Bank failures are suddenly the topic du jour.
As you might have heard by now, the financial markets and banking system are roiled after the sudden failure of SVB Financial Group’s Silicon Valley Bank (SVB). The 2nd largest bank failure in history almost seemed to come out of nowhere and it happened really fast. What just happened is rate; closing without being insolvent (no credit issue, but deposit flight.) SBV, the 16th largest bank at the time, embraced the start-up culture of its namesake locale; move fast, disrupt and break things.
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The collapse of SVB brought flashbacks of 2008: “Are we really going through this again?”, “Didn’t we have rail guards in place to make sure it never happens again?” Waking up to not knowing if you will access your money is not a great start to your day. The better safe than sorry mentality prevailed. It was “Don’t ask questions. Just withdraw the money now.”
On an individual basis, moving your money to a safer bank is a prudent choice. On a collective basis, it’s crashing down the financial system. What we have is a crisis of confidence. The problem with bank runs is that they become a self fulfilling prophecy. As more people withdraw cash, the likelihood of default increases, triggering further withdrawals.
Confidence is the main currency of banking. Without it, there’s no financial system. You need to have 100% certitude that your money is going to be there when you wake up.
Following the collapse of SVB, two other banks followed SVB into receivership: Silvergate Bank and Signature Bank. A deep analysis of the three banks reveals that the common denominator among the failed banks is that their name all began with the letters “SI”. If your bank doesn’t start with the letters “SI”, your deposits are fine.
A lot has happened really fast. I always wonder why it takes a crisis to learn firsthand about banks? Probably because 1) It’s more fun to watch paint dry, and 2) when things are going well, why bother?
How did we get to this? I’m going to try to peel off the layers of the onion without getting too deep into the arcane accounting details of banking. Here are fair questions to ask at this point.
How did SVB collapse last Friday?
It was a bank run. Depositors rush to withdraw their money. SBV didn’t have enough cash on hand to cover their withdrawal. It failed.
Look, imagine you are a bank, and all your friends and family loan you money (deposits) because you said you would keep it safe and pay out interest. You take that money and make long-term loans with it. But tomorrow morning, your friends and family read on Twitter that their deposits might be in trouble. Panicking, they all rush back to you demanding their money back. Guess what? You don’t have it. Guess what? You are in trouble. Guess what? You don’t want to find out.
Why did depositors run on the bank?
A panic started in group chats and social media that their deposits were in danger of disapearing. Some highly influential financial personalities said that depositors should withdraw their money right away or risk losing it. It went viral and compounded the problem. You don’t need to go wait in line anymore to get your cash. You can transfer money with the app. Too many people did that and killed the bank in the process.
Why did the depositors panic?
SVB suffered a $1.8 billion loss and attempted to address its liquidity problem by selling equity. The move backfired. SVB’s share started going down. A red flag was raised. Depositors got spooked who rushed to withdraw their money before the situation got worse.
How did SVB lose $1.8 billion?
The short answer: SVB took a $1.8 billion loss trying to rebalance its underperforming $21 billion debt portfolio. To address the problem, SVB said it planned to raise $2 billion in equity, but never got to complete it. Depositors saw the capital raise as a sign of trouble, the word spread, and it was a downward spiral after that.
The longer answer provides some background. There are two main factors behind the loss. The first factor is that many of SVB’s deposits were held by startups. When interest rates were low during the pandemic, SVB received a massive amount of deposits. SVB grew a lot really fast. Most startups have all their money in one bank. And most of the deposits (93%), anything over $250k, were uninsured. Now that these startups (SBV’s clients) are facing headwinds and burning cash (going through deposits), SBV experienced an increase in withdrawals from depositors. But this doesn’t cover the $1.8 billion loss and the mistake SBV made.
The second factor covers the main reason for the loss and the mistake SBV made. Generally a bank goes under because of credit risk; too many loans going bad, like during the Great Financial Crisis (GFC) when baristas defaulted on their mortgages en masse. But that wasn’t the case here. SVB didn’t have a credit problem (for now). Even with borrowers repaying their loans as promised, SVB’s problem was it’s structure (balance sheet mismanagement). SBV was a victim of forgetting an old banking 101 lesson: Asset-liability matching.
What’s this Asset-Liability Mismatch thing?
For a broader more complete explanation, I’ll refer you to Prof. Sanjoy Sircar’s article in BW BusinessWorld. But here’s a summary:
The asset-liability mismatch is when the bank has to pay a short-term liability (deposits) for which it is undergoing a long-term asset (loans/investments). A balance sheet has assets and liabilities. Banks accept deposits (liabilities) and offer loans (assets). In addition to loans, securities portfolios also compose bank assets. When a bank makes long-term loans by using money raised from short-term sources like deposits, it exposes itself to risk.
The incentive to take short-term funds to make longer-term loans is profit. When you use cheaper short-term funds to give out long-term loans, then it increases profits because the short-term sources of money are cheaper than the long-term sources of money.
The risk is that the depositors may demand their money back anytime. In such a situation, the bank may not have the funds to do so, as they are all locked up in long-term loans or invested in securities that are underwater. This is the scenario which has played out many times in the past, more recently at SVB.
How did the Asset-Liability Mismatch play out at SVB?
Banks acquire funds through short term deposits while they lend them for longer maturities.
After the initial rush of deposits during the pandemic, SVB couldn’t loan all of it. SBV invested depositors’ funds in long-term bonds and mortgage-backed securities (MBS), at the top of the market. The reason they did that is for higher yield. The yield on the bond portfolio was 1.7%.
Of course operating in a zero interest rate environment has its challenges, but buying debt out 10 years to squeeze out another 50 or 60 basis points. You just don’t do it. This led to an asset/liability mismatch and trouble.
We know what happened next. The Federal Reserve increased interest rates to combat inflation, the value of their bonds and MBS portfolio cratered, taking SVB with it.
As Prof. Sanjoy Sircar explain, large banks manage the asset-liability mismatch risk by having a large, diversified base of depositors whose funds stay inside the bank for longer terms. We call those deposits “sticky” (you could argue that deposits are less sticky now because of mobile banking, with a simple click you can transfer your funds out).
Sticky deposits provide large banks with cheaper money and keep rolling it over and over again (it stays at the bank). This rolling-over of deposits provides an opportunity to the bank to give long-term loans at a lower cost and in turn, increase its profits.
SVB has one type of depositors: startups that need their deposits because they are in a downcycle. It wasn’t sticky enough.
Imagine a large wave of deposits coming in, and then washes out. That’s what happened to SBV. Tons of money came in fast and left fast.
Another issue that SBV was facing, and all banks, is the inverted yield curve.
What’s this Inverted Yield Curve thing?
Normally long-term sources of funds are costlier than short-term sources. A 30-year loan is more expensive than a 1-year loan because of the duration risk (it’s a riskier loan). Sounds logical so far.
But right now the world is upside down. The short-term interest rates are higher than long-term interest rates. Right now, the payments on shorter term Treasury bonds exceed the interest paid on longer term bonds. A 1-year Treasury has a yield of 4.4% and a 30-year Treasury has a yield of 3.6%. The result is an inverted yield curve. An inverted yield curve points to trouble. It indicates the likelihood of the economy slipping into recession is high.
An inverted yield curve is a sign that wider financial conditions are not so easy, presenting banks with a far more challenging economic and financial environment. When your cost of funding exceeds the rate of return, that’s not good.
This is an issue for banks because their deposits (liabilities) can cost more than their loans/securities (assets). SBV had short-term liabilities, or deposits, which it financed with long-term bonds and MBS. The yield on the bond portfolio was 1.7%. The borrowing rate was 4.5%, which is the amount they pay depositors, exceeding the return on assets. The yield curve was upside down and they didn’t know how to deal with it.
Are all banks in trouble?
No.
To be fair, at the moment all banks have the “unrealized loss issue” with their securities portfolio. The number being floated around is $620 billion unrealized losses on their securities portfolio according to the FDIC, underscoring the hit from rising interest rates. But it’s only a real “issue” if you have to sell and realize a loss. If you hold the securities to maturity, you get your capital back (no loss realized and you get to re-invest). SBV didn’t have a choice because deposit outflows forced their hand to sell at a loss.
Plus, this is a different kind of crisis. Regional banks aren’t in the spotlight because of mountains of troubled loans; their immediate problem is deposit outflows, and replacing those deposits with expensive funding.
Should I be worried about my deposits?
No.
The Fed, FDIC, and U.S. Treasury said that all depositors (insured and uninsured) will be made whole.
Should bank investors be worried?
Depositors can sleep at night. For investors that’s a different story. The bank you are invested in is probably fine, but it’s the reaction from clients and shareholders causing it to blow up.
Should you be worried? Yes and no. It depends. Should you be worried about the banking system’s stability? Yes. Even though the banking system remains sound, it comes with a question mark. Are all the banks in trouble? No. The big worry is a risk of contagion that brings everything down with it.
We have a two-tier system: The big banks where it is always safe to deposit and do business, and everyone else.
The big banks, like Bank of America and JPMorgan Chase of this world, are fine. They will benefit from the crisis. Deposits from smaller institutions are flowing to them and their cost of capital is likely going down. It’s a case of where the strong gets stronger and the weak gets weaker.
Regional banks are in a different bucket. Their deposits are often concentrated. The key issue is not loan defaults but potentially significant deposit outflows can leave a bank in a tough spot.
The other issue banks have to deal with is their held-to-maturity (HTM) portfolio of securities. If the deposit outlook is fine, securities can be HTM at par without realizing losses (threatening core equity, but you get your capital back at maturity). Most scenarios point to the core equity ratio getting wiped out if HTM losses are realized. But that’s the key question. What’s the likelihood that happens? Very low in my opinion. These HTM securities can be held to maturity if the bank doesn’t need to raise cash.
It’s not easy to assess how banks will fare out. You have to make a lot of assumptions. Banks are a little bit of a black box. What’s the deposit outflow? What’s the impact of higher funding cost? The pressure on their loan portfolios? The government’s potential role in quelling a more significant crisis? The theoretical capital impact of an immediate liquidation of a bank’s entire investment securities portfolio? What happens to core equity when deposits leaves and investments are liquidated at a loss?
The government has taken measures to make sure deposits are fine (at the moment there are mixed reports on future bank failure but that seems to be the idea). Their goal is to restore confidence in the system and to prevent further bank runs.
Summary
We are not out of the woods. Further bumps in the road should be expected.
Overall, I believe solvency fears on banks are overdone. The problem is when a wave of panic hits, it’s hard to gauge the impact. Because we are currently in panic mode. Fundamentals don’t matter. Fear is the dominant emotion. Confidence needs to be restored. Investors can earn significant returns here by leaning into the fear and buying the bloodbath. But if you play with fire, you can get burned.
Hope this article provides a better understand of what’s happening.
