Post SVB Explainer

By Alexandria Investment Research on March 16, 2023

Silicon Valley Bank (SVB) collapsed in a mere 48 hours – seemingly financially sound on Wednesday and insolvent by Friday morning. The rapid series of events surrounding SVB, which regulators took over last Friday morning, came on the heels of the demise of Silvergate Bank and was followed by the failure of Signature Bank on Sunday.

The cascade of bank failures, including extreme stress at PacWest Bancorp, First Republic Bank, Comerica, and Western Alliance Bancorp, is unsettling and substantially undermines confidence among depositors – particularly large depositors with balances above FDIC insured limits.

In response, regulators are acting decisively in guaranteeing that all depositors at SVB and Signature Bank have full access to their deposits. This includes large depositors.

In addition, the Fed has implemented a new lending program whereby banks can exchange high-quality securities (such as Treasury Bonds) for one-year loans. This program provides measurable liquidity so that banks can fulfill withdrawal requests while simultaneously allowing their high-quality bonds to mature (without prematurely selling the bonds at a loss, given the rapid rise in interest rates over the past year).

Taken together, regulators’ actions essentially backstop all deposits held by domestic banks.

While the efforts regulators have announced are beneficial, we believe that the efforts can be described with the modifier “thus far.” We suspect more needs to be implemented to ensure the financial system remains on firm ground. Depositors may be reassured, but the pronouncement that investors (equity and debt investors) will not be protected is simply extending the funding pressure (bank run) from depositors over to equity and bond investors. Moreover, the amplifying power of social media cannot be underestimated in the presence of uncertainty or misinformation.

Because custodians are not in the business of gathering deposits and using those deposits to fund loans or invest in bonds the concerns reverberating across markets do not automatically extend to investment accounts that reside at these institutions. Custodians are legally distinct entities from traditional banks (even when a bank owns the custodian). To this point, your investment accounts are not covered by the FDIC but rather the separate SIPC coverage (with custodians providing excess SIPC coverage). Note, however, that some investment accounts utilize “bank” funds for money market sweep options which in essence serve as a deposit in the bank sponsor for that money market fund. In those situations, the “bank” option is typically covered by the FDIC.

For those people with assets tied up in this crisis, we recognize the stress in trying to safeguard precious assets. Through all this turmoil it is important to recognize that the issues dragging these banks down are concurrently similar among these banks and a function of what a bank is.

At their core, banks gather deposits and use that money to make loans and/or buy bonds. The challenge is that most deposits can be withdrawn anytime, while loans and bonds mature over time. This mismatch is a key reason why banks are highly regulated – creating guardrails for how much banks must hold in cash and high-quality assets and retaining them as buffers for potential loan losses.

The root of this banking crisis is recent inflation and the Fed’s rapid series of interest rate hikes, which dragged down the value of the bonds and mortgages held by banks (particularly longer-term holdings). Credit is not the issue; instead, banks suddenly facing large withdrawals of deposits are eventually forced to sell holdings of bonds at a loss, thereby eroding capital cushions and confidence/trust in the bank. Importantly, because banks inherently borrow short-term and reinvest on a longer-term basis, no bank is structured for a 50% withdrawal of deposits over the course of days. This is precisely why regulators stepped in to protect depositors and provide a tool for banks to convert bond holdings into cash without absorbing a loss.

In the case of SVB, the bank’s deposits were more susceptible to a rapid withdrawal – most of the deposits were from businesses concentrated within the technology, venture capital, and startup “sectors”. Over a two-year period, SVB experienced a tripling in deposits as VC & tech startups saw a rapid influx in cash from investors, and that cash had to be invested somewhere. A greater amount wound up in bonds with longer maturities as SVB balanced the cost of deposits and operating expenses compared to interest income available in loans and bonds. The differing composition of deposits across the banking industry exacerbated the issues at SVB (roughly 12% of SVB’s deposits were FDIC insured vs ~35% industry average). In essence, SVB’s depositors were more likely to face economic pressures simultaneously – and in many cases were closely linked through common owners and advisors, compared to other banks that skew toward a more diverse group of individuals or businesses for deposits.  

SVB clearly made mistakes in misjudging the stickiness of their deposits (and, therefore, own bonds with maturities that were too long). Still, the real issue was a loss of confidence and trust, accelerated by social media, that created a self-fulfilling prophecy by prompting an acceleration in deposit withdrawals and a reluctance for investors to fill the void.

Looking ahead, the Fed and the FDIC have unlimited capacity to restore confidence among depositors at U.S. financial institutions. Taking a more limited approach feeds uncertainty and leads to higher cumulative costs. For this reason, we don’t think we have seen the end of the regulators’ approach. Depositors at other banks may be mostly reassured based on the actions thus far, but the risks for investors remain largely unaltered – a key reason the banks listed above are down sharply. In essence, the Fed is facilitating deposits to move from weak to strong banks, with investors absorbing the losses.

More is likely to develop on this topic, and it is uncertain what role social media (Twitter or Discord) may play in precipitating pressure on a bank. While many bank stocks are down in sympathy or due to a lack of clear information, regulators have unlimited capacity to intervene if necessary. For this reason, the more lasting impact of recent events is likely to be constrained earnings and reduced shareholder returns among most banks and greater regulatory oversight of regional banks.

With all this in mind, we are actively reviewing and reevaluating our investments, including money market funds, in the context of the fluid environment that will continue to evolve over the following days and weeks.