Editors’ Note: MarketMinder Europe doesn’t make individual security recommendations. The below merely represent a broader theme we wish to highlight.
One week after American regional financial firm Silicon Valley Bank (SIVB) first roiled markets with plans to raise capital and book big losses on its US Treasury bond portfolio, talk of a banking crisis hasn’t died down. SIVB officially failed Friday, when the US’s Federal Deposit Insurance Corporation (FDIC) took over.[i] Another regional bank, Signature Bank, followed suit Saturday.[ii] On Sunday, the Federal Reserve (Fed) pumped liquidity to smaller regional banks and guaranteed all SIVB and Signature deposits above the FDIC’s $250,000 deposit insurance ceiling (£206,250).[iii] But talk of contagion and the hunt for the next domino to fall continued, sending US bank stocks sharply lower this week.[iv] But our research suggests the American banking system is overall quite healthy, and we think this storm too should pass before long, with stocks likely rebounding faster than most commentators we follow deem possible now.
Very few commentators we follow argue the failures of SIVB and Signature alone will cause a deep downturn. Though described as the second- and third-largest bank failures in history, this is accurate only if you don’t adjust for inflation or scale relative to the size of the economy.[v] Great Depression-era failures were far, far larger once you do these maths.[vi] No, the main item on the world’s radar now is contagion—the potential for bank runs to spread to other similarly sized institutions, culminating in a national or even global financial meltdown. Tellingly, smaller regional banks have taken a disproportionately large hit over the last week, and credit ratings agency Moody’s put six on notice for a potential downgrade.[vii] Deposits are reportedly fleeing for the four largest, so-called too big to fail US banks.[viii]
In our view, this narrative glosses over a couple of important factors. One: The US banking system is extremely well capitalised: Tier 1 capital—the highest-quality buffer—is well above regulatory minimums and significantly above its level before 2007 – 2009’s global financial crisis.[ix] Meanwhile, loan-to-deposit ratios are below pretty much any point in the last 50 years, showing banks have far greater capability to meet withdrawal requests without dumping illiquid assets than many commentators we follow are giving them credit for now.[x] Smaller banks do have less cash as a percentage of total assets than large banks, but the Fed’s new liquidity programme appears aimed at helping with this.[xi]
Two, SIVB and Signature Bank have very little in common with the broader regional banking system. Signature ballooned on the cryptocurrency industry, putting it in hot water after crypto crashed.[xii] SIVB was largely created by the venture capital (VC) world to serve the VC world—the funds and partners as well as their portfolio companies and their employees, customers and friends.[xiii] Many funding deals included banking with SIVB as a condition.[xiv] We think that structure, not simply being a midsized regional bank, brought it down. It meant SIVB was overly exposed to Tech and Tech-like companies—particularly the younger ones that burned through cash at faster rates because their client base wasn’t large enough to support operations with sales revenues. As the startup world hit tough sledding last year, these companies reportedly drew down cash reserves to continue funding operations. Meanwhile, the US Treasury bonds on SIVB’s balance sheet fell in value as interest rates rose, eroding its capital.[xv] That culminated in the planned capital raise, which might have worked had the VCs not told their portfolio companies to pull their money before everyone else did.[xvi] It all turned into a very rapid, sudden run on SIVB’s deposits. And with the bonds on its balance sheet down tied to rising rates, the company needed capital pretty desperately.
But don’t other banks own Treasury bonds? Yes. But we think there are caveats to this. For one, SIVB carried an unusually high percentage of its assets in fixed-rate, longer-term securities, making it particularly exposed to rising rates.[xvii] We think this is where accounting rules come into play. Banks can designate assets as either Available for Sale (AFS) or Hold to Maturity (HTM). AFS is for the most liquid assets—those banks can sell to meet cash needs. Hence, they are marked to the most recently observed market value. HTM is for the less liquid, harder to value assets that banks don’t intend to sell and are therefore at less risk of realising losses on. Therefore, they are no longer marked to market for regulatory capital purposes. This is in contrast to 2008, when then-prevailing rules dictated that even illiquid assets banks had no intent of trading had to be marked to market. As long-term interest rates rise and Treasury bond values fall, banks can move holdings from AFS to HTM to avoid the mark-to-market capital hit. Doing so is a tradeoff, since it sacrifices liquidity, but most banks had enough of a cushion to do it.[xviii] SIVB didn’t, leading to last week’s announcement that it would firesale over $20 billion (£16.5 billion) worth of Treasurys at a $1.8 billion (£1.5 billion) loss.[xix]
Despite SIVB and Signature Bank’s unique issues, we aren’t ruling out the possibility of more American bank failures. Bank runs are psychological events, and sometimes rumours trump reason. The Fed also seemed to us to sow more chaos than confidence. The decision to bail out uninsured deposits will likely reverberate for years to come and could be a watershed moment. But in the very short term, whilst easing fears of startups (strangely, in our view, and suddenly cast as local small businesses rather than companies with several dozen employees and bigtime venture funding) not making payroll this week, it creates the presumption amongst market participants that the Fed and Treasury will guarantee uninsured deposits at any other failed institution. They claimed their move won’t cost taxpayers a cent, and the largest banks will pay for it via a special surcharge.[xx] But in our experience, banks tend to pass these things on to customers.
As for the Fed’s liquidity programme, its structure seems beneficial enough to us. It lets banks get short-term loans using their AFS portfolios as collateral—but at the securities’ par values (meaning their value at issuance or maturity), not market values. We interpret this to mean banks can convert their AFS portfolios to cash without selling and taking losses. In theory, it can help bridge any gaps that arise. But whenever the Fed creates new programmes like this, based on our study of the market’s reactions and relevant financial commentary, we find it often gives the impression that they see a massive problem, which can heighten panic. That seemed to us to be at play this week. If that continues, deposits keep fleeing and a few more banks go under, the fear factor could linger. Lending could also take a hit if banks decide a dollar in reserve is better than a dollar lent, so we will be watching US loan growth data closely as they come out each week. Furthermore, we think the response here raises the question once again about how regulators approach banks that encounter trouble. Post-2008 financial regulations in the US and globally were intended to fix this, but alas, that doesn’t seem to have happened. Already we have seen calls for more regulation—which could create uncertainty. We are monitoring that aspect of the story closely.
In the very near term, volatility could persist—both to the downside and upside. But whether or not a new market low lies ahead, the conditions seem ripe to us for a new bull market. Pessimism reigns, based on the tenor of most commentary. Most banks are in excellent shape, as we explained, and the system has abundant liquidity to enable the stronger many to absorb the troubled few. Reacting to the latest troubles and recent returns means locking in those drawdowns and reducing exposure to the inevitable recovery. Discipline and patience will likely win out in the end, in our view.
[i] “A Timeline of the Silicon Valley Bank Collapse,” Max Zahn, Associated Press, 14/3/2023.
[iii] Source: Federal Reserve, as of 15/3/2023.
[iv] Source: FactSet, as of 15/3/2023. Statement based on S&P 500 Banks industry total returns in USD, 8/3/2023 – 15/3/2023. Currency fluctuations between the dollar and pound may result in higher or lower investment returns.
[v] Source: Company filings, as of 15/3/2023.
[vi] Source: Company filings and US Bureau of Economic Analysis, as of 15/3/2023. Economic size is based on gross domestic product, which is a government-produced measure of economic output.
[vii] “Moody’s Cuts Outlook on US Banking System to Negative, Citing ‘Rapidly Deteriorating Operating Environment,’” Jeff Cox, CNBC, 14/3/2023. Additional Source: FactSet, as of 15/3/2023. Statement based on S&P 500 Banks industry constituents’ price returns in USD, 8/3/2023 – 15/3/2023. Currency fluctuations between the dollar and pound may result in higher or lower investment returns.
[viii] “Too-Big-To-Fail US Lenders Rake In Deposits After Three Banks Fail,” Staff, Bloomberg, 14/3/2023. Accessed via Business Standard.
[ix] Source: FactSet and Federal Reserve, as of 15/3/2023.
[x] Source: Federal Reserve Bank of St. Louis, as of 15/3/2023.
[xi] Source: Federal Reserve, as of 15/3/2023.
[xii] See Note i.
[xiii] “Here’s How the Second-Biggest Bank Collapse in US History Happened in Just 48 Hours,” Hugh Son, CNBC, 10/3/2023.
[xiv] “Silicon Valley Bank Signed Exclusive Banking Deals With Some Clients, Leaving Them Unable to Diversify,” Rohan Goswami, CNBC, 13/3/2023.
[xv] Source: FactSet, as of 15/3/2023. Statement based on 10-year US Treasury yields, 31/12/2021 – 10/3/2023.
[xvi] “Venture Capitalists Urge Startups to Withdraw Funds From Crisis-Laden Silicon Valley Bank,” Ryan Browne and Hugh Son, CNBC, 10/3/2023.
[xvii] “SVB Is Not a Canary in the Banking Coal Mine,” Robert Armstrong, Financial Times, 15/3/2023. Accessed via World News Era.
[xviii] Source: Fisher Investments research and company filings, as of 15/3/2023.
[xix] See Note i.
[xx] Source: Federal Reserve, as of 15/3/2023.
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