Silicon Valley Bank vs financial system: are the worries over? 

24.03.2023 10:28|Investment Advice Department, Conotoxia Ltd.

Two weeks ago, we saw the two biggest bank closures since the 2008 financial crisis. What are the implications for regulators and public confidence in the financial system, and what are the chances that something similar may also happen with other banks? 

Summary

  • SVB was shut down on March 10 after customers tried to withdraw around 25% of all bank deposits in one day. 
  •  Key reasons for SVB's crunch in liquidity may be attributed to the bank's asset-liability duration mismatch and significant unrealised losses in fixed-income securities due to the rising interest rate environment.
  • Numerous other US banks hold large amounts of unrealised losses similar to those of SVB and, therefore, may be under threat of facing similar difficulties as long as the Fed keeps interest rates high. 
  •  The US government and responsible agencies are taking action to restore the public's confidence in the US banking system and not allow the contagion of panic to spread to other financial institutions. 
  • Uncertainty has spread to other US and overseas financial institutions, pressing on the banks' stock prices globally. 

What happened?

Silicon Valley Bank, previously the 16th largest commercial bank in the US, suddenly closed on Friday, March 10, after its customers, worried about their deposits, began withdrawing funds in large numbers. It was the largest bank brought to collapse since the failure of Washington Mutual in 2008.

SVB specialised in financing venture-backed start-ups. It provided banking services to almost half of all venture-backed technology and life science companies in the US. It also operated in Canada, China, the EU, the UK and Israel. Benefiting from the explosive growth of the tech sector in recent years and fuelled by ultra-low borrowing costs, the bank's assets more than tripled in the three years to March 2022. At this time, nearly 200 billion USD were deposited at the bank. 

A little bit of fixed income theory

In 2022, as the Federal Reserve started to pivot its monetary policy to a considerably tighter one aimed at restricting further economic growth and uncontrollable inflation, the tech industry appeared to be strongly affected. From such large and well-known companies as Meta Platforms and Amazon to less-known tech start-ups, employees faced layoffs, and owners faced problems with repaying increased debt servicing costs and difficulties raising new loans. Consequently, these companies started withdrawing their funds from bank deposits. 

Meanwhile, on the other side of the balance sheet, banks usually invest part of their customers' deposits into safe and liquid financial instruments, such as US Treasury bills. SVB chose to put its customers' deposits into federal agency mortgage-backed securities (MBS), which generally have minimal credit risk but may face sizable interest-rate risk. These MBS have decreased in value (along with virtually all fixed-income securities) since the Federal Reserve started raising interest rates. In short, increased interest rates drive the bond yields up, which are negatively correlated with bond prices. As a result, SVB and other banks end up holding fixed-income securities at lowered valuations (read: at an unrealised loss). If the bank classifies its portfolio as "held-to-maturity", it may not recognise the loss and carry the securities on the balance sheet at their cost rather than their current value. 

Now, if the duration of the bank's fixed-income portfolio is the same as the duration of its customers' deposits, the bank should get back its invested funds at face value (usually 100%) at maturity and suffer little or no loss, depending on the price at which the assets were purchased. Conversely, the SVB invested in long-term (more than 10 years to maturity) fixed-income securities, resulting in an asset-liability duration mismatch.

Bank run – a self-fulfilling prophecy

As SVB customers increasingly demanded their deposits back, the bank was forced to sell 21 billion USD of their fixed-income portfolio to meet the demand for withdrawals while realising a 1.8 billion USD loss. Additionally, the bank announced that it plans to raise 2.2 billion USD in additional capital to continue operating and servicing clients accordingly. This news sparked fear among the bank's customers, who rushed to withdraw even more money from the bank. As is often the case with bank runs, these fears become a self-fulfilling prophecy: the more frightened customers are, the more funds they want to withdraw, and the greater the chance that the bank would  not be able to meet all the requests. In this case, customers tried to withdraw as much as 42 billion USD in a single day, around 25% of all bank deposits. 

As a result, the Federal Deposit Insurance Corporation announced on Friday that it is taking control of the bank and will distribute the deposits back to their owners following the legal procedure of winding down the bank's assets. The FDIC insurance works only for deposits up to 250 thousand USD, while the rest of the amount is uninsured. In fact, according to the recent 10-K filing by the SVB, as much as 90% of all deposits are not covered by the FDIC insurance scheme.

SVB Financial Group’s stock

Furthermore, SVB Financial Group's stock also reacted by dropping 60% on March 9 before its trading was halted. It is worth noting that SVB Financial Group's stock has been tumbling since the end of 2021 after its price exceeded 700 USD per share, signaling potential challenges it may be facing.

Source: TradingView

What happens now? 

Since the SVB shutdown, the US government, the Federal Reserve Board, and the FDIC have had busy days assuring that the US financial system is stable. On March 12, the FRB announced that it would make funds available to eligible banks, credit unions, savings associations and other depository institutions through a new Bank Term Funding Program. This program will offer loans of up to one year to provide additional liquidity and eliminate the need for a bank to sell undervalued assets.

The Bank Term Funding Program, along with other actions taken in recent days, was necessary to reassure the public that the US government has the situation under control and that there is no threat to the overall financial system. Why is it so important? 

Bank closures such as the SVB's show us that customer confidence is essential to a bank's ability to operate successfully. After all, the public entrusts banks with their savings and daily cash flow. Conversely, when trust is lost, customers want to get their money back as quickly as possible, leading to a panic-driven bank run that no bank could easily withstand. 

Although they may appear otherwise, US officials may be correct to worry about the upcoming events started by the closure of the SVB. While certain aspects of the SVB suggest that the bank's shutdown results from an idiosyncratic risk and potential negligence, in reality, it may be too good to be true.  

According to the Federal Deposit Insurance Corporation, by the end of 2022, US banks alone were sitting on 620 billion USD in unrealised losses consisting of assets that have decreased in value but not yet sold – basically the same situation where SVB found itself. Economic tightening in the form of higher interest rates has a ripple effect throughout the economy and often takes time to be fully realised. Therefore, it is important to understand that the technology industry and the SVB are far from the only ones to feel these effects.

While the Fed may reconsider further interest rate hikes, especially considering that the latest inflation data have shown a slowing trend, it may still take a considerable time for the Fed to start lowering the interest rates. This means that an increasing number of banks may need to start selling their assets to meet the reducing deposits and increasing withdrawals of their customers. While banks will be able to use the newly introduced Bank Term Funding Program, questions may arise about the short-term nature of these loans (what if the high-interest rate environment is here to stay for a longer period than one year?) and the overall idea of obtaining more loans to fight a liquidity crisis. 

Other banks

In order to show how systemic the current risks in the financial sector may be, we can look at how other banks reacted to the SVB shutdown. On Monday morning, as trading resumed after a worrisome weekend, numerous banks' stock prices were hit hard by fears of contagion within the financial sector. In total, stock trading was halted at least once for 22 banks in the US on Monday, with such names on the list as Charles Schwab, East West Bancorp, and First Republic Bank. Some of these shares plunged more than 60%. 

Furthermore, the closure of another bank during the weekend – Signature Bank – denotes that US officials may have been extremely worried about the potential contagion of panic from the SVB. While increased withdrawal activity was visible among the bank's customers on Friday, Signature Bank's board member announced that there was no threat to the bank's solvency and that the bank may have been shut down for other reasons.  

Overseas, just a few days later, a much more well-known bank – Credit Suisse – announced that its biggest backer, Saudi National Bank, would not provide any further financial help to the bank, sending its stock price more than 20% lower. To reassure the public that their savings are safe, Credit Suisse swiftly announced they would execute the option to borrow up to 50 billion CHF from the Swiss National Bank. Credit Suisse may be considered the first major global bank that reached an emergency lifeline since the financial crisis in 2008. 

Conclusion

The above-discussed events give an insight that investors may not consider the SVB as a one-time event. Further upheavals in the financial sector may take place as long as the monetary policies of major economies are kept tight and interest rates high. The Federal Reserve is closely monitoring the current situation, and the latest events may motivate them to slow down the rate hikes in future meetings. Still, they seem  unlikely to lower the rates to a comfortable level in the nearest future. Meanwhile, the more prominent banks may have an opportunity to purchase the assets of the shutdown banks at significant discounts, such as HSBC has already agreed to buy the SVB's subsidiary in the UK for 1 pound.

 

Santa Zvaigzne-Sproge, CFA, Head of Investment Advice Department at Conotoxia Ltd. (Conotoxia investment service)

Materials, analysis, and opinions contained, referenced, or provided herein are intended solely for informational and educational purposes. The personal opinion of the author does not represent and should not be constructed as a statement, or investment advice made by Conotoxia Ltd. All indiscriminate reliance on illustrative or informational materials may lead to losses. Past performance is not a reliable indicator of future results.

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Santa Zvaigzne-Sproģe, CFA

Santa Zvaigzne-Sproģe, CFA

Head of Investment Advice Department

A certified financial analyst with a broad experience in financial markets obtained working as a broker and securities specialist in various financial institutions across the Baltics.

In addition to obtaining the prestigious CFA license from CFA Institute and Advanced Certificate from CySEC in 2022 as well as Investment Advisor’s license from Baltic Financial Advisor’s Association in 2019, Santa holds MBA from Swiss Business School in Switzerland and master’s degree in finance from BA School of Business and Finance in Latvia.


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71.98% of retail investor accounts lose money when trading CFDs with this provider. You should consider whether you understand how CFDs work and whether you can afford to take the high risk of losing your money.

CFDs are complex instruments and come with a high risk of losing money rapidly due to leverage. 71.98% of retail investor accounts lose money when trading CFDs with this provider. You should consider whether you understand how CFDs work and whether you can afford to take the high risk of losing your money.
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