Subprime Covid Crisis: Effect of Inflation on Banking

Industry

Banking, in layman's terms, is working as a fund-transferring agent between those who

have excess funds to those who need funds. The business of banking has been in
existence since time immemorial. The history of banking can be traced back to
prototype banks of merchants who gave grain loans to farmers and traders in 2000 BC
in cities of Assyria and Babylonia. Banking has come a long way since then, and it
performs a plethora of activities like accepting deposits, lending advances, providing
clearing services, cross-selling products like insurance, and so forth.

Post-COVID-19, a rise in prices of goods and services has been observed. The rate at
which prices rise is called inflation. One main reason for inflation is an increase in
demand vis-a-vis supply. During the lockdown, people spent less on travel and other
luxuries such as dining out, shopping, etc. thus money got accumulated. Supply chains
of some non-essential items were also disrupted during the pandemic. This
accumulation of wealth is driving up demand, which is further exacerbated by a
disrupted Supply chain thus causing higher inflation rates.  

Governments generally strive to keep inflation within an optimal range that fosters
development without decreasing the purchasing power of the currency. Extreme levels
of inflation, also called hyperinflation, can wreak havoc on an economy.  Hyperinflation
was observed in Zimbabwe in 2008–09, which led to the demise of the Zimbabwean
dollar (ZMD) and the adoption of the US dollar (USD) by Zimbabwe as its official
currency. To combat inflation, regulatory authorities around the world deploy two main
methods; the first is the alteration of Fiscal Policy by the government and the second is
the deployment of monetary policy tools by the country’s central bank. This concept was
proposed by famous British economist John Maynard Keynes in the 1930s and is
referred to as Keynesian Economics Theory.

Fiscal policy, in general terms, is the regulation of government spending and tax policies
to control the money supply in an economy. During inflation, the government increases
tax rates and reduces subsidies provided on goods to restrict the money supply.
Monetary policy, on the other hand, is administered by varying interest rates and
affecting the money supply by buying or selling government bonds in the open market.
Central banks increase interest rates and sell bonds in the open market to quell
inflation.

Post-Covid, to combat inflation, central banks around the world have increased interest
rates. The US Federal Reserve has increased interest rates by a whopping 450 to 475
basis points (4.5 to 4.75 percent) since March 2022. The repo rate (base lending rate
fixed by the RBI) has also increased by 250 basis points (2.5%) in the last 15 months.
Treasury bond yield has increased by minimum 50-100 basis points (0.5-1 percent)
since March 2020 in all major economies.
Bond’s yield is negatively correlated with bond price; therefore, an increase in yield
decreases the bond prices. This decrease in bond prices results in Mark-to-Market
(MTM) loss for banks. As per the ICRA report, Indian Banks had to report an MTM loss
of almost Rs. 13,000 Crores in Q1FY23.  Banks’ operational cost too increases during
inflation, which puts pressure on the bank’s lending rates as the bank has to pass the
same to its customers. Higher interest rate also increases credit risk as default rate
increases due to liquidity issues on account of higher loan installments. Higher inflation
can be beneficial to the lender, as people have to take loans, especially for high-ticket
items for there may not be enough income to support purchasing the same without
banks’ assistance. Also with higher loan sizes (Due to increase in the price of products);
banks would get more interest income.

The 2008 financial crisis, which rocked the worldwide economy and led to the failure of
several financial institutions, most notably Lehman Brothers, was a result of banks'
lending subprime loans at teaser rates without proper due diligence. The collapse of
Lehman Brothers and other banks affected the entire banking system and it ultimately
led to a crash in the worldwide economy. Post Covid we are witnessing a similar crash
in the process. The collapse of Silicon Valley Bank (hereinafter SVB) in March 2023 can
be a trigger point for the impending crash.

SVB was a commercial bank founded in 1983 and headquartered in Santa Clara,
California, USA. The bank mainly catered to the technology industry by providing loans
to high-risk startups. Bank's deposits soared from $62 billion in March 2020 to $124
billion in March 2021. The reason for the increase in deposits is large investments into
startups by venture capital (VC) firms and technology firms making hefty profits during
COVID. These startups as always deposited their excess funds with the SVB. SVB, like
any banking organization, invested the funds received to make profits. However, SVB
invested the deposits in longer-duration bonds due to their higher yield. Bank didn’t
want to take risks by giving out loans or diversifying their portfolio. Since 2022, many
startup firms started to withdraw money from the SVB, since they needed funds for their
operations. In addition, mass layoffs by major tech firms in 2022 forced depositors to
withdraw funds from SVB. SVB had no option except to sell its bonds at a lower price as
the yields have risen. This caused huge losses to the bank. The bank kept accumulating
losses on selling its investments to pay its depositors. Finally, on March 10, 2023, the
government took control of the bank after it collapsed.

This failure of SVB will affect the entire Technology sector as several startups lost their
substantial funds. Further Technology firms will find it tough to secure financing post-
failure of SVB. The collapse of SVB has also led to the questioning of the American
banking system. Though this collapse may not be as devastating as the 2008 financial
crisis, but it is bound to cause ripple effects on the entire world economy.