Is the US banking system headed for a fourth-generation crisis?

In my columns, I try to use a simplified style that can be understood by readers from all walks of life as much as possible. In order to make technical subjects easier to understand with examples, I sometimes try to support my explanation with graphics. Sometimes, although it is rare, I write articles with technical content in order to make a note of history. Today's column will be one of the latter as I try to draw attention to a possible new banking crisis in the U.S. The literature on this subject is quite long and contains technical details. I will however be careful to simplify and summarize as much as possible.

First-generation models argue that the increase in budget deficits in economies where a fixed exchange rate system is applied causes financial crises. According to the argument of this model; governments print excessive amounts of money to finance growing budget deficits, and as a result, the fixed exchange rate policy is distorted. The deterioration of the fixed exchange rate policy causes the foreign investors in the country to want to go out and the locals to turn to foreign exchange. The speculative movements that occur as a result of the central bank's inability to meet the increasing foreign exchange demand trigger the crisis.

When the first-generation models could not explain the exchange rate mechanism crisis (ERM) that emerged in Europe in 1992-1993, the second-generation crisis models came to the fore. First-generation crisis models look for the cause of crises mainly in macroeconomic problems. However, as in the ERM crisis, the absence of a problem in macroeconomic models before the crisis required a new approach. According to this new approach; At a time when the country's monetary and fiscal policies are performing successfully, speculative attacks on the local currency may cause an economic crisis.

The basis of third-generation crises is the risk appetite brought about by the functioning of the banking system. Banks, whose most important income is the interest from loans, may also turn to projects with high risk in order to increase their profits. This attitude of banks causes the prices of various financial assets to increase excessively over time. This situation, which we call the “balloon”, is not a permanent balance, on the contrary, it turns into a temporary but extremely risky climate. As the sustainability of the system begins to be questioned, rising concerns burst the bubble and the price of these assets drops rapidly. As a result of this decline, banks begin to have problems in collecting their credit-based receivables, and finally, the banking crisis triggers the economic crisis, bringing with it currency crises.

Silicon Valley Bank, a technology sector-focused lender operating in the U.S., recorded a loss on its bond portfolio and some investors decided to withdraw their investments in the bank. After the bank announced that it would sell shares due to the loss, the shares of the bank started to fall and the bank went bankrupt when the bank could not raise its capital. So what was the reason for this bond loss?

Silicon Valley Bank had a significant amount of U.S. Treasury bonds in its portfolio. In the period when the Fed implemented a loose monetary policy, we see that the bank turned to long-term government bonds on the asset side. The price of these long-term government bonds begins to fall as the Fed begins raising interest rates. I won't take too long. As a result of the decrease in the value of these bonds, which are funded by deposits in the bank, it becomes impossible for the bank to fulfill its obligations and the bank goes bankrupt.

Although other banks in the U.S., which had difficulties in meeting their obligations in the past, went bankrupt, what happened to the Silicon Valley Bank is different in two respects. The first is that the bank's loan portfolio is heavily focused on crypto start-ups. The second is the purchase of “government bonds held to maturity” at a high rate with deposits. The government bond ratio of the bank in question in total assets is just below 80%.

So there are two main reasons why the bank went bankrupt. The first is that its customer portfolio is composed of crypto asset start-ups with a high-risk appetite and a tendency to move quickly, and the second is that it has created its assets from treasury papers, whose value is volatile, depreciating due to monetary policy during the exit periods of the crisis. Although the authorities state that the situation is under control, if this bankruptcy spreads in such a way that it puts the banking sector into crisis, then it may be possible to call the emerging crisis "the fourth generation crisis" in terms of its content.