In a mere span of five days in 2023, the American banking landscape was shaken to its core as three banks collapsed while two others teetered on the brink of crisisOne of the significant casualties was Silicon Valley Bank (SVB), which reported staggering losses of $15 billion due to its investments in mortgage-backed securities (MBS) and U.STreasury bondsThis episode was merely the tip of the iceberg, as the aggregate losses within the American banking sector reached a staggering $620 billion—forty times what SVB had lostMost of these losses, however, were cleverly disguised within the Held-to-Maturity (HTM) investment categoryTo grasp how this financial crisis unfolded, we must delve deep into SVB’s financial reports and unearth the latent issues embedded within the banks across the nation.

The rollercoaster ride of interest rates from 2020 to 2022 illuminates the vulnerabilities of the banking sector

Initially, in response to the global pandemic, the Federal Reserve drastically lowered interest rates, essentially cranking up the money-printing machineThen came the abrupt shift in 2022, when the Fed raised interest rates sharply to combat inflation, triggering a cascade of financial complicationsIn an astonishing surge, total bank deposits rocketed from $13.3 trillion before the pandemic to $17.6 trillion—the most significant influx in history—marking an increase of $4.3 trillion over just three yearsHowever, demand for loans had a starkly different narrative, remaining weak throughout this periodAs a result, banks were left with a surplus of cash, which they primarily funneled into investments rather than lendingOnly about 15% of the new deposits made their way into loans, while a staggering 85% was diverted towards purchasing U.Sbonds and MBS.

Silicon Valley Bank faced a unique predicament, witnessing its deposits triple over just two years

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With an overload of deposits and an inability to convert these into loans, SVB significantly boosted its investment in financial assets in 2021. The bank's HTM investments skyrocketed from $6.7 billion in 2020 to $85.5 billion in 2021—a staggering jump that was indicative of its desperate search for yield.

There-in lies the complexity of bank accounting, as the classification of assets into HTM (Held-to-Maturity) and AFS (Available-for-Sale) provided banks with some leeway to manipulate their financial statementsDuring times of declining interest rates, bonds tend to appreciate, tempting banks to categorize their bond investments under AFS to demonstrate profitsConversely, when interest rates rise, bonds depreciate, offering banks a motivation to switch some bonds to HTM to obscure their lossesAt the close of 2021, as expectations for interest rate hikes intensified, many banks began transitioning AFS assets to HTM in a bid to mask their declining values, resulting in the industry seeing a shift from a 75:15 ratio of AFS to HTM to an even split

SVB, due to its exponential deposit growth far overshadowing its peers, similarly followed this trend aggressively, pushing its HTM investments up by $80 billion.

By the end of 2022, SVB had accumulated $91.3 billion in THM investments which had resulted in approximately $15.1 billion in book losses— a significant concern considering its total equity was a mere $11.8 billion at the timeThis situation essentially meant that SVB had reached a state of technical insolvency.

In a bid to mask these burgeoning problems further, SVB attempted to exploit a regulatory loophole regarding interest rate swap productsRegulatory guidelines dictated that only AFS assets required interest rate swaps; hence, SVB took the opportunity in 2022 to substantially reduce its purchases of these swaps, cutting back nearly $10 billion compared to 2021 in efforts to preserve its net profits.

Against the backdrop of a perplexing financial landscape, the surge in deposit withdrawals presented a daunting crisis for Silicon Valley Bank

Decision-making was limited to two challenging options: the first involved selling off HTM securities to cover the funding gap, a move that would lay bare the hidden losses and damage the bank’s reputation irrevocablyThe alternative was raising funds through issuing new bonds or stocks, a strategy doomed to inflate operational costs and dilute the stakes of current shareholders while gnawing at profit marginsBoth choices loomed large with their ominous challenges.

On March 8, 2023, SVB released its quarterly report revealing a shocking loss of $1.8 billion, triggering an initial wave of panic among depositorsA day later, several startups came face to face with withdrawal difficulties; prompts from venture capital firms urging entrepreneurs to withdraw funds resulted in a second wave of bank runsMarch 10 saw SVB announcing a stock issuance, which caused its stock price to plummet; by March 11, the bank made the drastic move of declaring bankruptcy, with the FDIC stepping in to take control.

SVB's downfall, however, was not an isolated incident; it epitomizes the pervasive issues infecting the American banking system at large

Data reflects that myriad institutions, including JPMorgan Chase, Bank of America, Citibank, and Wells Fargo, similarly obscured significant losses under HTM post their 2021 MBS acquisitions.

Currently, the collapse of three banks alongside two more facing liquidity crises has put a spotlight on the overall fragility of the American banking systemWhile interventions from the Federal Reserve may provide temporary respite, the financial crisis is far from being quelledHistorical patterns suggest that initial losses experienced during a crisis are often just the beginning; as credit rating agencies downgrade institutions, cost of capital rises, and liquidity contracts, the ripple effects may start spreading into various asset classes and regions, deepening the ongoing crisis.

Looking back at the Great Depression of 1929 and the financial crisis of 2008, both were triggered by cycles of interest rate hikes and cuts wielded by the Federal Reserve