Fault Lines: Bank Failures Cause Market Tremors

On March 10 Silicon Valley Bank (SVB) collapsed and was taken over by the Federal Deposit Insurance Corporation (FDIC). This was followed by the collapse of Signature Bank (SBNY) and another takeover by the FDIC takeover on March 12. There followed a period of volatility for the banking sector, turmoil in equity and fixed income markets, and intervention by the federal government.

Bank runs on both SVB and SBNY are ultimately what led to collapse and takeover by the FDIC. The situation with SBNY is easier to understand. SBNY had been among the few lenders to accept deposits in the form of crypto assets. By March 10, concerns about the bank’s exposure to cryptocurrencies had set off a deadly run on its deposits.

As for SVB, a surprise filing from the bank on March 8 reported it had sold its $21 billion bond portfolio at loss of $1.8 billion. SVB had acquired long duration investments which lost value as interest rates were raised. The bank took the loss on the sale when their clients needed liquidity, while putting its credit rating at risk. Shortly after the portfolio sale, the bank tried to raise capital through both a private and public offering. This caused depositors to scramble to withdraw their money on March 9.

SVB reported a profit of $3.4 billion for 2022 when it had approximately $172 billion in deposits. At year-end 2022, the bank had $209 billion in total assets and was the sixteenth largest bank in the U.S. by assets. Its $5.23 billion in revenue was about 84% of the firm’s total for 2022. This was the first bank failure since 2020 and the second largest bank failure in U.S. history.

The Insured and the Uninsured

The FDIC insures deposits up to a limit of $250,000; anything above that is uninsured. At year end 2022, approximately 87% of SVB’s deposits were uninsured, as those accounts exceeded the $250,000 maximum. In a 2019 speech at the Brookings Institution by Martin J. Gruenberg (then an FDIC board member and now the agency’s chairman) stated that the average amount of uninsured deposits for a bank the size of SVB at that time was approximately 43%, far above what SVB was holding in 2022. SVB’s uninsured accounts were regarded not as retail accounts, but business accounts. SVB had very few retail customers.

However, the FDIC announced late in the evening of March 12 that all depositors of SVB and SBNY —insured and uninsured—would have access to the full amount of their deposits beginning on March 13. The Biden administration stressed that taxpayers would not foot the bill for the rescue plan: The banks that fund the deposit insurance system would pay for any losses incurred from protecting uninsured depositors at SVB and SBNY.

It is believed that the FDIC and the Fed decided to insure all depositors to protect American workers and small businesses as well as shore up our financial system.

At this point, the actions by the FDIC and the Fed are not considered a “bailout” such as what occurred following the financial crisis of 2008. The banks’ shareholders and “certain unsecured debtholders” won’t get federal protection, and senior management staff are no longer in place.

Between 2008 and 2012, approximately 465 banks failed. The difference between that time period and now is that currently, the banks are able to figure out what their losses are with some degree of confidence whereas during the Great Recession, it was very hard for the banks to figure out what their losses were because a majority of losses were from mortgage-related financial assets. At the time, the market value of the underlying asset, the home, was more difficult to value on a day to day basis than todays crisis.

In addition, the Fed announced that is establishing a new Bank Term Funding Program, which will offer loans of up to one year in length to eligible depository institutions and U.S. branches or agencies of foreign banks that pledge qualifying assets as collateral. This lending program is meant to provide short-term to medium-term liquidity to institutions that hold assets with long maturities, to mitigate the need to sell such assets at a loss in times of stress. There are no minimum or maximum borrowing amounts.

Mistakes Were Made

SVB catered to start-ups and venture capital firms specializing in new and disruptive technology, cryptocurrency, speculative biopharma, and healthcare development and innovation. These types of bank customers park large cash balances to fund their working capital and other liquidity needs. In turn, a bank such as SVB loans these balances to other customers and invests these balances in securities to generate a yield attractive to these depositors.

SVB’s leadership may have had a hand in creating the situation that resulted in the bank’s demise. Reporting from The Lever website noted that, in 2015, SVB president Greg Becker submitted a statement to a Senate panel regarding regulations passed after the 2008 financial crisis for mid-sized banks, pushing exemptions for more banks, including SVB.

Despite some senators’ misgivings, Becker’s effort and the efforts of others succeeded, and legislation was passed in 2018 stating that some mid-sized institutions, including SVB, are “not required to conduct and publicly report the results of a company-run stress test” and “reduces the required minimum frequency of liquidity stress tests and granularity of certain liquidity risk-management requirements.”

Becker (who, according to a report in Barron’s, sold $3.6 million of his own stock two weeks ago) left his position on the board of directors at the Federal Reserve Bank of San Francisco, to which he had been elected in 2019, on March 10.

Under normal market conditions, deposits are relatively sticky (i.e., depositors are unlikely to move them) and returns from the securities portfolio are relatively predictable. In the past year, however, there has been stress on the deposit side for SVB as venture capital depositors have been burning cash at an unusually high level amid the difficult funding environment and adverse impact that higher interest rates have on the valuations of high growth companies. That left the outflows from SVB much higher than the bank expected.

At the same time, limited activity in initial public offerings (IPOs) of stock and other liquidity events also led SVB depositors to draw down balances. To meet the demand for withdrawals of these deposits, SVB had to sell assets from its security portfolio. These assets also suffered from the rise in interest rates and were valued at less-than-par value. So, the bank was forced to sell these securities at a loss, and then failed to raise the capital it needed.

SVB held more than 70% of their securities portfolio in low-interest rate “held-to-maturity” bonds, which limited their balance sheet flexibility. That means that SVB did not have to mark-to-market (i.e., measure the fair market value) of those bonds until they were sold, limiting the bank’s ability to manage the balance sheet appropriately and giving investors a perhaps distorted view of its balance sheet.

Apparently, the bank’s management chose to sell the $21 billion bond portfolio at a loss because many of those bonds were yielding an average of only 1.79% at a time when interest rates had risen drastically. The bank was starting to look like a relative underperformer, leading Moody’s to consider a downgrade to SVB’s rating. With the help of its adviser Goldman Sachs, the bank’s management decided to raise new equity from the venture capital firm General Atlantic while also seeking to raise money in the public market.

It isn’t clear if this infusion or capital was made under duress. However, because SVB decided to use the public market to raise some capital and had to wait for the markets to open, the deal fell apart overnight. In trying to reassure investors with a capital infusion, the bank miscalculated and instead alarmed them. The market was surprised, and the bank’s depositor base flocked to withdraw their deposits en masse, which led to the FDIC takeover.

Conclusion: The Calm After the Storm

SVB’s proxy statement, filed earlier this month, reveals that the firm’s chief risk officer stepped away from her role early last year, and the bank did not hire a replacement until this past January. It is unclear how the bank managed risks in the interim period. A risk officer typically anticipates and manages regulatory, operational, competitive, or other risks faced by a firm.

SVB’s risk chief reports directly to a “Risk Committee,” which includes chairpersons of SVB’s Board and all the Board committees, in addition to the chief executive officer, according to filings from the company. The committee is responsible for hiring, evaluating, and terminating the CRO, and as of 2023, was made up of seven members.

Silicon Valley Bank was without an official Chief Risk Officer during a difficult transition in the venture capital market—the industry SVB services so closely. At the beginning of 2022, as interest rates started to climb, venture capitalists pulled back and slowed down their pace of dealmaking, leaving the tech companies they backed with less capital to run their businesses. That directly influenced deposits at Silicon Valley Bank.

Ultimately, the bank was undone by piling into bonds just before rates rose, managing the $21 billion bond portfolio poorly, trying to go into the public market to raise capital despite having a private infusion of capital lined up, and having a concentrated depositor base that ultimately lost confidence in SVB.

Moving forward, we expect lending standards to tighten, more caution in investing by venture capitalists, and a slowing in economic activity. The impact of any contagion spreading to regional banks’ problems is minimal now that the Fed has guaranteed deposits at SVB and SBNY.

The U.S. banking sector as a whole and particularly the large, systemically important institutions have been through significant stress testing and are forced to carry exceedingly high levels of capital and liquidity while also being very closely monitored by regulators. From an investment standpoint the falling tide of bank stock banks in the wake of the SVB and SBNY failures is likely to push the value down of most other bank stocks. We would look at any selling pressure in this sector as temporary. The Washington Post reported that many banking regulators have expressed confidence that the SVB and SBNY collapse is an isolated event and will not spread broadly through the country’s financial sector.

The big question after the collapse of SVB is what the Fed will do at its next meeting on March 21 and 22. Before the collapse, the market was betting on a 50-basis point rise. Now the betting has changed to a wide range, anywhere from 25 basis points to a cut. Our belief is that the Fed will look at the recent data release and the stability of the financial markets when it makes its decision next week.

Please note any exposure that Bowen Asset Management LLC to Silicon Valley Bank (SVB) or Signature Bank (SBNY) is peripheral at best. Our exposure comes from holdings in banks and/or diversified funds including index funds that we hold on our client’s behalf. We will continue to monitor and analyze for other associated risks to client portfolios and take action to mitigate those risks as appropriate. We have no direct holding in customer portfolios in either Silicon Valley Bank (SVB) or Signature Bank (SBNY).

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