The recent collapse of Silicon Valley Bank (SVB), a regional US bank that funded start-up companies in the technology and innovation sector, has created a worldwide wave of financial instability.
Despite the efforts of US financial regulators to contain the potential damage by immediately providing full protection to the bank’s depositors, the collapse triggered a global dip in banking share prices.
The turmoil in financial markets led to the collapse of Swiss banking giant Credit Suisse, which was promptly taken over by UBS, an even larger bank. This was after an initial US$54 billion (£45 billion) lifeline from the Swiss central bank proved to be insufficient to rescue Credit Suisse.
How is it possible that the collapse of a relatively small financial institution like SVB could be so contagious as to end up having global consequences, including bringing down a 167-year-old financial institution like Credit Suisse?
Answering this question requires an understanding of systemic risk, which refers to risks associated with the entire financial system. Broadly speaking, there are two distinct sources of systemic risk: balance sheet contagion and information runs.
Balance sheet contagion
The risk of balance sheet contagion arises from the vast number of financial agreements between companies in the international financial system. No bank operates in isolation – they are all tightly interconnected through agreements that might include both short-term and long-term loans, and various other contract types such as derivatives.