Regulators, investors, and depositors are having flashbacks to the Global Financial Crisis (GFC) as panic is spreading through the banking industry once again. This time, the focus is on small- and mid-size regional banks. There have been a few casualties already, most notably Silicon Valley Bank (SVB).
SVB’s primary business was providing global commercial banking, private banking and wealth management, investment banking, and venture capital and credit investing to startup companies in the technology and health care industries. Their website touts them as “the financial partner of the innovation economy.” Until 2022, business was very good. A flood of venture capital into technology startups in recent years had to go somewhere. Silicon Valley Bank was often the bank of choice, and it became the 16th largest bank in the U.S.
There are a lot of ways for banks to make money. At their core, though, they earn a spread over what they pay on deposits (liabilities for the bank) and what they earn on their assets. As SVB received cash from their clients, they wanted to make money on these deposits. A bank can do this in a couple ways. The first way is to lend the money to other companies or individuals at a higher interest rate than they are paying on their deposits. This comes with all the risks of investing in small, unproven, and often unprofitable companies. The second way is taking the money and (with perhaps some leverage) purchasing other investments. The government restricted what banks can invest in after the GFC, so a common investment for a bank is a government security (either a simple treasury bond or slightly riskier mortgage-backed security). SVB thought there simply were not enough good companies to lend to with all the money they had coming in. They chose option two, which was their ultimate undoing.
How can investing in a bunch of guaranteed government bonds and securities lead to a bank failure? By having a mismatch between the length of the bank’s liabilities (i.e., deposits) and assets (what they chose to invest in). A couple of market changes over the past 12 months contributed to its demise:
- A cash crunch for unprofitable tech startups. During the boom years, startups (both profitable and non) had no trouble raising cash in ever-rising rounds of funding. In late 2021 and early 2022, the tide went out. Valuations of public market tech stocks were often cut in half. Venture capital money flowing into the space slowed dramatically as the Federal Reserve raised interest rates repeatedly last year. As a result, companies that had no trouble getting their hands on new cash suddenly started withdrawing cash they had already raised, often held in accounts at SVB.
- Rising interest rates. To combat decades-high inflation, the Federal Reserve began raising interest rates last March. An aggressive approach to monetary tightening led to a historically bad year for bond prices.
The problem for SVB was that before 2022, interest rates on short duration government bonds was almost non-existent. To get a larger spread on what they were paying depositors, they invested in longer duration bonds, which carried with it higher interest rates. Of course, those higher interest rates did not come without shorter-term risks. When interest rates go up, bond prices fall. And the longer the duration of the bond, the greater it falls.
Clients began withdrawing money to cover everyday expenses for their company (think payroll, etc). As cash left the bank, the bank was forced to sell assets to satisfy withdrawals. They were forced to sell their longer-dated bonds, which had fallen significantly in price after the recent rise in interest rates. The bonds are still good, but their current values did not match the assets that were leaving. This didn’t matter until it did, and it started mattering last week.
Another complication for SVB was their relative homogenous client base. Most depositors were startup companies that received money from the same venture capital funds. Once concern over whether companies could withdraw their cash from SVB spread, there was a good, old-fashioned bank run. Since withdrawals were taken at 100 cents on the dollars and SVB’s investment portfolio was no longer worth anything near that, the bank quickly became insolvent. The resulting closure of SVB has sparked additional concern regarding which other banks would face a similar fate.
To stem panic and prevent similar bank runs on Monday morning, the government announced several backstops:
- All client deposits at SVB would be protected and accessible starting Monday.
- New York-based Signature Bank, another institution with heavy ties to the startup community, would also be shut down. Like SVB, all deposits would be protected and available.
- There would be no protection for either company’s equity shareholders or bondholders.
- The Fed stepped in with a separate facility that will provide loans of up to one year for institutions affected by the bank failures.
For Our Clients
SageView is monitoring the situation with SVB closely. As we await more information, it is important that we as investors (and bank depositors) keep in mind the following points:
- The FDIC insures all bank deposits up to $250,000. If your aggregate assets in any one bank are less than this amount, your assets are safe. SVB was not a community bank catering to middle-income Americans. SVB’s customers were predominantly startup tech firms using their SVB accounts for business operations. The government’s decision to protect investor deposits at SVB helps companies whose account balance far exceed FDIC limits. Most Americans would not need to count on a special government action to protect their assets; FDIC insurance covers them already.
- We do not believe these bank failures are the start of a broader financial sector meltdown. This is not a repeat of 2007-2008. Banks are much healthier today and much more restricted as to what they can carry on their books. Again, the assets that SVB carried are fundamentally fine and should mature at full face value. The issue SVB faces is being caused by an asset-liability mismatch during a time when investors are pulling money from the bank. In 2007, the quality of the assets banks carried was much worse (e.g. junk mortgages) and banks were much more highly levered. There may be more pain for small and mid-sized banks, but the systemic risk to the whole economy is much lower today than 15 years ago.
- These bank failures may influence Fed policy going forward. As recently as last week, the market widely expected another 50-basis point rate hike during the Fed’s upcoming March meeting. Following the failure of SVB, the Fed is likely to slow their interest rate increases or stop altogether, because it would be counterproductive to increase interest rates (which lowers the value of the banks’ assets) while providing emergency funding to depositors.
- Work with your financial advisor to ensure that your personal assets and liabilities are properly aligned. SVB failed because they got this relatively simple concept wrong. Do not make a similar mistake by relying on equity positions to fund short-term liabilities. Make sure your overall asset mix aligns with your spending plans.
If you have any questions, please reach out to your SageView advisor or you can send an email to email@example.com.