Declines in the stock market and a deterioration in sentiment in recent days were partially due to sharp banking sector declines this week. These stemmed from worries over what started as capital crisis in a couple of specific California banks (SVB Financial/Silicon Valley Bank and Silvergate), ending their failures within a few days. While Silvergate represented a fairly small market cap of under $100 mil., with under $4 bil. in customer deposits, SVB had a market cap of over $6 bil., putting it in mid-cap stock territory, and, with over $200 bil. in assets, now represents the largest bank failure since Washington Mutual during the 2008 financial crisis. For SVB, the rapid decline over a 48-hour period was exacerbated by corporate clients withdrawing funds at a frantic pace, resulting in the inability of the bank to raise capital and/or find a suitable buyer. More importantly, it raised fears over the prospect of wider banking sector issues, particularly as the U.S. treasury yield curve remains inverted. At the same time, there were increased calls for a government bailout of some sort for SVB, particularly because of the focused venture capital clientele, particularly in technology and health care, where a failure and asset loss could put a dent in U.S. innovation. This appears dramatic from the terms of a single bank, but again points to the idiosyncratic nature of these types of events.
In these situations, as is often the case with bank capital problems, issues surrounding risk control appeared to lead to an erosion of capital, although we may still find out more. Bank insolvency happens when assets dip below liabilities; essentially the bank is ‘bankrupt’. As loans are bank assets, lending defaults are a fast and sure way to problems, as are changes in asset values from other causes. For SVB, it wasn’t credit per se, but appeared to be bets on the treasury yield curve gone wrong due to changing interest rates and embedded duration risk of long-dated treasury bonds (pulling down asset market values). For Silvergate, which catered to digital asset lending, it was the recent collapse in cryptocurrency prices, presumably backing those loans (also pulling asset levels down). Mortgage quality issues during the Great Recession led to more stringent regulations regarding heftier bank capital levels, which in theory help to reduce these failure risks, and have appeared to work since that time, with banks generally running at the strongest capital levels in decades.
An inverted curve creates challenges for bank financing the longer it lasts. Aside from the current case, this is particularly true for smaller local banks with simpler depositor/lender operations and who tend to use fewer tools (like securities and derivatives) to manage and diversify risks. In a very simple banking model, the only assets are loans, such as 30-year fixed rate mortgages (paying upwards of 7% today, but many still on the books with rates as low as 3%). These have to be balanced on the liability side with variable-rate deposits (tied to short-term rates, where yields were 0% for years but have been rising due to competitive pressures). The differential between the asset-liability rates is a good portion of ‘net interest margin’ and has been increasingly squeezed as rates on both sides of the balance sheet converge. That differential must be also large enough to pay for the bank’s operations, such as real estate costs and salaries, let alone a profit and dividends to shareholders. Treasury curve inversions have tended to not last long for this reason—it makes traditional banking untenable.
Banking at its core is about stability and confidence, with a fear of bank runs (as seen in vintage photos of customers standing in line to close accounts before the money runs out), representing a key and persistent business risk over the centuries. During the Great Depression in the 1930’s, fear of and actual runs led to the creation of FDIC insurance (with the limit now at $250,000), which has worked well in backstopping bank run risk. Broadly, this is risk-sharing, by offloading potential customer losses away from the single bank (with increasingly limited funds) toward the U.S. government (with theoretically unlimited funds). The thought at the time was that confidence in the financial ‘system’ as a whole would also trickle down to that for individual banks, which it largely has, at least for individual depositors. However, corporate customers with deposits over the limit may be in a more precarious position. Private insurance or other asset backing may play into this as well, but that remains an issue to be hashed out.
However, while some customer bank assets are protected, banks can and will still fail, and a variety of smaller banks do fail every year for different reasons. Almost exclusively, failure tends to be from issues with lending quality/defaults (often due to sector, region, borrower concentration, or backed by volatile collateral), excessive financial risk-taking with other assets, management oversight problems, or outright fraud in some cases. Accounts and operations are often then merged into those of another bank, usually a local operator, as facilitated by the FDIC. Aside from some extra paperwork, this can be relatively seamless for FDIC-insured customers, but bondholders certainly fare worse, and equity shareholders worse yet.
At the same time, it’s important not to minimize issues caused by mismatches in financing. The savings and loan crisis in the 1980s saw a catalyst in the Paul Volcker Fed era of raising short-term treasury rates sharply to combat inflation, while longer-term loan assets were stuck at lower rate levels from the 1960s and 1970s. However, there were differences, with S&L’s at the time being far less regulated than commercial banks, along with further deregulation, many examples of extreme risk-taking (such as in the new market for junk bonds), and basic fraud. No doubt, the Federal Reserve is aware of this history and an important part of their job is bank regulation. Banks are less dependent on single funding sources as in the past, but adds a layer of complexity when handing the side effects of interest rate policy vs. battling inflation.
Ryan M. Long, CFA
Director of Investments
FocusPoint Solutions, Inc.