The 2023 banking crises unfolded at lightning speed, exposing how risk can quickly emerge from unsuspected nooks of the financial system. Silicon Valley Bank (SVB
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“Crypto has already demonstrated its value as a potent addition to the modern financial system. Its innovations can help mitigate risks associated with centralized single-point failures,” stated Matvey Diadkov, founder, CIO Bitmedia.io. Innovations in Crypto and Crypto finance were developed in response to the 2008-2009 TradFi banking crises. Like many new technology cycles, crypto got caught in excessive hype and a speculative frenzy. Numerous failures in 2022, mainly in Custodial Centralized Finance (CeFi), led to the current “crypto winter.” Ironically, the catastrophic implosions happened due to TradFi practices (centralized opaque custody) infiltrating crypto platforms and feckless behaviors by fraudulent rogue actors at the helm. Crypto is not the cause of recent TradFi bank runs. On the contrary, crypto’s ingenious features, such as self-custody, transparency via on-chain data, tokenization, immediate settlement, and more, offer novel ways to avert catastrophic single-point failures; restrict rogue behaviors by decision-makers, and prevent loss of funds. “The more crypto business and institutions try to replicate the structures of traditional finance to claim credibility, the more prone they are to become big black box failures. At the heart of this lies the requirement for self-custody of digital assets,” stated Jaydeep Korde, CEO of Launchnodes.
What went wrong with banks in 2023 – Excessive risk, too little diversification, and myopic profit-motivated executives playing fast and loose with the rules while eschewing red flags. They failed in their primary responsibilities of risk management, capital preservation, and adequate liquidity. Pay and bonuses pegged to return on equity (RoE) at these publicly traded banks incentivized executives to prioritize short-term profit metrics over risk management, setting the cataclysmic events in motion.
After a decade of near-zero interest rates, the recent steep rate hike cycle by the Federal Reserve (Fed) tightened liquidity, creating balance-sheet stresses. Executives at these banks failed to balance long-term assets with short-term liabilities and manage interest rate risks. Perilous bets on interest-rate sensitive bond securities to spruce up short-term financials without implementing adequate hedges began accruing unrealized losses as the interest rates rose. Thereby significantly worsening the balance sheet stresses, creating liquidity crises, and becoming the single-point failure Achilles heel. Large deposits from concentrated business segments, exceeding the $250,000 Federal Deposit Insurance Corporation (FDIC)limit, were uninsured and proved super flighty. At the whiff of bad news, the large pool of uninsured depositors bailed, creating withdrawal frenzies and bank runs. A networked community of sophisticated depositors, social media-fueled fear, and near-instant transaction-enabling technologies transferred out vast sums electronically, catalyzing the bank runs at astonishing speed. As reported, over 90% of the deposits at SVB, Signature Bank, and 68% at First Republic Bank were uninsured.
As the aforementioned banks began to spiral down under the tsunami of bad news, numerous government bodies intervened quickly to cordon off the contagion. Within a couple of days of SVB and Signature Bank going into receivership, the Fed and Treasury guaranteed all deposits to the fullest, overriding the standard limit of $250,000 per account. Stock and Bond holdings’ values go to zero.
The government’s last-resort rescues and backstops, however, set a bad precedent by tacitly condoning excessive risk-taking by profit-motivated senior executives at these failed banks. Reigniting the ‘Moral Hazard’ dilemma and a replay of risk socialization. My Upside, Your Risk – Corporate insiders and stakeholders make money when risk-taking works, while others bear the losses when risky bets fail. Ironically, without government intervention, the existing receivership process would have exposed the SVB depositors to only modest haircuts (the losses in the bond portfolio). SVB’s deep-pocketed sophisticated risk-appreciating high net worth clients could have withstood the potential exposure. “The 10 largest deposit accounts at Silicon Valley Bank held a combined $13.3 billion,” stated the chair of the FDIC. The government’s sweeping promises to the depositors seemingly have protected billionaires and the ultra-rich. “The uninsured depositors of SVB are not a needy group…. The bigger problem is the Fed’s too rapid unwinding of 14 years of lax monetary policy,” stated Sheila Bair, former chair of the FDIC and a senior fellow at the Center for Financial Stability (link
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Silicon Valley Bank: Recent steep interest rate hikes froze technology investments and IPOs, halting SVB’s deposit inflows while accelerating withdrawals and liquidity stresses. SVB management had accumulated a massive $124bn bond portfolio (more than 50% of its assets) and decided not to adequately hedge against the interest rate exposure, even as the Fed embarked on its steepest interest rate hiking cycle in 2022. They further juiced up short-term P&L by liquidating or letting expire rate hedges on all its securities, entering 2023 almost entirely unhedged against interest rate risks. Thereby accruing substantial unrealized losses in its bond holdings. SVB failed to raise money to meet cash outflows, forcing it to sell the bond portfolio and realize big losses. News headlines of substantial losses with diminished liquidity created a confidence crisis. Depositors from interconnected startups backed by sophisticated and herd mentality Venture Capitalists (VCs) swiftly moved money out, orchestrating the bank run. SVB also operated without a chief risk officer from April 2022 to December 2022.
Signature Bank: As the crisis engulfed SVB, more than 90% of uninsured Signature Bank deposits from concentrated private equity and legal business segments started fleeing, causing a run, and forcing the bank into receivership. Signature’s assets were 66% loans and the rest in debt securities.
First Republic Bank had 67% of uninsured deposit accounts, somewhat in line with other regional banks and much less than the over 90% at SVB and Signature Bank. The bank also has a pristine loan book and conservative underwriting. Its geographic location, mostly high net worth Silicon Valley clientele, and business model similar to SVB made First Republic Bank the poster child of current banking crises caught up in the contagion and thrown to the sharks by the short sellers. First Republic has recently lost roughly $70 billion in deposits, creating an urgency to raise cash. To shore up its balance sheet, 11 banks, including JPMorgan Chase
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Credit Suisse, the second-largest bank in Switzerland, collapsed in March 2023 and was purchased by rival UBS for 3 billion CHF (about USD 3.3 billion). Scandals, management shifts, and significant losses had recently plagued Credit Suisse. Credit Suisse was a contagion casualty of bank failures in the US. Swiss regulators brokered the purchase of Credit Suisse by UBS.
Failed banks are not the norm in the banking industry. These failures do not relegate TradFi institutions as ineffectual and untrustworthy. On the contrary, TradFi banks effectively leverage assets and manage risk. In the aftermath of the 2008-2009 financial crises, the Volcker Rule within the Dodd-Frank Wall Act of 2010 was introduced to mitigate risky transactions by banks and systemic risks to deposits. Basel III outlines liquidity ratios and mandated capital requirements, i.e., liquid assets banks must have on hand to sustain operations while still honoring withdrawals. Banks are required to ringfence deposits, not engage in proprietary trading with deposits, and remain stress-tested for liquidity.
Crypto and blockchain inherently lend ingenious alternatives to centralized TradFi intermediary platforms. To gain wide adoption with trustworthiness, DeFi, and CeFi crypto finance products should incorporate TradFi’s risk-mitigating framework, which has been evolving and improving for over a hundred years. “Crypto’s intricate technical concepts, and not aligning seamlessly within the mandates of existing regulatory bodies, creates an urgent need for international coordination and development of consistent standards and regulations for crypto,” stated Albert Davis, President of the Rotary eClub of Wall Street. Non-custodial crypto DeFi staking platforms and decentralized exchanges (DEXs) do not have keys to the users’ wallets, hence cannot rehypothecate customer deposits. These already provide transparent and effective trading mechanisms and immediate settlements. Their plainly visible on-chain, transparent liquidity pools and total locked-in value (TVL) give complete accountability of all trades adding or removing assets. Such comprehensive transparency prevents nefarious actors from hiding or manipulating assets and liabilities on-chain. In contrast, crypto CeFi platforms, like TradFi, have custody of customer deposits and have been prone to fraud and mismanagement (add links). Therefore, CeFi platforms must ringfence client funds and incorporate the existing TradFi rules regarding proprietary trading, liquidity ratios, and mandated capital requirements.
The banking crisis of 2023 points to stark risk management failures by some bank executives and shortcomings in the existing regulatory fabric. However, it is not a broad systemic issue within the banking sector. TradFi’s infrastructure, risk-assessment mechanisms, and regulatory compliance have been evolving and improving for over a century. Crypto innovations incorporating TradFi risk management structure can create robust and trustworthy solutions for the billions of banked and unbanked.
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