't ironclad. Even if they are insured, cash can be difficult to withdraw from a bankrupt bank. Other banks are therefore likely to see withdrawals of deposits at the same time that some are seeing losses due to exposure to SVB.

It's hard to say how severe this contagion will be before some time has passed, but there will be further losses in the banking sector, that's for sure.

Our current financial system is up for a test. If it's as robust as central bankers assure us that it is, the SVB failure will be contained to that one bank, a handful of their clients, and their employees. Things will sort themselves out. The newly unemployed will find work with other companies, a few start-ups will have failed and some people will have lost some money to SVB, and that's the end of that story.

However, if the system is as fragile as some fear, we'll see dominos falling everywhere. A whole bunch of small banks will find themselves bankrupt due to bad loans and depositors withdrawing money. Businesses dependent on these banks will have to stop their operations, the unemployed will fail to find new work, and there will be a rush to sell real-estate and other assets in order to raise cash. There will be defaults on loan payments from businesses and private clients. Larger banks will get in trouble, and the whole economy gets clogged up in an illiquid mess.

Reflection in a soap bubble

By Brocken Inaglory. The image was edited by user:Alvesgaspar - Own work, CC BY-SA 3.0, Link