Silicon Valley Bank and the Regional Bank Crisis
Christopher Bowlby - Mar 15, 2023
In the last week, Silicon Valley Bank (SVB) has gone from being a small regional bank in northern California to the epicentre of a liquidity crisis that has been thrust into the forefront of macroeconomic issues.
Silicon Valley Bank and the Regional Bank Crisis
In the last week, Silicon Valley Bank (SVB) has gone from being a small regional bank in northern California to the epicentre of a liquidity crisis that has been thrust into the forefront of macroeconomic issues. To many Canadians, SVB was not a household name before last week. The US banking system is quite different than that of the Canadian marketplace, where there are many smaller regional banks across the country to go along with the large Multinationals such as JP Morgan, Citigroup, Bank of America, etc. There are a few regional banks in Canada, such as Canadian Western Bank and Laurentian Bank. In the US, many smaller regional banks have grown significantly in size. One of the largest beneficiaries of the floor of capital to technology and Silicon Valley was SVB. Since the beginning of the pandemic, deposits at SVB increased from $60B to $200B by the end of the first quarter of 2022.
SVB started in 1983, and with its close ties to business in the valley and fostering relationships with Venture Capitalists saw their deposit balance grow significantly in recent years. With a large influx of deposits, historically low-interest rates and insufficient loan demand to match deposits, the bank invested deposits in low-risk securities such as Treasury Bills, Mortgage-Backed Securities, etc., to earn a return on assets, a practice that is very standard across the banking sector. With the increase in deposits, so did SVB’s asset portfolio, ballooning from $27B in the first quarter of 2020 to $128B by the end of 2021. This asset portfolio averaged a yield of 1.79%, while 10-year Treasuries yielded 3.9% last week.
SVB had a unique balance sheet as approximately 97% of their deposits were uninsured, meaning over the $250,000 threshold for FDIC insured, due to many companies in the valley parking their cash at SVB.
Last Thursday, SVB had a bank run of approximately $42B in one day, traced back to an influential newsletter in the valley called The Diff, by Byrne Hobart, read extensively by the Venture Capital community. With his analysis in February and March, Byrne concluded that due to the rise of interest rates by the Federal Reserve to combat inflation, the fixed-income portfolio of SVB was facing significant unrealized losses that were not reported on the balance sheet as banks are not required to mark assets to market because as long as they have deposits, they can hold assets until maturity and the fixed income can mature at par value. This lack of mark-to-market accounting is due to the general belief of going concerns that banks do not margin called by their depositors and that it would take a massive run on deposits to financially impair a financial institution of SVB’s size.
Due to the nature of SVB’s business and a majority of their deposits coming from a handful of large investors, who are mainly smaller cash-burning start-ups in technology and healthcare, and an outsized asset book which mostly grew during a period of historically low-interest rates, SVB was primed for the disaster that ensued.
Once the newsletter was digested by Venture Capital managers and due to the massive shift in culture in technology stemming from a change to a culture of austerity and becoming more risk-averse as companies and money managers battened down the hatches caused panic to set in as what was once thought of as safe cash deposits was suddenly at risk if others made a run on capital first. Much like the prisoner's dilemma, VCs such as Peter Thiel’s Founders Fund, Andreessen Horowitz and Y Combinator, and their Portfolio companies panicked and rushed to move funds out of SVB in rapid succession, causing SVB to have a capital call of $42B; thereby in just a few hours on Thursday, a quarter of SVB's deposits were drained in the bank run. Much like a margin call at an investment bank, SVB was forced to liquidate available-for-sale securities, i.e. Treasuries and MBSs, and realize losses on $21B of securities and realize $1.8B in losses.
SVB was forced to scramble to reassure clients that their deposits were safe and tried to raise $2.25B with an equity raise to shore up its balance sheet. This move sent more panic throughout the deposit bank, causing the bank run to increase and SVB to enter a death spiral. As of the end of the day on Thursday, SVB had a negative cash balance of $958 million which caused the bank to become insolvent and was the worst bank collapse since 2008 with the failure of Lehman Brothers. Additionally, another Financial Institution, Signature Bank, which had significant exposure to digital assets and cryptocurrency exchanges, was also hit with a bank run causing them to go into receivership.
Over the weekend, the bank entered receivership with the FDIC, the Federal Reserve, and the Treasury Department came in to backstop uninsured depositors and announced the Bank Term Funding Program (BTFP). The BTFP is a lending facility for banks to pledge Treasurys, MBSs and over debt as collateral for advances on the par value of the debt and thereby not realize capital losses from the rise in interest rates. By backstopping uninsured deposits and creating a lending facility to allow banks to exchange low-risk securities and not have to realize losses, the government worked to stop additional bank runs.
On Monday, markets saw additional runs on other regional banks sell-off as investors worried that the regulators backstop of depositors would wipe out equity and debt holders, which President Biden reaffirmed with his speech on Monday. While these crises are quite profound, the risk of contagion across the financial system is mitigated by the US government, especially as the tsunami of panic dissipates and ration re-enters investors' thought processes.
Looking forward, there are a few critical realizations from this liquidity crisis. Firstly, this crisis at SVB was due to a unique set of circumstances plaguing the technology sector and fixed-income markets due to higher interest rates. Secondly, we have seen a massive shift in forward interest rate expectations and bond yields on the front end of the curve collapse, the most significant decline in 2-year Treasury yields since 1987, and the yield curve steepening dramatically. Over the last week, we have seen expectations for next week's FOMC meeting be cut significantly from 100% odds of a 50bps increase priced into fixed-income markets to 50% odds of a 25bps increase.
Throughout this interest rate hiking cycle, we have anticipated that the Federal Reserve would continue hiking until we saw the pressures of higher rates cause something in the financial system to break. With the collapse of Silicon Valley Bank, the change in interest rates has exposed massive cracks in the fixed-income market and asset portfolios across financial institutions. These effects have been most felt by the smaller regional banks, which are much more reliant upon deposits than the Big five banks in both Canada and the US, which have diversified operations, massive balance sheets and tier 1 capital requirements in accordance with the Basel III accords.
While investors have felt the effects of higher interest rates over the last year, it was a matter of time before cracks were felt in the financial system. So far, the effects have only been felt in the sub-portion of the banking sector, which had an outsized exposure to the technology sector. Our team has used this pullback constructively to add to high-quality names that traded off with the rest of the market.
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