Bank Failure in a Time of Tight Money

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Jakarta, 14 Maret 2023 - A fast response is needed so that even the slightest shock can be immediately mitigated so that it does not spread and has the potential to cause systemic impacts.

Silicon Valley Bank (SVB), closed by the California Department of Financial Protection and Innovation, in the United States, is the largest bank to fall since the 2008 global financial crisis. With total assets of US$209 billion, SVB was the backbone of technology-based start-up funding.

A person from inside Silicon Valley Bank, middle rear, talks to people waiting outside of an entrance to Silicon Valley Bank in Santa Clara, Calif., Friday, March 10, 2023. The Federal Deposit Insurance Corporation seized the assets of the bank on Friday, marking the largest bank failure since Washington Mutual during the height of the 2008 financial crisis.

Signals of panic spread to global financial markets, marked by a fall in stock prices in the banking sector and the technology-based industrial sector. The closure of SVB is one of the signals of a dimming of financial innovation. This began with the collapse of crypto asset prices (crypto winter), a wave of layoffs in the start-up sector, and corrections to the valuations of technology-based companies.

Domestically, as reported by the Financial Services Authority (OJK), there are 25 peer-to-peer (P2P) lending companies with a ratio of bad loans exceeding 5 percent. In addition, there are 19 technology-based financial companies with equity below Rp 2.5 billion (US$162,200). In fact, as stipulated in OJK Regulation No. 10/2022 on information technology-based joint services, the capital for all financial technology (fintech) companies must be above Rp 2.5 billion starting July 2023. It seems that there will be fintech companies that will go out of business because they do not meet capital requirements.

The arrival of the fintech winter is getting even harder with the collapse of SVB, while the risk of a global recession still haunts. Although macroeconomically we are relatively safe, several micro sectors need extra strict attention. Do not let failure in one sector turn into a snowball that has the potential for a systemic impact on our economy.

Increase in interest rates

The recent series of declines in the technology-based financial sector and other start-ups is the result of the tight credit policy implemented since the middle of last year. So far, many business sectors in the economy, especially various technology-based start-ups, have enjoyed an abundance of cheap liquidity due to the extra-easy monetary policy implemented since the 2008 global financial crisis and which has intensified since the COVID-19 pandemic.

The loose money policy is now over. Since mid-2022, the monetary authorities have been grappling with the phenomenon of high inflation following the Ukrainian crisis. In the US, inflation reached 9.1 percent in June 2022, while in Europe it was above 10 percent.

In response to this situation, interest rates were raised rapidly on an unprecedented scale. The effect of a sudden increase in interest rates is like a series of train cars being wrecked by a sudden brake.

Inflation in the US in January 2023 had subsided to 6.4 percent, while hiring amounted to 311,000 workers, reducing the unemployment rate to 3.6 percent. Seeing this data, the US Fed Reserve is again preparing to raise interest rates significantly. This March, the Fed is expected to raise interest rates again by 50 basis points to around 5.25 percent.

In law, the monetary authority in the US is tasked with suppressing unemployment, creating price stability and maintaining moderate interest rates in the long term. Given the good level of employment, the monetary policy will be focused on reducing inflation to 2 percent as a reference for success.

The direction of monetary policy in the US will have several implications. First, for developing countries like Indonesia, the situation will be challenging. Following the announcement of the Fed's interest rate hike plan, the rupiah immediately weakened to about Rp 15,500 per US dollar. Imagine, if the Fed's interest rate is in the range of 5.5-6 percent until the end of this year, of course our benchmark interest rate must be increased to at least 6.5 percent or even 7 percent in order to ensure the rupiah will not be under too much pressure.

Second, an increase in interest rates will usually be immediately followed by an increase in bad loans in sectors that have so far enjoyed low interest rates. The higher the interest rate increases, the more widespread the phenomenon of failure, such as in online lending companies. The lenders which have so far provided cheap loans have been affected. In general, bad loans are expected to increase in line with rising interest rates.

Third, the productive sector which has so far relied on cheap funding will also be affected. The technology-based start-ups, which have so far been showered with cheap funds, have also begun to the feel the impact. Investors are increasingly selective in providing funding only to business sectors that have proven to be profitable.

The investment approach that relies on future profit levels, known as the "burning money" strategy, is no longer attractive to investors. After SVB's bankruptcy, funding for the technology-based start-up sector will be tighter.

Fourth, if investment in various sectors diminishes, production will weaken people's purchasing power. At this point, economic growth will suffer a correction. If the correction is deep, it is called a recession.

It seems that full vigilance must be exercised, especially in the financial sector and the technology-based start-ups.

It looks like Indonesia's economic growth in 2023 will not be as high as 2022's growth of 5.31 percent. Even though a correction to the magnitude of economic growth at the macro level is likely to be marginal, the impact on several micro sectors will be fundamental, particularly in the non-bank financial sector and technology-based sectors.

The situation is inseparable from the shift in the direction of monetary policy around the world from a policy of easing liquidity (quantitative easing) to tightening (quantitative tightening). In the process of transition, there are always various surprises that can quickly turn into a crisis. Usually, a trigger factor, which can be an event or information, ignites an already fragile fundamental situation.

Throughout this year, it seems that full vigilance must be exercised, especially in the financial sector and the technology-based start-ups, so that even if shocks occur, the fundamental situation can maintained. A quick response is also needed so that even the slightest shock can be immediately mitigated so that it does not spread and has the potential to cause systemic impacts.

Economic Analysis by Dr. Agustinus Prasetyantoko, Rector of Atma Jaya Catholic University of Indonesia.

This article was published by Kompas.id