The sudden collapse of SVB continues to send reverberations throughout not just the fintech ecosystem, but also the broader financial markets.

While in many ways it feels too early to look back on what happened, and events are unfolding live, we can nonetheless draw some conclusions about how the world has changed and how it will continue to change in the near future.

Here are ten implications of the new world we live in:

1. The ending of the forty year bull market in bonds will be a turbulent transition:

A lot has been written about the end of the forty year bull market in bonds that started in the early 1980s. A big driver behind this bull market was the macro economic impact of the demographic bubble represented by the baby boomers. Born right after the Second World War, this generation started entering their mid-thirties by the early 1980s, at which point they started accumulating capital at pace, which gradually but inevitably started putting downward pressure on real rates. Baby boomers are now entering their mid-seventies, and rather than accumulating capital, they are now decumulating it.

This was clearly not the only driver behind low rates – globalisation, technological improvements, and the emergence of developing countries all played major roles.

Whatever the causes, the bull market is now coming to an end, and as the SVB example painfully illustrated, the transition will be anything but smooth. They got caught on the wrong side of rate movements, and as confidence in their balance sheet collapsed, so did the bank, in a matter of hours.

Beyond SVB, considering debt to GDP ratios for sovereign countries also brings home the magnitude of the challenge that lies ahead. If a country has a debt to GDP ratio of 200%, a one percentage rise in interest rates, corresponds to 2% of GDP. As more income is diverted to debt service, budgets and consumption will shrink, with monumental consequences.

2. The perception of bonds will change:

As rates go up, bond prices decline. And the longer the duration of the bond, the more severe the reduction. We will now start to adjust to a world where bonds are not necessarily seen as safe havens, or more specifically, will only be seen as safe havens in cases where they can be held to maturity.

For example, a bond with a 1% coupon and thirty year maturity, has a duration of about 25, which means that if the rates rise by 1%, the price of the bond would go down by about 25%.

As rates rise, the reality of this simple math will reverberate through world of finance.

3. The narrative around how to allocate your pensions will change:

Over the last forty years, bonds yielded positive returns to holders as rates were going down. As this changes, bonds may very well return to more historical norms of close to zero real returns, or negative returns over short periods of time when rates increase rapidly.

This will have implications for how portfolios are constructed for the purposes of retirement and pensions.

Very likely, bonds will increasing be come to seen as a hedge against inflation, as opposed to a strategy for generating real returns. Inflation linked bonds that can lock in a real rate of return may also become more popular.

4. Banks will not be able to rely on income from bond portfolios the way they used to:

As the SVB example illustrates, bonds will likely have lower real returns, and hence become a less reliable tool for generating excess income, on bank balance sheets or elsewhere.

As a result, banks will likely start favouring lending where they can pass rate rises onto consumers, and make excess returns.

5. Lending platforms that can pass on cost of debt and manage risk effectively will become more valuable:

It follows from the above point that lending platforms that can generate low risk, high yield assets in a predictable and low yield fashion will become more valuable, and banks may in fact be willing to pay a premium to acquire such assets.

Clearly, in the very near term, there will be a lot of turbulence, and the natural tendency for banks will be to pull back and retrench. But as the dust settles, they will likely look to bolster their lending capabilities.

6. The Fed will have to make difficult trade-offs between inflation, financial stability, and unemployment and there may be no easy paths forward:

The Fed will have very difficult trade-offs to make in the coming months, and will very likely have to choose between reducing inflation or creating more market volatility. It is impossible to say which way they will act, but there will likely be a stark trade-off between reducing inflation vs. avoiding future events akin to the SVB failure.

Predictions are hard here, but one very possible outcome is that the Fed may end up raising its inflation target. This would have the added benefit (from the Fed’s perspective) of inflating away the debt burden.

7. Protectionism and the roll-back of globalisation may be a political response in many countries that ultimately has negative growth consequences:

Times of turmoil lead to simple narratives, and unfortunately, many of those simple narratives involve protectionism and anti-immigrant sentiments, just to name a few.

Ironically, globalisation, immigration, and trade are all forces that drive economic growth, and to the extent these are rolled back, growth will suffer further, potentially creating new challenges and reducing dynamism in the economy.

8. Bank consolidation will only gather pace:

Flight to quality in deposits will likely be a real thing, and this, along will all prior forces around economies of scale, will continue to drive bank consolidation.

9. Modern finance is faster:

The run on SVB happened at the speed Silicon Valley is used to, and it is fair to assume that this is the new gear modern finance will now operate at this moment henceforth.

Regulators will have to keep up with these challenges, and it is likely that the bank regulators globally will find ways to adapt, including the introduction of digital currencies.

10. Fintech is here to stay:

Finally, all this change means that the impetus for innovation in financial services will only increase.

To adapt to this new world, we will need visionary and skilled entrepreneurs along with expert venture capitalists willing to back them in order to help solve the new challenges presented by the brave new world of tomorrow.

As the fintech and start-up community leaves a tumultuous weekend behind, we can now collectively take a deep breath and reflect on what transpired.

There will undoubtedly be a lot written about why SVB failed, what could have been done differently, and who should shoulder the blame.

The human psyche favours simple answers, and this tends to lead to a tendency where we want to find one primary cause for a big event. Reality, of course, is much more nuanced. When something big like a bank failure happens, there are a confluence of factors that come together, but our brains still crave that simple narrative.

If we look at SVB, the list of causes is long indeed: the fractional banking system has an inherent tendency towards bank runs, a very small percentage of the deposit base was protected by FDIC insurance which is designed to prevent such runs, the interest rate exposure on either side of the balance sheet was misaligned, they were very concentrated in one niche customer segment, the venture community can exhibit herd like behaviour, all moving at the speed of Twitter, they had a high Beta footloose deposit base, and so the list goes on.

But looking at that list there is one particular cause that is worth highlighting, especially in light of the fact that March 14^th was World Pi Day (3.14), as this particular cause demonstrates the awesome power of simple math. That is the concept of bond duration, and what that did to their bond portfolio.

While there was a lot of publicity around the $1.8bn loss SVB realized when selling $21bn of bonds, there was another and bigger ticking time bomb on their balance sheet, which was the Held to Maturity (HTM) bond portfolio. As of September 2022, SVB had a bond portfolio in excess of $90bn, and the mark to market losses on that portfolio were a staggering $15.9bn, greater than their $11.5bn in tangible equity at that point in time, as was reported in their financial statements.

In other words, if SVB had been forced to sell its entire bond portfolio, the losses on that would have wiped out its entire equity book value plus some! But how is this possible – after all, bonds are supposed to be safe right? How can a bond portfolio crystalize such big losses?

It is very important to note here that there is nothing wrong with holding a bond portfolio to maturity, and in fact if one does so, there is no credit risk. And no loss would have crystalized. The bond does what it says on the label and you get the returns promised, it would just take many many years. The problem occurred because they had to sell today because of the run, and that laid bare the interest rate risk as explained below.

Let’s look at this interest rate risk, which brings us back to the power of math and the concept of bond duration which is fundamentally all about discounted cash flows and net present value. Here is a simple illustration.

If you buy a one-year maturity bond, with a 1% nominal coupon, when interest rates are also at 1%, that bond is worth par at your time of purchase. So you would pay $1,000, expect to get a $10 coupon plus the principal in one year’s time, discount that cash flow into the present with the 1% discount rate, and arrive at a $1,000 value. In other words, par.

Now, imagine that interest rates increase to 2% the instant you bought the above bond. Instead of discounting your expected $1,010 return on the bond by 1% to get $1,000, you would have to discount it by 2%, getting $990.19. Your bond is trading at a discount, and you just lost some money on your safe bond. Of course, if you hold your bond to maturity, you will still collect the $1,010 in one year’s time, but that money is only worth $990 today because we discount it at a higher rate. That is how bond math works.

But this was a one-year maturity bond, which incidentally has a duration of 1 (or close to it, depending on when the coupon gets paid) so the math was pretty simple.

If this had been a thirty-year maturity bond, we would first need to formulaically calculate the exact duration of the bond which is a measure how sensitive a bond’s price is to changes in interest rates. If we think of the cash flows flowing from the bond (the annual coupons and principal payment at the end) as bags of money positioned on a lever, the duration is the fulcrum point that balances this lever.

With a one-year bond that only pays one coupon at the end along with the principal, this fulcrum point is exactly 1. With a thirty-year bond that has a 1% coupon, it turns out that the fulcrum point is closer to 25 years.  

As a general rule, for every 1% increase or decrease in interest rates, a bond’s price will change approximately 1% in the opposite direction for every year of duration. So if we bought a thirty year bond, and rates went from 1% to 2% the day after we bought it, we would expect our bond to lose about 25% of its value, going from $1,000 to $750. So much for bonds being safe!

Now, clearly the folks that did this at SVB were aware of bond duration, and they had some sort of rate hedges and other instruments in place. However, the fact remains that they took on interest rate risk, and the duration math (as well as the rate environment) moved against them, and fast.

The fact that the Dodd-Frank rollback in the US (which happened in 2018) also reduced the buffer of shareholder funds needed to absorb such losses at banks did not help, and SVB was just under the $250bn threshold that would have come with more regulatory oversight and interest rate sensitivity stress testing.

While there are many learnings and insights from what happened, one is clearly to always work from first principles and be aware that the conventional wisdom around you may not necessarily be correct. As we just saw, bonds are safe only when held to maturity, and if you have to sell a long maturity bond early, math and markets can catch up with you.

When in doubt, always do the math. Much like Pi is a constant in math, make math a constant in your life.