On Friday, March 10, 2023 Silicon Valley Bank’s doors were abruptly shut after a run on the bank’s assets by depositors. What occurred, as well as the underlying causes, have immense implications for the banking sector and the economy as a whole.
Silicon Valley Bank (SVB) focused on venture capital (VC) and other tech & healthcare startups, claiming almost half of those companies as customers. It managed to secure that niche by providing favorable deposit and loan conditions and personal services (such as mortgages for key personnel) to industry participants. In exchange it required those customers to utilize SVB for all of their deposits.
As low interest rates fueled the tech boom allowing VC companies to raise billions of dollars for their clients, SVB reaped the rewards. By the end of the 1st quarter of 2022, deposits at SVB rose to $198 billion up from $42 billion three years earlier, making SVB the 16th largest bank in the country. But as inflation accelerated in 2022 and interest rates rose, these same VC and tech companies were unable to raise more capital. As a result, they relied on their cash reserves at banks to fund operations. SVB’s deposits consequentially fell to $173 billion by year end.
This decline in deposits impacted SVB significantly for several reasons. First, deposits represented 89% of SVB’s liabilities. Banks typically have a greater percentage of other liabilities such as long-term debt which is less subject to immediate withdrawal. In effect, the duration of SVB’s liabilities was extremely short, and the bank was dependent on customers retaining their deposits at the bank.
“The duration of SVB’s liabilities was extremely short, and the bank was dependent on customers retaining their deposits at the bank.”
But what did SVB do with that deposit money? First, they didn’t invest in risky assets from a credit standpoint. The funds were invested largely in U.S. Treasuries, U.S. Agencies, and U.S. Agency mortgage securities. But that’s not the only kind of risk. Instead of investing in instruments with short maturities – thereby making sure they had the funds if customers pulled their deposits – SVB to an overwhelming extent invested in assets with long maturities.
A little explanation is needed. Banks classify their investments as either Available for Sale (AFS) or Held to Maturity (HTM). Because banks may sell their AFS investments prior to maturity, the holding value is adjusted with changes in market prices; and the resulting gain or loss flows through the financial statements. HTM investments, on the other hand, are not adjusted for market prices on the theory that they will never be sold until they mature; and that market fluctuations shouldn’t impact bank capital or net worth. At year end 2022, SVB classified $91.3 billion of investments as HTM, a disproportionate share of its investment portfolio according to industry norms. Further, $4.5 billion of those investments had maturities between five and ten years and $86.0 billion had maturities in excess of 10 years.
The problem becomes apparent when one realizes that when interest rates rise, as they did in 2022, fixed income prices fall in response. As a result, SVB had $15.1 billion in losses in their investment portfolio at year end that was not reflected in its net worth. This unrecognized loss compares to a net worth of $16.3 billion at year end.
So let’s move on to the chain of events that occurred beginning Wednesday, March 8, 2023. That day SVB’s stock price closed at $267.83. After the close SVB announced that since year end it had sold $21 billion in assets at a loss of $1.9 billion after tax to fund withdrawals by depositors. To make up for the loss, the company said it would raise $2.25 billion in fresh capital. Complicating matters was that same day another bank, Silvergate Capital, largely serving the crypto currency industry, announced it would wind down its bank after selling off investments at a loss to meet depositor withdrawals.
The market was spooked, and the stock reacted negatively to the news. On Thursday the stock plunged while VC investors pulled their funds from the bank and advised their associated companies to withdraw their funds. On that day depositors attempted to withdraw $42 billion, which the bank couldn’t readily satisfy, and the stock closed at $106.04. The stock never opened on Friday, March 10, and the bank was placed into receivership under the FDIC.
Meanwhile, on Friday another bank, Signature Bank in New York ran into trouble. Signature Bank largely served the construction industry but had a side niche in crypto currency. Construction industry depositors became nervous as a result of Silvergate and SVB, and outflows that day totaled 20% of deposits.
On Sunday March 12, Signature Bank was also placed into receivership under the FDIC. While FDIC insurance only covers the first $250,000 of a depositor’s funds, all deposits at Signature and SVB will be covered by FDIC insurance as the “systematic risk exception” has been invoked by the government. Since then we’ve seen Credit Suisse in Europe and First Republic Bank in the U.S. teeter, though for now efforts to shore up their finances seem to be holding.
SVB’s issues seem to have been two-fold. First, they concentrated on one sector and were subject to the vagaries of that sector. This is not uncommon, especially among regional banks. More fundamentally, however, there was a mismatch between their assets and liabilities. Deposits are subject to immediate withdrawal, but SVB’s assets were invested in long-term instruments subject to market fluctuation. This too is not uncommon, as the FDIC reported that as of year-end the banking sector has $620 billion in unrecognized losses – largely as a result of interest rate movements.
“SVB concentrated on one sector and were subject to the vagaries of that sector… More fundamentally, there was a mismatch between assets and liabilities.”
So SVB may be just the tip of the iceberg. Remarkably, while banking regulations encourage investments in government securities for safety reasons, they do not consider interest rate risk when evaluating bank capital. While this may bring up images of 2007 and 2008, there is a significant difference. The prior financial crisis was an issue of credit quality. When institutions sold off their investments to raise capital, this drove down the price of risky assets in general making institutions’ remaining investments less valuable. This became a vicious cycle that eventually claimed such firms as AIG. In 2023, these banking issues are driving investors to bid up the price of Treasuries and other safe assets. An ironic result is underlying unrecognized losses are diminishing. We are not out of the woods. Bank runs have the potential to derail the economy but declines in asset quality are much less of an issue today.
This crisis puts the Fed in a quandary. After years of artificially depressing interest rates, in the last year it has driven up interest rates signaling its intentions to do so further in an attempt to slow the economy and tame inflation. Certain institutions, and perhaps sectors, are not prepared for the stress of rising interest rates. Pursuing this strategy further might lead to a full-blown financial crisis.
Ironically, SVB and the related issues may cause financial institutions, industry, and perhaps even consumers to become more cautious. This may result in the slowing of demand which the Fed has been attempting to affect. We think the Fed will slow, if not halt, the pace of interest rate increases. Economic growth will probably not be as robust as we had expected just a short while ago. For the time being we expect interest rates to ease.
“The twin impacts of slowing growth and lower interest rates than originally expected will impact valuations in the stock market – with the former acting as a brake and the latter acting as a positive force.”
They say in economics there’s no such thing as a free lunch. We’re now beginning to feel the cost of years of overspending by the government combined with artificially low interest rates. Stay tuned!
Stephen J. Fauer, CFA
Chief Investment Officer
Past performance does not guarantee future results. Pinnacle Capital Management is an SEC Registered Investment Advisor and proud member of the Pinnacle Family of Companies, an organization designed to provide a full range of financial solutions to individuals, businesses, and institutions. For more information on our member companies, visit PinnacleHoldingCo.com. Opinions are our own and do not constitute financial advice. Talk to your financial professional for any advice specific to your situation.