Markets gravitate towards reaching equilibrium, a state in which supply, and demand perfectly balance each other.
Understanding this economic theory can help us appreciate why, when markets are soaring, a new challenge can present itself that sends them tumbling, or vice versa a dose of good news can push markets to recover during a downturn.
A variety of macroeconomic factors can create ripples that can bring about unexpected consequences.
Last month, we wrote about how the FTSE 100 was hitting new highs in early 2023, however recent events stemming from the collapse of the Silicon Valley Bank (SVB) have caused concerns about the liquidity of global banks and led to markets stumbling.
It is important to ignore alarmist comparisons to 2008 and understand the key details of what is going on with bank liquidity. Read on to discover what liquidity means, how it affects your investments, and steps you can take to protect your wealth.
A bank’s liquidity refers to its ability to pay its bills or meet the demand for funds
Banks have an ever-present need to have easily accessible funds to draw from to meet planned payments and the demand for funds. This might involve paying back loans or having cash available to meet withdrawal requests.
According to Capital, a bank’s liquidity refers to its ability to meet these requirements. A bank’s central business is likely to be derived from providing funding from which it earns interest income, and investing deposits from which it can earn investment returns.
As major banks tend to lend among themselves, a single bank’s poor liquidity — for example, if they have too much tied up in investments and not enough free capital to meet payments or withdrawals — can have a domino effect which can cause issues at other banks. This is what has happened recently with the SVB and the subsequent issues at Credit Suisse and Deutsche Bank.
A bank’s liquidity can be negatively affected by:
- Poor returns on deposit investments
- High costs of borrowing from other banks
- Low interest income from loans.
These issues can quickly eat away at a bank’s profits and send alarm bells ringing in the sector.
An explanation of what happened at SVB
According to the Guardian, SVB served many of the major tech firms based in the local area. After a large influx of cash was deposited with the bank throughout the 2010s, it decided to look for a beneficial return by investing cash in long-term US Treasury bonds. These bonds are typically seen as a stable investment.
However, a convergence of the decision to overinvest funds — not properly assessing potential risks to the bank’s liquidity — and a sharp rise in interest rates throughout 2022 and early 2023 created a situation in which depositors demanded higher returns and the bank was forced to sell some of its bonds at a loss.
The news prompted tech investors to panic, triggering a “bank run” where large-scale withdrawals take place and confidence in the bank rapidly declines.
According to CNBC, in the approximately 24 hours following news becoming public, customers withdrew a staggering $42 billion in deposits, leaving the bank with a negative cash balance of nearly $1 billion before it eventually collapsed the following day.
According to the BBC, the panic spread to banks in the European sector such as Credit Suisse and Deutsche Bank, while the Evening Standard reports that the banking crisis has seen the FTSE 100 tumble 8% in just 21 days leading up to 23 March 2023.
It is important to remember that the issues resulting from SVB weren’t caused by structural issues as in the 2008 financial crisis, but rather poor liquidity, or risk, management.
Bank liquidity issues can teach you important lessons about appropriately managing your exposure to risk
Bank liquidity can be overseen in a safe and stable way through appropriate risk management. If a bank has a healthy balance of cash reserves to money invested, also known as “excess bank liquidity”, it might be better prepared to meet the sudden demands caused by short-term issues.
It is a vital lesson in risk management.
Before you decide to invest your hard-earned cash, you might want to consider firstly your tolerance for risk — how much you can afford to invest and your ability to handle potential losses — and secondly the safety nets you have in place to protect your wealth.
Simple steps to protect your wealth despite investment worries
You are likely to want safety nets in place to provide for you and your loved ones in the case of emergency and protect your investments from any short-term volatility, such as:
- Keeping an emergency savings fund of between three and six months’ worth of essential bills like mortgage/rent, utilities, and groceries to cover outgoings
- Ensuring your investment portfolio is well-diversified across different markets and assets to mitigate against potential losses
- Consider taking out health or income protection to ensure you can continue to pay your regular commitments if the unexpected happens.
Get in touch
If you have any lingering concerns about the ongoing banking situation and your investments, a good first step might be to reach out for reassurance by contacting us at email@example.com or calling 0345 505 3500.
This article is no substitute for financial advice and should not be treated as such. To determine the best course of action for your individual circumstances, please contact us.
The value of your investments (and any income from them) can go down as well as up and you may not get back the full amount you invested. Past performance is not a reliable indicator of future performance. Investments should be considered over the longer term and should fit in with your overall attitude to risk and financial circumstances.