The world struggles to predict financial fallout from California bank collapse

As the millionaire depositors in Silicon Valley Bank gotall their money back courtesy of a U.S. government agency, there were no doubt sighs of relief among those bank customers whowould otherwise have taken a severe financial beating.

Until the U.S. government swooped in Monday, that included the vast majority of deposits at SVB, which catered to Silicon Valley startups and venture capital firms. Deposits over $250,000 US are uninsured by the Federal Deposit Insurance Corporation or FDIC.

Even the conservative-leaning Wall Street Journal, harking back to the hundreds of billions of dollars handed out following the2008 banking meltdown, is debating whether the support for uninsured depositors in the second largest bank failure in U.S. history should be declared"a bailout."

One concern is"moral hazard," the concept that by handing out money to people who should have lost it in a free-market transaction means they will be reckless in future, and maybe their banks will be more reckless too.

But thatis only one among many financial considerationssuddenly altered by the unexpected capitulation of the pre-eminent banker to California startups.

Perhaps the biggest question raised by the collapsethat has led to a ripple of selling across the global markets, including Canada,is why didn't we see this coming? Added to that is the question what other unexpected fallout there could be as the world contends with inflation and higher interest rates?

WATCH |How the collapse of a California bank is worrying the startup community:

U.S. bank failures leave Canadas tech sector shaken

1 year ago

Duration 1:53

The bank failures in the U.S. have sent shockwaves north, rattling the Canadian tech sector. Depositors have rushed to get their money out, but there's a broader fear it will chill investment.

Bank shares stumbled

Libertarian ideologues in the venture capital community who might have quoted Ronald Reagan's famous bon mot,"The top ninemost terrifying words in the English language are: I'm from the government, and I'm here to help," mayturn down the money.

The U.S. Federal Deposit Insurance agencythat effectively took over the assets of the failed bank movedquickly,announcing on Sunday that all insured depositors would have immediate access to their cash. By Monday it said uninsured depositors, those with more that$250,000 US, would also get their money back. But they said taxpayers would notbe on the hook.

"Any losses to the Deposit Insurance Fund to support uninsured depositors will be recovered by a special assessment on banks, as required by law," said the Monday FDIC release.

Despite that quick action, bank shares around the world declined.

The Canadian Big Five were down between two and four per cent as the day began although they recovered most of their losses later in the day.Some smaller U.S. banks were hit harder as the FDIC and the U.S. government said its decision to reimburse uninsured depositors was a special case and would not apply to everyone.

Rates too high too fast?

Big bank failures are a worrying signal for all financial markets, but for banks in particular the way SVBcollapsed was especially disquieting. And it all had to do with interest rates.

One key lesson for banks is that rising rates meant depositors in SVBhad begun looking for a better return on their savings. That can be a problem for any bank because, while it seems only months ago there was too much money slopping around the economy willing to accept tiny rates of return, suddenly using and lending people's money may be getting more expensive.

It's sometimes easy to forget the essential rule that banks take deposits and then lend that money out over a longer term at a higher interest rate. If people start start withdrawing theirdeposits, as they did at SVB last week, the bank knows it cannot call in its loans fast enough to pay the depositors the cash it owes them.

In general, that is not a problem becausedepositors are confident their bank is well managed and so everyone will not want their money at the same time. Not only that but banks keep reserves of cash and cash-like assets to satisfy a sudden surge in those who are anxious to withdraw.

And here is where interest rates hit the SVB a second time. Some of those cash assets were in bonds bought a few years ago when interest rates were low. Kept for the life of the bond, the bank would get all that money back. But due to the sometimes confusing way the bond market worksbonds sold before maturity can be worth a lot less.

When depositors heard SVB was taking a drubbing on the sale of its bonds needed to pay depositors, they rushed for the exit. In California tech culture, they didn't wait to line up at the bank as in bank runs of old. Instead,they used their cell phones to move their moneyinstantly. But by protecting themselves, they made things worse.

Private profits, socialist losses

Whether or not the FDIC move is considered a bailout,inevitably critics will say the rescue of multimillion-dollar businesses is another example of"privatizing profits and socializing losses."

But, as in 2008, there are some good reasons for governments and central banks to show support.

Some commentators, including John Rapley writing this weekend in the Globe and Mail declared that businesses must be allow to fail, the idea thatonly crisesallow the cleansing action of "creative destruction" where collapsing businesses make room for new and better businesses.

Evidently there were many others who decided that preventing thedestruction of an entire generation of dynamic young technology companies due to a quirky bank failurewas more important than someaustere economic principle.

The question remains, however, whether the collapse of SVB was a quirk or some kind of systemic problem. And if we did not see that one coming, are others lurking?

Certainly markets are now betting that interest rates will not continue to rise as quickly as Federal Reserve chair Jerome Powell recently predicted. Whether by luck or good management, the recent pause announced by the Bank of Canada's Tiff Macklem is looking prescient.

As economic historians have told me in the past, financial crises often arrive unexpectedly,their causes only understoodin retrospect.

Regulators, who are supposed to defend us from crises, will be scanning the horizon for more fallout.

So will investors. And the unpredictability of how they respondis one reason why what happens next remains difficult to predict.