We are facing a complex situation there in the US and some of the Western nations. They have a complex as well as a very difficult task in their hand. They can neither afford the failure of the banking system nor afford to let the inflation go on increasing. If the Federal Reserve and the Central banks don’t pump funds to the needy banks, more banks will collapse. And if they pump funds, that will lead to excess supply currency in the market which in turn fuels inflation.
However, inflation is a much smaller problem in comparison to the failure of the banking system. If the banking system fails the whole economy will fail. No government can afford that. Though in Western nations the Federal Reserve or the Central Banks are neither responsible nor accountable to play the savior role to the private banks. In case of bank failure, the Federal Deposit Insurance Corporation (FDIC) would cover only a part of the total deposit which is covered by insurance. The depositors will lose all those amounts which is not covered by insurance. The fall of Silicon Valley Bank despite having strong asset base has become a huge concern for all the nation.
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People need to know that an increase in the money supply is not the only reason for inflation. The additional supply of money need not increase inflation. Inflation happens mostly because of the demand-supply gap. Let me give an example. Suppose there is only 100 Kg rice available in the market and the buyers having a total of Rs.1000/- to buy ric.. So the price of rice will be Rs.10/- per Kg. Now suppose we increase the salary of the people and they have Rs2000/- to buy rice. But the supply of rice remains the same at 100 Kg. Withing increasing purchasing power buyers would like to buy the additional quantities, however, since the supply is limited they will be able to buy on 100 Ks. So the demand-supply intersection point will decide the price at Rs.20. This is an inflation situation of Rupee losing its value/purchasing power. Now suppose if the supply also increased to 200 Kg, the price would have remained constant at Rs.10/- only. So we can see an increase in money supply alone doesn’t create inflation. If you can address the demand - supply gap inflation situation can be addressed. This is related to the demand for essential commodities. This actually happens because of a shortage of supply corresponding to demand, not because of an increase in money supply. Higher demands for consumer goods and industrial products generally do not lead to inflation since the supply can be increased to calibrate with demand.
Over the last one year, the Federal rate of interest rate has been increased by around 500%, from 0.75% to 4.75%. This has put the commercial bank under the severe burden of paying higher interest on the deposit where demand for fresh credit has not increased rather higher interest rates draw more deposits to the bank. The federal rate was increased to pull back the additional currency volume from circulation. During COVID-19, the US printed some additional $ 5 trillion in currency. A major part of this volume got invested across the globe since the federal interest rate was low. But from September 2021 the federal rate started rising in an effort to quell the inflation. The problem of rapid increase in interest rates intensified in 2022 and 2023.
And deposits started pouring back into the US. The commercial banks started raking up huge deposits. SVB’s assets and deposits almost doubled in 2021. However, there were very few opportunities to lend out such huge deposits and the banks started reeling under the huge cost of interest payment. So, what SVB could not lend out, had to invest in ultra-safe U.S. Treasury securities. However, the game started here. The US Treasury has a typical way to balance it out the high-interest cost by cutting down the value of these bonds & securities as the interest cost goes up. On the contrary, if the interest cost goes down the value of the securities goes up. The bank recently said it took a US$1.8 billion hit on the sale of some of those securities. This resulted in a fall in the bank’s stock price. And the bank couldn’t raise fresh capital from the market.
An astonishing 94% of Silicon Valley Bank's deposits — including large cash holdings by tech startups — were uninsured by the FDIC. That prompted prominent venture capital firms to become cautious and they advised the companies they invested in to pull their business from Silicon Valley Bank. Which resulted in a snowball effect with growing numbers of depositors queuing up to withdraw their deposits. On a single day 9th March alone customers pulled out $42 billion from Silicon Valley Bank, draining the lender of all of its liquid cash. Which is almost 25% of its entire deposit base. And no bank in the world would survive that kind of withdrawal on a single day. This forced the regulators to shut the bank down on 10th March. The fall of SVB is despite having a strong asset base. In a way, the increase in the Federal Reserve rate is directly responsible for the fall of SVC. The only way to save the bank is to infuse additional capital to offset any extraordinary spike or skew in demand for withdrawal.
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This is exactly the reason I say that major banks should be under the public sector. The Federal Reserve or the Central Banks only need to assure the depositors that their money is absolutely safe, nobody needs to panic. Which could have averted the fall of SVC. People must have observed that when SVC faced massive withdrawal demand, other US banks experienced a huge spurt in deposits. So in a way, there would be a balance in withdrawal and deposit. However, there could be a move to divert some of the investment into the secure market. But that would also essentially reduce currency volume in circulation. In India, commercial banks operate with a predefined reserve ratio determined by RBI to regulate the money supply in the market. Secondly, Banks can deposit surplus funds with RBI. I believe the current Indian banking system in India is much better than the banking system followed in the USA. However, there are areas in our banking system that need correction. But overall banks in the public sector are a much better and robust system. The US for the time being has to go through this turmoil of tug of war between increasing interest rates to pull back currency volume from the market as well as pumping money into the banking system. But things will settle down if the Federal Reserve gives a counter-guarantee that all the deposits with commercial banks are safe.
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