Could something similar happen in Canada?

American business magnate Warren Buffett once famously observed: “You won’t know who was swimming naked until the tide goes out.”

Last week, Silicon Valley Bank was put in danger by rising rates of interest, resulting in an old-fashioned bank run in which bank customers rushed to withdraw all their money immediately.

Failure sixteenth largest bank in the US highlights the weakness of its area of interest business model in the digital age.

Could something similar happen in Canada? For Canada’s largest banks, the reply is not any. However, recent history suggests that smaller, area of interest financial services firms mustn’t turn into complacent.

Sensitive business model

The first step in assessing any security vulnerability in Canada is to grasp why Silicon Valley Bank failed.

Silicon Valley Bank was running a dangerous business. Used short-term money deposits from technology customers buy U.S. mortgage bonds with longer maturities. This maturity mismatch might be profitable in good times, but can destroy an investor in bad times.

Rise in rates of interest over the past 12 months caused losses of $2 billion on Silicon Valley Bank bonds. Facing a possible credit standing downgrade, the bank tried to boost equity capital to strengthen its balance sheet, but to no avail.

When this news spread on social media, it led to fast online deposit withdrawals this depleted Silicon Valley Bank’s money reserves. US regulators took over the bank to stop the panic.

Short-term deposits finance long-term bonds

Silicon Valley Bank’s weakness might be seen by comparing its balance sheet with other banks. At the top of 2022, Silicon Valley Bank used short-term customer deposits to fund greater than 80% of its $212 billion in assets.

The five closest regional banks – Capital One Financial, First Republic Bank, KeyCorp, M&T Bank and US Bancorp – had similar shares of assets. But Big Four banks in the USA — JPMorgan Chase, Bank of America, Citigroup and Wells Fargo — had more diversified financing.

Silicon Valley Bank invested these funds in mortgage bonds and other securities, representing 60 percent of its assets. Silicon Valley Bank’s value was almost 3 times that of its closest peers and greater than twice that of the US Big Four.

To offset this risk, Silicon Valley Bank held extra cash than its closest competitors, with a six percent asset yield. But when the bank run began, the sale of bonds at a loss was not enough to offset the electronic withdrawal of deposits.

How secure are Canadian banks?

Could a similar bank robbery occur north of the border? The answer for Canada’s largest banks is not any.

Canada’s Big Five banks — Royal Bank, TD Bank, Scotiabank, Bank of Montreal and CIBC — remain among the many safest in the world. They are large, diversified and well capitalized. They have leadership experience and are closely monitored by a respected banking supervisor.

The Canadian Big Five have almost an identical funding profiles to the Big Four in the US. A bigger share of Big Five loans makes them arguably safer, as most Canadian mortgages are insured by the Canada Mortgage and Housing Corporation.

Financial markets agree with this assessment. As of yesterday, Canadian Big Five share prices had fallen a median of 16 per cent over the past 52 weeks, together with a 13 per cent decline for the Big Four US banks.

Meanwhile, Silicon Valley Bank’s share price fell 80 percent before trading was halted last Friday. By contrast, Silicon Valley Bank’s five closest competitors lost a median of 40 percent.

Innovation increases risk

This evaluation doesn’t conclude that there are not any vulnerable entities in the Canadian economic system. Silicon Valley Bank shows that revolutionary, area of interest business models are more vulnerable to threats.

This pattern is consistent with the history of bank runs. There has not been a bank run in the UK for 140 years the collapse of Northern Rock in 2007. This area of interest lender used short-term financing from other banks to fund long-term mortgage loans. This mismatch led to the lender’s collapse when interbank markets froze earlier in the 12 months Global financial crisis 2007-08.

Canada in 2017 there was a partial bank run. Home Capital Group was a distinct segment lender offering uninsured mortgage loans to Canadians with less creditworthiness. This dangerous business was financed by high-interest savings accounts and other deposits. As Home Capital depositors lost confidence, the partial bank run was only stopped when a bunch of Canadian institutional investors threw a $2 billion bailout to Home Capital.

Trust relies on three pillars

These bank runs are a reminder that trust in banking rests on three pillars: risk management, deposit insurance and banking supervision.

All banks use leverage, which makes risk management a key success factor. Canada’s largest banks have demonstrated this ability over many many years, most recently through the global financial crisis.

Eligible deposits in Canada are insured by the Canadian Deposit Insurance Corporationa crown corporation that insures as much as $100,000 into an account held at member institutions.

Federal financial institutions are supervised by the Office of the Superintendent of Financial Institutionswhich monitors the extent of capital and risk taken.

These three pillars are being tested as rising rates of interest expose weaknesses in the worldwide economic system. The decade of low-cost money resulted in many inventions and area of interest business models.

As the economic slowdown continues, more failures are certain to occur in the worldwide economic system.