The Zero Interest Rate Policy (ZIRP) is a monetary policy tool used by central banks to stimulate borrowing and spending during economic downturns. This article explains how ZIRP works, its potential positive and negative effects on the economy, and its recent impact on Silicon Valley Bank. It also explores the cascading effect that changes in interest rates, and the value of investments can have on the entire financial system, from banks to tech companies and beyond. Lastly, the article emphasizes the importance of carefully balancing the benefits and risks of ZIRP and other monetary policy tools to ensure sustainable economic growth and stability.

1 . The Curious Case of  Silicon Valley Bank

Silicon Valley Bank (SVB), the 16th-largest bank in the United States, failed on March 10, 2023.

During the Zero Interest Rate Policy in 2020, SVB invested heavily in low-interest U.S. government bonds. But the bank's investment took a hit as the US Federal Reserve Bank persisted in raising interest rates throughout 2022-23, causing the bonds' value to decline. As a result, the bank's financial position and returns on investments were directly impacted. This caused concern among investors, who started selling off their investments and withdrawing their deposits from the bank. This put immense pressure on the bank's liquidity and ability to continue its operations.

As the panic persisted and the bank's liquidity became increasingly strained, it was forced to close down, ultimately leading to its placement under FDIC. This closure significantly impacted the tech industry, with many companies struggling to retrieve their invested funds.

In response to a surge in VC business, SVB saw its deposits soar to $189.20 billion in 2021 from $102 billion, resulting in a surplus of liquidity. To manage this excess, the bank invested over $80 billion of its deposits into mortgage-backed securities (MBS) for its hold-to-maturity (HTM) portfolio, earning an average yield of 1.56%.

However, as the US central bank raised interest rates nine times in 2022 to combat rising inflation, the value of these MBS declined. This was due to investors being able to purchase long-duration bonds directly from the Fed at rates ranging from 4% to 5%, a more attractive option for investors than SVB's MBS holdings.

2 . The Zero Interest Rate Policy (ZIRP) and its Impact on Economy

The Zero Interest Rate Policy (ZIRP) is a monetary policy tool used by central banks to stimulate borrowing and spending during economic downturns. Under ZIRP, the central bank sets its benchmark interest rate to zero or close to zero, which makes borrowing cheaper for businesses and individuals, and encourages them to spend more.

ZIRP can positively impact the economy by stimulating investment and consumption. Lower borrowing costs can lead to increased business investment and hiring and increased consumer spending, which can boost economic growth and create jobs. This is especially important during a recession or a period of slow growth when consumer and business confidence is low.

However, ZIRP can also have negative effects on the economy. Firstly, it can lead to inflationary pressures, as the low borrowing costs can cause an increase in demand for goods and services, driving up prices. In addition, ZIRP can lead to asset bubbles, as investors are encouraged to seek higher returns by investing in assets such as stocks and real estate, which can lead to overvalued assets and financial instability.

For example, suppose that Silicon Valley Bank invested $1 billion in U.S government bonds that had a low-interest rate of 2%. This investment was meant to provide the bank with a stable source of income while also helping it to maintain its liquidity.

However, if the Federal Reserve Bank of the United States increases interest rates to 4%, the value of these bonds would decline. This is because investors would be able to earn a higher rate of return by investing in other instruments, such as bonds with a 4% interest rate.

As a result, the value of Silicon Valley Bank's investment portfolio would decline from $1 billion to, say, $900 million, causing a loss of $100 million. This loss would not only affect the bank's profitability but also its ability to provide financing to tech companies in its portfolio.

Suppose that one of the tech companies in Silicon Valley Bank's portfolio relied on a $10 million loan to finance its expansion plans. If the bank is unable to provide this loan due to its weakened financial position, the tech company would be forced to look for financing elsewhere or scale back its growth plans, which would negatively impact its value in the eyes of investors.

Overall, this example demonstrates how changes in interest rates and the value of investments can have a cascading effect on the entire financial system, from banks to tech companies and beyond.

Moreover, ZIRP can reduce interest income for savers and retirees who rely on interest payments for living expenses. This can reduce consumer spending and impact their ability to save for retirement, potentially leading to long-term economic challenges.

Overall, ZIRP can be useful in stimulating borrowing and spending during an economic downturn. Still, it should be used cautiously, as it can lead to inflation, financial instability, and other negative effects. Central banks must carefully balance the benefits and risks of ZIRP and other monetary policy tools to ensure sustainable economic growth and stability.

Inflationary pressures: Let's say that the inflation rate in a country is currently 2%, and the central bank decides to implement ZIRP by lowering its benchmark interest rate to 0%. This makes borrowing cheaper and encourages businesses and individuals to take out loans and spend more. As a result, demand for goods and services increases, which can drive up prices and lead to inflation. If, for example, the increase in demand leads to a 2% increase in prices, the inflation rate would double to 4%. This can be calculated using the following formula:

Inflation rate after ZIRP = Inflation rate before ZIRP + (Inflation rate before ZIRP x Change in demand)

In this case, the calculation would be:

Inflation rate after ZIRP = 2% + (2% x 1) = 4%

Financial instability: Let's say that a country's stock market is currently valued at $1 trillion, and the central bank decides to implement ZIRP by lowering its benchmark interest rate to 0%. This makes borrowing cheaper and encourages investors to seek higher returns by investing in assets such as stocks. As a result, demand for stocks increases, driving up stock prices and valuations. If, for example, the increase in demand leads to a 20% increase in stock valuations, the market would be valued at $1.2 trillion. This can be calculated using the following formula:

New stock market valuation = Old stock market valuation + (Old stock market valuation x Change in demand)  

In this case, the calculation would be:

New stock market valuation = $1 trillion + ($1 trillion x 0.20) = $1.2 trillion

This increase in stock valuations can lead to asset bubbles and financial instability, as investors may invest in overvalued assets. If the bubble bursts, it can lead to significant losses for investors and potentially even a financial crisis.

It's important to note that these are hypothetical examples. The actual effects of ZIRP can vary depending on a range of factors, including the size and strength of the economy, the level of inflation, and the response of businesses and consumers to changes in interest rates.

When the central bank implements ZIRP, it lowers the benchmark interest rate to near zero. This makes borrowing cheaper for businesses and individuals and reduces the interest rates paid to savers and investors holding deposits or bonds that earn fixed interest rates. Savers and retirees, who rely on interest income to support their living expenses, can significantly reduce their income.

For example, let's say that a retiree has a fixed deposit of $100,000 with a bank that pays an interest rate of 2% per year. Before ZIRP, the retiree would earn $2,000 in interest income per year. However, if the central bank implements ZIRP and lowers the benchmark interest rate to 0%, the bank may also reduce the interest rate on the fixed deposit to 0.5%. In this case, the retiree's interest income would drop to $500 per year. This can significantly impact their ability to support their living expenses.

Similarly, retirees holding bonds with fixed interest rates can also see their income reduced. When interest rates fall, the value of existing bonds with higher interest rates increases, but the interest income earned on those bonds remains fixed. If the retiree needs to sell the bonds to generate cash, they may need to accept a lower price for the bonds than what they originally paid, resulting in a loss.

Therefore, while ZIRP can stimulate borrowing and spending, it can also have unintended consequences for savers and retirees who rely on interest income. It's important for policymakers to consider the impacts of ZIRP on different segments of the population and take steps to mitigate any negative effects. This can include providing support to retirees and savers through social safety net programs or introducing alternative investment options that offer higher returns.

Reference list: 

• Silicon valley bank (SVB) crisis collapse explained in simple terms
• 'Silicon Valley Bank went for extra 40 bps yield and blew itself up': What is MBS that triggered the collapse?