The closing of three financial institutions in the past week has sent a sense of crisis through the financial world. Deposits are insured at FDIC institutions up to $250,000. Some accounts are many times this number. Venture capitalists (VCs) typically deposit in the hundreds of millions into banks, to be withdrawn as the funds are utilized. This was especially true of Silicon Valley Bank (SVB), a forty-year-old institution that made a name for itself catering to start ups and VC clients.
SVB at last report had $211 billion in deposits. This was offset with a combination of loans to various firms and purchases of US Treasury securities. As interest rates climbed and customers drew down their balances, the bank needed more funds to meet withdrawals. The problem was the Treasury investments had gone down in value. SVB was advised by Goldman Sachs to sell off part of its bond portfolio at a loss to raise funds to meet customer withdrawals. This generated a $1.8 billion loss on a portfolio sale of $20 billion. In anticipation of this, Goldman also was arranging a stock sale to replenish the bank’s capital to replace the $1.8 billion.
After the bond portfolio loss was made public the stock sale did not take place. There was a run on the bank as depositors demanded their funds. The bank could not liquidate assets, including loans, fast enough to meet the demand for deposits. The FDIC shut down the bank and took them over. Their stock, which peaked at over $700 a share in 2019, is now worthless. Goldman, who bought the bonds from the bank, made $100 million on the trade as interest rates declined with the government intervention. The speed of the bank’s fall is a product of the communications evolution they in part financed. The reasons are as old as banking itself.
Banks fail for three reasons. The first is liquidity risk. Banks by nature take in deposits to make loans of some duration (usually three months to eight years). As interest rates rise, banks often cannot keep up with competition for interest rates on short-term funds. This is especially true of retail banks whose overhead in the form of branches, staff, etc. adds to their cost of operation. They normally pay this cost through obtaining deposits at low or no cost through the branches. As people go online and find higher yields, banks suffer outflows of funds which impacts their liquidity.
The second reason is interest rate risk. In addition to the liquidity issues above, rising interest rates threaten banks who cannot raise their loan revenues in tandem with higher cost of funds. In times of low loan demand banks buy Treasury securities to make something off the deposits. If a bank incorrectly forecast interest rates, it could wind up (as SVB did) with losses on its bond purchases. These losses are sometimes not recorded on the assumption that the bonds will be held to maturity and will thus return to face value. However, if the bank needs to sell the bonds prior to maturity, the loss is recognized and charged against the capital of the institution.
The third risk is systemic risk. This is the risk that a bank failure will trigger other bank closings. The poster child for this is the banking system in 1929, when regulators let banks go under until the situation got out of control. This caused a severe recession to become the Great Depression.
The FDIC moved in and guaranteed all deposits of SVB regardless of size to ensure that there would not be a bank panic. They did this because they saw the bank’s demise as systemic. This was a bit ironic, as laws passed in 2018 increased the size of a bank considered systemic from $50 billion in deposits to $250 billion. At $212 billion, SVB was exempt. This law was passed at the behest of the regional banking lobby. Their members resented being put under the same regulatory burden as larger banks. At the same time, lobbyists reduced the amount of funds allocated to bank exams and compliance. Reducing enforcement of bank rules has the same effect as reducing IRS enforcement. SVB had no Chief Risk Officer for most of 2022. As a non-systemic bank, the role was not required.
As normal in such a situation, there is a great deal of finger pointing. At minimum, the size limit for systemic banks will be reduced, perhaps back to $50 billion. The enforcement arm of the FDIC will be funded. At this writing, there does not appear to be major losses in the SVB loan portfolio beyond the bonds. Thus, the cost to the taxpayers will be minimal. Stockholders will be wiped out. Life will go on.
The yin and yang of having regulations established in response to a crisis, only to be repealed some time later and then resurrected in the next crisis needs to stop. Regulations are written for a reason. While regulations need to be reviewed and revised periodically, this business of repeatedly closing the barn door after the horse escapes is crazy. It does nothing to build confidence in our banking system or the branch of government that oversees the same. Without the credit provided by banks, the economy grinds to a halt.
The demise of SVB has exposed the issues surrounding banking. Higher interest rates have led to deposit outflows, while static loan rates pressure profit margins on loans. Neither issue will be resolved soon. Banks that exist online with few or no branches will have a cost of funds advantage. That makes other lenders problematic.
The Economy
Economic activity continues apace. While corporate profits are being squeezed by higher expenses, especially for labor, revenues continue for most firms to be going up. New home construction has had the greatest gain in two years.
One area to watch is the fall of the dollar. If the dollar continues to depreciate relative to foreign currencies, expect greater demand for goods made domestically. The constraint is the size of the workforce. The semiconductor industry has already said they cannot find the workers necessary to staff the new chip manufacturing plants, which are supposed to cost over $100 billion to build.
Inflation
Overlooked in the bank crisis is the fact that inflation, while down, is nowhere near the two percent rate banked on by the Federal Reserve. The best readings are around five percent currently. While this is down, it is not down enough to satisfy the Fed.
A falling dollar will create another round of inflation, as imported goods will cost more to buy. Some people say the SVB implosion is shaking people’s confidence in the dollar as a world currency. Such a loss of faith can be inflationary as well.
Interest Rates
Pressure is being put on the Fed to pause the increases in the Fed Funds rate as a way of helping the banks. With inflation still running hot, this probably will not happen.
Other banks should not expect the SVB treatment should they find themselves in trouble. Smaller banks in particular will continue under pressure, and all depositors should not expect to be made whole with every bank insolvency. There is about $1 trillion in bank deposits not covered by FDIC insurance due to their being more than the $250,000 limit.
The Stock Market
Stocks will rebound from the declines caused by the bank crisis. Aside from crypto investments, most sectors should do better going forward, at least in the short run.
Once the sense of crisis has passed, the stock market will be faced with the same headwinds it had before the banks took over the headlines. Interest rates are going up. The labor force is not equal to the opportunities available. Business will be better in terms of revenues, but costs will be hard to contain. Profit growth will be difficult to come by.
The pressure of higher interest rates will continue to assert itself. As consumers find outlets that provide 4-5 percent return on their cash, the case for long-term bond investing will be wanting unless long-term interest rates materially exceed that.
Stocks will depend on the situation. With the demise of SVB, a prop for the tech sector has been removed. Expect the transition away from growth to value to continue.
Warren M. Barnett, CFA
March 20, 2023
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