Over the weekend, our research team actively monitored the fallout of the failure of Silicon Valley Bank (SVB), the second largest bank failure in US history. Regulators took over SVB on Friday, as well as another smaller bank, Signature Bank, on Sunday.
Events are moving rapidly. The dust may have settled on this immediate crisis, but it will take some time to assess full implications.
Here is our quick read of the situation.
Swift Action by Regulators over the Weekend
Markets were weak on Thursday and Friday as investors feared SVB’s failure might spark a possible run on deposits at other banks and threaten the stability of the financial system.
In response, over the weekend, the Treasury, the Federal Reserve Bank, and the FDIC acted quickly to send a strong message of support for SVB and Signature Bank depositors and the broader financial system.
As of Sunday evening, regulators have done three things:
- Auctioning the assets of SVB to potential buyers, likely at a major haircut, in order to protect uninsured deposits at SVB (which were often well over the $250,000 threshold for FDIC insurance). This helps protect the bank’s disproportionate exposure to start-up tech companies who face payrolls of billions of dollars and insulates against sector failures due to one bank.
- Guaranteeing that all uninsured deposits at SVB will be protected—by the banking industry and not by taxpayers. We believe this serves as a backstop if the auction isn’t unsuccessful.
- Providing a new bank term funding program for all banks, to allow banks needing to raise funds to do so without selling assets at distressed prices.
In particular, the new funding program is designed to reassure the broader financial system that all banks will be able to fund deposit withdrawals without having to incur losses on sale of assets, should that condition ever be necessary. It is a bold action designed to quell fear and doubt.
Importantly, we do not recommend making adjustments to client portfolios during this turmoil. Some quick points:
- We already track detailed financial data on banks, including deposit trends, credit risk, and balance sheet warnings. We expect to incorporate even more insights following these events.
- Our asset allocation strategy set for clients is designed to accommodate these developments.
- We use diversification to help clients navigate inherent volatility caused by issues like this one. We invest across many sectors and don’t have disproportionate exposure to any one company or sector. In fixed income, we put a premium on investment grade and shorter duration, helping to manage both credit risk and interest rate risk.
Why did regulators move so dramatically, if SVB was not a major bank?
There are typically several bank failures in any given year. SVB was the 16th largest bank in the US and only held about 1% of US deposits. We believe the main reason for the swift rescue was to staunch a potential crisis at smaller banks.
On Friday, banks reportedly began accessing the Fed’s short term funding mechanisms at a greater rate than usual to shore up liquidity. This activity apparently encouraged regulators to enact its emergency lending authority, a policy put in place during the Great Depression as a safety measure for the financial system.
Like SBV, a handful of small banks are pursuing a “high growth niche strategy” that increases their risk. Those banks represent about 3% of the US deposit base, by our analysis. We don’t consider them as presenting systemic risk on their own.
The broader concern would be one of contagion, whereby these handful of higher risk banks were to create a domino effect. Consider that:
- Many banks face a situation where they have securities or loans trading below the prices they paid for them. Most are not near the exposure of SVB and its peers, but a run on deposits might force wider selling of those assets, trigging large funding needs. In our view, these banks have a more diversified depositor base and more FDIC-insured deposits than SBV.
- Larger banks are much stronger financially following the Great Financial Crisis of 2008. That said, their regulatory capital ratios are inflated to an extent due to unrealized losses on their balance sheets. Also, only 15%-30% of the deposits are FDIC-insured across the Big Four banks, so its possible depositors might get concerned and pull money out.
- To us, the risks described here appear extreme and unlikely. The Biggest Four banks represent 38% of US deposits—very diversified base. It would take a big crisis to open that risk.
By acting quickly, we also think regulators probably recognized that the bigger the need for banking stability, the bigger the pressure on the Fed’s balance sheet and effort to reduce inflation. We suspect the Fed would want to isolate the problem quickly rather than let it linger.
Exposure to the Banking Industry in Our Portfolios
In our multi-asset class, balanced portfolios, banks typically represent around 3%-6% across stocks and fixed income at any time. Importantly, our diversified approach reduces exposure to any one particular bank.
What happened at SVB bank specifically?
- SVB’s business model catered to the technology, life science/healthcare industries as well as global private equity and venture capital clients. Many of these businesses suffered in 2022 and went from depositors to making withdrawals.
- SVB deposits grew 65% in 2020 and 86% in 2021 and most of these deposits were investment in securities that mature in over ten years. Meaning the company was taking significant interest rate risk. Also, a large percentage of SVB deposits (87%) where not FDIC insured, which theoretically meant there was a large amount of deposits at risk.
- SVB biggest asset on its balance sheet became investment securities (58%), not loans. A majority (75%) of these investments had been moved to held to maturity, which means unrealized losses were not reflected on the income statement or balance sheets because these securities are expected to be held to maturity. This is standard accounting practice, which may be changed in the future.
- The unrealized losses in the investment securities exceeded the banks tangible common equity. In the event of needing to sell their investment securities, they would have to realize losses and raise fresh capital to pass regulatory capital levels. This is what SVB had planned to do on Friday.
- Deposit holders did not wait for SVB to do so, and there was a classic bank run on Friday.
- Tech Start-ups: The cash-crunch highlights the underlying challenge to the tech/start-up community. They are wrestling with higher debt servicing costs already. Challenging times for high growth private companies if lending/funding continues to stay tight.
- More Regulation: Longer term, the SVB issue will probably encourage regulators to update oversight of banks and how they account for held to maturity investment securities. The GFC in 2008 brought regulatory scrutiny of credit risk. This time, it could go further to include interest rate risk… plus shedding great scrutiny on the relationship between banks and non-bank institutions… as well as incremental leniency on M&A activity in the banking sector.
All-in, we are not surprised that regulators stepped in quickly to send a signal to markets that it intends to contain the potential damage and ripple effects of bank failures at this time. That said, actions over the weekend are likely to have significant implications for regulatory oversight of the banking industry, which will take time to understand.
 These banks serve venture-backed growth companies, real estate lending, crypto, etc. They tend to emphasize uninsured deposits and either invested them in securities that have lost significant value (like SBV) or have lent money to cash-strapped ventures.