Market Perspective: Silicon Valley Bank Run

Overall impact of SVB’s failure explained

The failure of Silicon Valley Bank brought significant concern to the public regarding the U.S. banking system. Sunday brought additional news that a second bank, Signature Bank in New York, was closed by its state regulators. Fortunately, the Federal Deposit Insurance Corporation (FDIC), Federal Reserve, and the Treasury Department acted decisively on Sunday to help stem the tide of a crisis of confidence with the announcement of a new Bank Term Funding Program. The announced protections look to provide depositors with confidence to access all of their money in accounts at Silicon Valley Bank and Signature Bank.

The banking model is simple – borrow short-term, lend long-term. Banks gather deposits by offering an attractive savings rate and then make loans or buy other assets with a higher yield and pocket the difference. There are a few instances where banks typically run into trouble: making bad loans or purchasing bad assets, having a duration mismatch between their assets and liabilities, or having other unrelated businesses that fail.

Occasionally banks run into problems they can’t control, things like a recession, an inverted yield curve where yields are higher on short-term bonds than long-term ones, tougher regulations, or worst of all – client confidence. For the latter, banks keep only a small amount of cash on hand to help manage deposit activity. If the pace of deposit withdrawals increases, they can seek other funding sources and/or sell their asset portfolio. However, in situations where clients panic, whether justified or not, bank failures can become self-fulfilling prophecies, and this may never change.

The recent government action is extremely important, but it doesn’t end the risk of a potentially difficult adjustment for the economy. An orderly adjustment in the banking system is much healthier than the chaos that unfolded since the end of last week.

A stunning warp speed failure

After serving mostly venture capital and start-up clients successfully for over 40 years, Silicon Valley Bank (SVB) failed in less than 40 hours and quickly became the second largest bank failure in U.S. history. The failure is best seen as a destructive interplay on the nature of deposits being withdrawn due to fear and the value of bond holdings dropping due to higher interest rates, not from bad credit quality.

SVB’s concentration in the venture community was significant as SVB claimed to bank nearly half of all US venture-backed technology and life sciences startups.¹ Pressures on deposit withdrawals for SVB mounted over the past year as startups suffered elevated cash burn rates due to a sharp slowdown in public and private capital markets (especially for high growth companies) and a more challenging economic environment. This loss in deposits is anecdotal evidence of the concern we highlighted in our First Quarter 2022 Insight discussing the risks ahead for higher risk companies in a rising interest rate environment.

SVB’s mismatch of short-term liabilities and long-term assets in a period of rising interest rates compounded pressure from deposit withdrawals. This risk is present in all banks but may have been more pronounced at SVB. By choosing to hold a larger amount of longer-term Treasury and mortgage debt, which are very sensitive to interest rate changes, SVB losses were stacking up as interest rates moved sharply higher over the past year. To meet increased withdrawal demand, SVB was forced to realize losses on long-term assets that were otherwise good quality if held to maturity.

The catalyst for the bank run occurred Wednesday, March 8 when SVB disclosed a $1.8 billion loss alongside potential plans to replenish capital. At the same time, Moody’s credit downgrade made clients and investors increasingly nervous. Within 40 hours of disclosing the loss, the planned $2.25 billion equity offering was scrapped, and the share price fell 60% before trading was halted and the FDIC announced the closure before noon on Friday.

Exacerbating the bank run scenario, SVB’s large reliance on institutional and specifically venture deposits proved fatal as the closely connected community rapidly removed capital as several prominent venture investors instructed portfolio companies to withdraw excess deposits. On Thursday alone, the bank’s clients tried to withdraw $42 billion.

What happens now?

On Friday, California’s banking regulators shut down SVB and put it into receivership under the Federal Deposit Insurance Corp (FDIC). To protect the depositors, the FDIC created the Deposit Insurance National Bank of Santa Clara. For depositors, the FDIC has indicated insured deposits (less than $250k) would be available Monday.

However, on Sunday, the Federal Reserve announcement stated all deposits, insured and uninsured, will be available to depositors on Monday. The announcement also states, “no losses associated with the resolution of Silicon Valley Bank will be borne by the taxpayer.” SVB’s uninsured deposits have been estimated at $150 billion or more of their $175 billion of deposits.²

The details of making all assets available to depositors will become clear over time. Adjusting the assets at fair market value seems sufficient to cover existing liabilities. Additionally, SVB’s asset portfolio was generally high quality with over 60% of assets comprised of cash, US Treasury and Agency-backed debt and roughly 70% of their loans were internally rated as having lower credit loss profile.³

Over the next few days, it’s possible the FDIC finds a buyer for SVB which would provide the least disruptive outcome. Although the bank’s assets are attractive, the speed of the collapse coupled with unexpected large liabilities from previous acquisitions during the financial crisis may make any potential buyers apprehensive.

Contagion risk

Many believe SVB’s collapse will prove to be an isolated development given their high concentration of venture clients and the surge of deposits that occurred from those clients over the past three years as venture investment thrived. Many of those deposits were in turn funneled into purchases of intermediate and long-term bonds which, at that time, offered historically low interest rates.

To a large extent, this outlier view can also be supported by examining Tier 1 Capital ratios for SVB compared to other larger national and regional banks. Tier 1 Capital is often referred to as “going concern” risk and represents how much equity is available to absorb losses. For the small subset of banks we reviewed, Tier 1 ratios ranged between 9-12% versus the 6% regulatory minimum. However, when adjusting for unrealized losses on securities, the ratios drop to between 5-10% for all banks except SVB which drops to roughly zero.⁴

So, a good case can be made that SVB was in fact an outlier in terms of deposit risk, interest rate risk and adjusted capital ratios compared to other banks. That said, we know from prior experience that all banks are vulnerable to run risk, so additional outcomes will hinge more on what investors and depositors believe to be true.

Collectively, we believe the U.S. banking system is in very good condition largely because of more stringent financial crisis-era regulations. Since 2008, U.S. bank capital ratios increased 35% while loan-to-deposit ratios dropped by 40%.³ Additionally, during the financial crisis where bad assets gave rise to an estimated $1 trillion in banking losses, leaving many banks meaningfully under-capitalized, only 5% of all U.S. banks failed.⁵

While the FDIC reports today that banks have unrealized losses on securities of roughly $620 billion, those securities are higher quality and the loan portfolios are largely performing, which means they will continue to pay interest and principal which is a material difference. It’s important to stress these unrealized losses result from changes in interest rates, not the poor credit quality witnessed during the Global Financial Crisis.

Unsurprisingly, the market was unconvinced last week as the S&P 500 declined roughly 5% for the week led lower by the Dow Jones Regional Bank Index which posted losses of 18% over the past five days. In general, smaller regional banks with a less diversified deposit base, a disproportionately large amount of long-term assets, a high percentage of loans to deposits and especially those with crypto-related activity will likely be under continued scrutiny in the weeks ahead.

On the other hand, larger institutions, those deemed Global Systemically Important Banks are much less likely to incur material market skepticism in our view given their heightened capital supervisory requirements and larger loss absorbing capacity. Toward the end of last week, markets began to differentiate these fundamentals which is a positive, albeit early, sign.

Fed’s job is likely more complicated

Inflation has proved stickier than expected, consequently the Fed has moved aggressively to recalibrate monetary policy and, up until now, the consequences have been mostly manageable with falling asset prices, slowing auto and housing industries, softening wage growth and rates of inflation gradually subsiding.

Given SVB’s failure and related market developments, the Fed is challenged to manage inflation risk without substantially impairing the overall health of the banking sector. In our view, the best way for the Fed to resolve both issues is to remain committed to stamping out inflation. Barring large market dislocations, the Fed will likely continue raising short-term rates but in a much more measured way to further slow the economy, weaken inflation pressures and anchor long-term inflation expectations.

In turn, this should keep long-term rates from moving appreciably higher which should help prevent further write-downs on bank balance sheets. The quicker the inflation problem is managed the better, but it will take time to understand the implications more fully for credit and lending.

¹Strategic Actions/Q1’23 Mid-Quarter Update. Silicon Valley Bank March 8, 2023.
²Federal Deposit Insurance Company. December 2022.
³Strategic Actions/Q1’23 Mid-Quarter Update. Silicon Valley Bank March 8, 2023.
⁴Eye on the Market. JP Morgan Q4 2022 March 10, 2023.
⁵FDIC Resolution Tasks and Approaches. FDIC Staff Studies June 2020.