THE COLLAPSE OF of Silicon Valley Bank (SVB) on Friday, March 10, sent jitters through financial markets in a chilling reminder of the 2008 Global Financial Crisis when the fall of Lehman Brothers precipitated the biggest financial crisis since the Great Depression and brought the world economy to a halt.

While SVB is markedly different than the banks’ failures seen in 2008, less connected with other larger banks and very concentrated in the innovative companies and venture capitals, its collapse once again sheds light on the fragility of the financial system.

Bank runs, such as the one that led to SVB collapse, occur when a large number of depositors panic and attempt to withdraw their funds at once: on March 9 SVB depositors tried to withdraw $42 billion, leaving the bank with a negative cash balance of $958 million.

The run was triggered by the realization that SVB had invested a large amount of its portfolio in bonds, whose prices have plummeted with the rise in interest rates over the past year.

SVB was an unusual bank: most of its customers were start-ups who had deposits in excess of the $250,000 limit for insured deposits in the US. It used these deposits to buy long-dated bonds, which lost value, and did not hedge this risk (it could have done it, but that would have diminished its profitability).

Yet the policy response and media attention around the collapse of this mid-size US bank highlights a difficult trade-off policy-makers face when regulating the financial sector: panic vs moral hazard.

Panic vs moral hazard

The 2023 Nobel Prize in Economics was awarded to Ben Bernanke, Douglas Diamond, and Philip Dybvig for their research on how panic-driven bank runs occur. They show that because banks hold very liquid liabilities (deposits that can be withdrawn at any time) and invest in long-term assets (such as mortgages), this makes them inherently subject to the risk of withdrawals.

As a result, regulators ask banks to keep a share of their deposits as reserves to meet depositor withdrawals and enough capital to absorb losses in their portfolio of assets. However, while large US banks are more tightly regulated, regional banks (for which Trump’s 2018 Reform Act introduced a regulatory relief bill),such as SVB, are less so.

At the same time, the speed with which the panic surrounding SVB spread and the massive drain of deposits withdrawn ($42 billion in a matter of hours) was unbearable an amount for any institution, let alone a relatively small bank (by comparison, in 2008, depositors withdrew $16.7 billion in deposits from Washington Mutual, the largest US bank to collapse, over a ten-day stretch).

So while SVB faulty risk management precipitated a panic-driven bank run, the risk to the broader economy is that the panic spreads and leads to a systemic financial crisis. Which is why regulators feel compelled to act fast and contain such deposit flight in other financial institutions and the financial contagion from spreading.

US authorities acted fast during the weekend. At 6.15 pm (EST – 10.15 pm GMT) on Sunday the Secretary of the Treasury Janet L. Yellen, Federal Reserve Board Chair Jerome H. Powell, and FDIC Chairman Martin J. Gruenberg, announced that the Federal Deposit Insurance Corporation (FDIC) will fully protects all depositors.

But while regulatory intervention can reduce panic, it exacerbates the moral hazard problem of large financial institutions that are “too-big-to-fail” as governments perceive the economic costs of letting these firms fail as exceeding the fiscal costs of the bailouts.

The rest of the world is watching

While the panic seems contained for now, and the rest of the US financial sector is in a better position to absorb losses than in 2008, according to a FDIC report, US banks were sitting on $620 billion in unrealized losses, i.e. assets that have decreased in price but haven’t been sold yet, at the end of 2022.

In Europe, bank stocks fell on Monday and HSBC announced the purchase of the UK arm of Silicon Valley Bank (SVB UK ~ 3,000 customers worth £6.7bn – HSBC buys Silicon Valley Bank UK). This released some of the pressure on the Bank of England, as the purchase meant that all depositors’ money with SVB UK are now safe and secure.

On Wednesday, a new sell-off in European and US bank stocks took place after Credit Suisse, a Swiss Bank which has been battered by one scandal after another lost around 30% of its value after its main shareholder announced ruled out any capital injections in case of further needs.

The ECB has not reacted, as an ECB press conference is due to take place on Thursday, March 16, and the members of the ECB Governing Council are observing the so-called quiet period before key meetings.

However, a source Reuters on the Single Supervisory Board revealed that they “saw no direct impact from the SVB collapse on euro zone banks unless the ramifications spread to larger U.S. banks, raising the risk of contagion”.

What could this mean for monetary policy?

Following the strong US employment report released last week, market participants were expecting a further raise in interest rates, by up to 50 basis points at the next meeting.

However, given the current financial stability concerns on regional banks, on Monday Goldman Sachs’ economists said they no longer expect the Fed to deliver a rate increase next week. Meanwhile, other commentators are starting to think that the Fed might leave rates unchanged until the end of the year.

During the ECB press conference of February 2, ECB President Christine Lagarde mentioned the intention of increase the interest rate by 50 basis points on March 16.

While markets are already incorporating this increase, the exact wording ECB President Christine Lagarde’s press conference will be scrutinized even further, as the ECB might opt to provide much less guidance on future policy rate hikes.

Oana Peia is an assistant professor in the School of Economics at University College Dublin and a Research Fellow at the Geary Institute for Public Policy Her research is at the intersection of macroeconomics and finance with an emphasis on the role that financial intermediaries play in the real economy.

Davide Romelli is an Assistant Professor of Economics at Trinity College Dublin, Ireland. He is also a Research affiliate of IM-TCD (International Macro-TCD) and SUERF – The European Money and Finance Forum and a Fellow of the BAFFI-CAREFIN centre, Bocconi University. His research focuses on international finance and macroeconomics, central banking and financial supervision.