Silicon Valley Bank is bust. With $212bn in assets and a market capitalisation of $16bn as recently as Wednesday, it is by far the biggest bank failure since the global financial crisis. SVB is worlds away from Silvergate, the tiny crypto-bank that announced plans to wind down this week. Silvergate had just $11bn in assets and operated in finance’s toy section. SVB was a real bank and its collapse will have real economic consequences.
It is crucial to understand what those consequences are likely to be, rather than equating its failure with the bad lending, inadequate capital and hidden interdependencies that characterised the systemic crisis in 2008.
SVB’s problems began with the investment boom that followed the start of the coronavirus pandemic. As the go-to bank for California venture capitalists and start-ups, it was flooded with billions of deposits from young companies flush with investors’ cash. There was so much money — almost $130bn in new deposits in 2020 and 2021 — that SVB could not lend it all out. Instead, they invested much of the money in long-term US government-backed bonds. The bonds have no credit risk, and because SVB’s deposits cost almost nothing, they were profitable, too, despite paying only a few percentage points of interest.
But this balance sheet structure could only work while rates remained low. As the Federal Reserve battled inflation and rates rose, deposits became more expensive. In just the past year, SVB’s deposit costs rose from 0.14 per cent to 2.33 per cent. Meanwhile, the yields on its long government bonds didn’t budge. A profit squeeze was looming.
The bank planned to solve the problem by selling some long-term bonds and reinvesting at shorter maturities and higher yields. The losses such a sale would crystallise would be repaired with new equity. But investors and depositors did not wait to see if the plan would work. SVB shares and bonds sold off on Thursday. The same day, depositors rushed to pull their money — to the amount of $42bn in just 24 hours — forcing the Federal Deposit Insurance Corporation to step in.
In the past few years, plenty of other banks received waves of deposits and put the money to work in long bonds. Might they face the same fate as SVB? Possibly, but SVB was an outlier in the banking industry, in three ways: its deposits were unusually sensitive to interest rates; its assets were unusually insensitive; and its client base was unique.
A recent report from RBC Capital Markets ranked the 100 largest US banks in terms of various balance-sheet characteristics. SVB was 99th in the proportion of its deposits that were under $250,000, at less than 3 per cent. That is significant because large business depositors such as SVB’s are extremely price sensitive. They demand more interest as soon as they see rates rise. Small retail depositors don’t bother. Hence the immediate pressure on SVB’s margins. On the proportion of total bank assets held in securities, on the other hand, SVB was first, at 55 per cent. Most banks own lots of floating rate loans that pay more when rates rise. Not SVB.
Finally, SVB’s clients were creatures of low rates, too. When Fed policy was accommodative and the VC money was flowing, start-ups were confident and flush with cash. Higher rates and the tech sell-off has changed all that, leaving young companies jumpy and tight with their money. When Bloomberg reported on Thursday that Founders Fund, the prominent VC fund, was recommending its companies pull their money out of SVB, that may have sealed the bank’s fate.
Other banks’ portfolios of long-term government bonds will be a drag on margins for years to come. That was largely understood by analysts and investors before SVB fell apart, however. Still, its failure may have changed things in the banking system. After SVB’s demise, depositors, their confidence shaken, may demand more interest for their deposits, squeezing banks’ margins. But this is a profitability problem, rather than a threat to solvency in the style of the 2008 crisis.
It has been widely noted that this week’s events were the consequence of years of very low rates. So they were. In a more normal rate environment, banks would not have extended the duration of their bond portfolios in a search for yield. If banks now have to become more conservative to protect their balance sheets, that will have consequences for credit creation and the economy.
The risk of contagion within the banking system appears to be limited. But at the end of every central bank rate-increase cycle, there comes a phase where things in the financial system begin to break. These breakages, minor or major, erode the confidence of investors and consumers, increasing the odds of recessions. The failure of SVB does not herald another 2008, but it does mark the beginning of the breakage phase.
Read the full article here