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Avoidance of Bank Run vis-à-vis the recent Silicon Valley Bank Debacle

Updated: Feb 9

by Kapil Devnani, Kriti Chaturvedi *


Introduction

On 10th March 2023, with the collapse of Silicon Valley Bank (SVB), the entire banking system got into a state of turmoil, the effects of which could be felt not only in the USA but all over the world. Though the experts argue that the repercussions of the event are minimal in the Indian economy, however, the Indian start-up sector could get adversely affected. The major traceable cause triggering the collapse of SVB was “Bank Run”. Bank run refers to a situation where a significant number of depositors of any bank or financial institution decide to withdraw their deposits owing to a concern regarding the solvency of the bank. Such withdrawal of the deposited funds causes a situation of panic leading more depositors to withdraw their funds. The bank reserves may not be sufficient to cover such large scale withdrawals and hence liquidity of bank comes into question. In situations like these, the depositors act as their own enemies. Looking from an individual perspective depositors cannot be adjudged irrational for their conduct, it is, however, the duty of the state to prevent such a crisis.

Further, the entire basis of the banking system is reliant upon its trustworthiness, and incidents akin to the SVB crisis raise serious concerns as to the banking regulations. Therefore, it becomes the duty of the State to take lessons from such mishaps and introduce some arrangements to ensure the prevention of the same in the future.

The Silicon Valley Bank Catastrophe

The success of Silicon Valley Bank was heavily reliant on the growth of tech startups in the United States. Due to the COVID-19 outbreak, these companies experienced a surge in demand for their services, as their profits increased so did the investments into the bank, resulting in a significant increase in deposits at SVB. To manage these funds, SVB invested a considerable portion in US government bonds, which are generally viewed as low-risk investments.

However, the rise in interest rates by the US Federal Reserve to combat inflation led to a significant drop in the value of these bonds, prompting SVB to sell a portion of its bond portfolio at a loss. Though the rationale behind the practical decision was the welfare of depositors, it ultimately proved to be detrimental to the bank. Such selling at a loss exacerbated the situation since the depositors of the SVB, consisting primarily of start-ups, Venture Capital (VC), and other tech firms, made large-scale withdrawals and as a result, funding began to dry up. This led to the bank selling securities owned by it at losses, in turn causing panic in the market which led to depositors launching a run on the bank. Since SVB is a publicly-traded company, the sale of these bonds caused concern among investors, leading to a decline of over 65% in the share price over two days. This ultimately resulted in a significant liquidity crisis that had the potential to cause the collapse of the bank.

Probable Solutions to Avoid Such Crises in Future

Douglas Diamond and Phillips Dybvig, Nobel laureates of 2022 provided two solutions to the problem at hand. The first one is “Deposit Insurance”, which entails that the Banks should take up insurance on the deposits received so as to minimize risk; however, the theory possesses certain fallacies. Firstly, paying the premium for insurance of such massive deposits would reduce the profits of the Bank, resulting in the reduction of the amount being lent by banks and in turn limiting the flow of cash in the economy. Secondly, such assurance may also lure banks to undertake riskier investments, since the banks will have the insurers to indemnify the losses arising out of the risky investments. The second solution provided by them is the “Lender-of-last-resort” approach wherein a central bank or the government is expected to bail the bank out of illiquidity. The implementation of this approach also entails similar problem of banks undertaking oversized risks since they will have the lender-of-last-resort to bail them out.

Other solutions provided by different economists include that the depositors should only invest in Big Banks which are Too Big To Fail, however, this step will result in asset concentration in the hands of a few big players in banking, therefore, hampering the growth of the economy.

Another solution to this problem is by adopting a three-account model. In addition to normal Savings Accounts and Current Accounts, the Banks should provide an additional facility in the form of a “Storage Account”, which warrants the money to be kept for a longer period with minimal possibility of early withdrawal, and for ensuring this, two methods are suggested, first, there should be a fixed maturity period before which withdrawal of deposits would be highly discouraged and in case of an early withdrawal, a penalty should be imposed. Next, the depositors in the storage accounts may be provided with equity stock in relation to the bank, and in case of their exit before a maturity period, their stocks would be forfeited. Therefore, a situation of double loss, in the form of penalty as well as loss of equity will be triggered by early withdrawal. This would create a “sail or sink together” situation for the depositors concerning the bank thereby preventing social media-fueled panic run or a bank run. These methods will ensure that the incidents like Silicon Valley Bank do not get repeated.

Although, the introduction of Storage Account does not mean that the depositors will automatically shift from Saving Account to Storage Account. Some monetary incentives are needed to be attached for this method of parking money in the Bank to work. The incentive in the form of provision of equity in the bank might help in achieving this aim. So, in turn what is suggested is making the Depositors as the Shareholders or the Investors in that Bank. It is also true that not every depositor can be turned into an Investor, so the Regulatory Authorities should scoop here and set up a limit over which this facility would be mandatorily applicable in the country. This approach of reward and penalty will surely help to avoid incidents like the SVB collapse.

Additionally, the proper implementation of this approach also requires nationwide application as the aim here is to protect the whole economy and any bank left out might do the harm.

Conclusion

The phenomenon of bank run presents an effective example where withdrawal of funds by an individual creates a ripple effect into the economy. Media often adds fuel to the fire and creates a panic which triggers a plethora of investors to withdraw their funds from the bank. One cannot control the media or the acts of investors for that matter. However, one can take steps to avoid such economic crisis and out of all the possible options mentioned in this Blog, three-account system could be considered as the most viable one. However, even this option is not fool-proof as it comes with its own cons, the majority of which could be settled through the reward and penalty approach. Additionally, this system, if implemented would surely require a lot of efforts, not only from the legislative branch, but also from the administrative branch of the Government.


*Kapil Devnani and Kriti Chaturvedi are both fourth year students at Hidayatullah National Law University, Raipur at the time of publication of this blog.


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