In light of recent major failures of financial institutions, there is growing skepticism regarding the viability of the current global financial system. Notable occurrences such as the collapses of the Silvergate and Silicon Valley Bank, as well as UBS's acquisition of Credit Suisse, have highlighted the structural weaknesses in the global banking system. As a result, cryptocurrencies have once again become a topic of interest. This article will delve into the underlying causes of these bank failures and examine whether cryptocurrencies could serve as a safeguard against such systemic issues.
While there are many causes of the Silvergate and Silicon Valley bank failures, the question that arises is whether fractional reserve banking is to blame.
What is fractional reserve banking?
Fractional reserve banking is a system in which banks are required to hold only a fraction of their deposits in reserve, while the rest is lent out. The idea behind this system is that banks can make a profit by earning interest on the loans they make. Banks lend out the depositor’s fund at interest rates significantly higher than the interest they pay to depositors. This system has been beneficial for the economy, allowing people to take out business loans to start a company, student loans to go to college, or a mortgage loan for a house. However, this system only works when most clients leave a large amount of their money at the bank. If too many people try to withdraw their money at the same time, also called a bank run, the bank could collapse as it may not have the money on hand to honor depositors because the funds have been lent out. A depositor’s lack of confidence can lead to successive bank runs, which can threaten the stability of a country’s financial system.
The recent failures of banks are a result of multiple factors such as quantitative easing, low-interest rates, and a long period of easy access to the almost 0% loans from the federal government, which encouraged risky behavior after 2008. The financial crisis highlighted the fragility of the banking system, leading to a loss of trust in banks. Additionally, fintech and digital currencies have disrupted the traditional banking model, providing customers with alternative options to store and transfer their money.
While fractional reserve banking is often singled out as a risky practice, other factors such as poor risk management have also contributed to the failure of banks. In the case of Silicon Valley Bank, it suffered losses on its investment in government bonds with fixed interest rates due to rising interest rates.
The Failure of Silicon Valley Bank
The Silicon Valley bank had invested $80 billion in bonds with an average yield of 1.5%. However, as the Federal Reserve increased interest rates, newer bonds with higher yields became available on the market, causing the value of the bank's fixed-rate bonds to decrease. SVB did not have the best risk management policies as hedging interest rate risk was not done to a satisfactory level. However, the poor management of the risk on the SVB side has triggered the losses to another level.
As a result, the bank's holdings of bonds with a yield of 1.5% became less attractive to investors, causing their value to decline. This situation highlights the importance of carefully monitoring market trends and adjusting investment strategies accordingly to maximize returns and minimize risks. Seeing the developments, many depositors wanted to withdraw their money, and a traditional “bank run” happened after 7 March 2023. The bank was shut down by Californian regulators, and SVB was taken over by the FDIC (Federal Deposit Insurance Corporation). Finally, the Federal Reserve Board on Sunday,12 March 2023, announced it will make available additional funding to eligible depository institutions to help assure banks have the ability to meet the needs of all their depositors.
What are the issues with other banks?
The financial industry is currently witnessing solvency issues with several banks, including Signature Bank, and Credit Suisse. On March 19, 2023, UBS agreed to buy Credit Suisse in a government-brokered deal worth 3 billion Swiss francs ($3.25 billion USD), while New York Community Bank agreed to acquire a significant portion of Signature Bank for $2.7 billion. Under the acquisition, Signature Bank branches will operate under the name Flagstar Bank, a subsidiary of New York Community Bank.
In the current financial climate, it is crucial for banks to monitor their portfolios and make strategic decisions to mitigate potential risks. Furthermore, in the past weeks, Deutsche Bank shares decreased significantly, and default insurance is at its highest rate since 2018.
Are cryptocurrencies becoming safe havens in terms of security and decentralization for investors again?
Cryptocurrencies have been around for over a decade, and they have gone through several ups and downs. Recently, there has been a renewed interest in cryptocurrencies, as investors seek alternative assets and safe havens amid the recent banking crisis that has been observed. While Bitcoin opened the year of 2023 at $16,625, in 3 months it is being traded higher than $27,500, a 65% increase in this time span. The recent turmoil in the traditional financial scene has once indicated that investors see Bitcoin and other cryptocurrencies as a hedge against the failures caused by centralized entities. Decentralized nature, a limited supply of coins with a predefined rule of entering into circulation, and having a self-custody of the cryptocurrencies are key main drivers that investors price highly in these turbulent times.
In summary, while fractional reserve banking is often blamed for the failure of banks, it is only one of several factors that have contributed to this problem. The low-interest-rate environment, bad risk management at financial institutions, and the rise of digital currencies have all played a role in shaping the current state of the financial industry. Finally, cryptocurrencies offer unique advantages such as decentralization, security, and transparency, which have led to renewed interest in them as potential safe havens for investors.