The wounds of the 2008 financial crisis cut deep. So unsurprisingly when another US bank fails, everyone sits up and takes notice. This past weekend, Silicon Valley Bank collapsed (2nd largest failure in history), creating a deposit crisis among other regional banks, and sending shockwaves through the entire industry.
Large Federal Response
The FDIC, Treasury, and Federal Reserve announced on Sunday that all deposits at SVB were fully guaranteed under an exception to the $250k deposit insurance cap known as a systemic risk exception designed to stem high-level crises in the banking system beyond a single institution. In addition to the deposit guarantee (which mean that customer operations will open as normal), the Federal Reserve and Treasury also announced that they would create a new term funding facility (the Bank Term Funding Program or BTFP) to allow banks to meet deposit requests.
The question for investors is whether the sell-off was a one-off triggered by problems unique to SVB, or whether it was a sign of broader weaknesses in the US banking sector. We believe both are true. While SVB failed because of bank specific dynamics, the Fed’s aggressive rate hike policy revealed their weakness and perhaps this is just the first crack to an already unstable economy. Even though the situation is fluid, it is possible to highlight a few important points.
SVB Was Unique…
First, the good news — Silicon Valley Bank was a unique situation in that:
- most of its deposits came from corporations rather than individuals,
- the bank was aggressive in lending to start-up businesses (especially in technology)
- the bank grew extremely rapidly
- the bank was very aggressive in the management of its balance sheet.
When technology firms experienced a tougher economic environment over the last year, they needed liquidity via some of their deposits back. To meet these needs, last week SBV announced it would liquidate $20B+ of its investments in government securities (at a loss due to severely higher rates). This incited fear among its entire client base, resulting in a $42 billion run on the bank in which clients withdrawing deposits forced further liquidation of the bank’s investments. While the Bank might have been able to survive one of these issues, combining all these factors is a certain recipe for disaster.
SVB’s balance grew 250% between early 2019 and the end of 2022
US bank balance sheet growth, 1Q 2019 – 4Q 2022
JPMAM, Bloomberg, Gavekal Research/Macrobond
With few retail deposits, SVB had a high-risk deposit base
JPMAM, Gavekal Research/Macrobond
…However, May Not Be Alone
The other half of this story is the Federal Reserve. We need to remember a year ago the Fed funds rate was 0-0.25% and the yield curve 40bps steep; today Fed funds rate is 4.5-4.75% (heading toward 6%) and yield curve 100bps inverted. An inverted yield curve disrupts the whole bank business model of borrowing short to lend long.
Source: BofA Global Investment Strategy, Bloomberg, Global Financial Data
When the Federal Reserve starts to raise interest rates, it generally keeps doing so until something breaks. Well, something just broke. It was only a week ago that Federal Reserve chair Jay Powell promised to continue fighting inflation with tighter monetary policy, even suggesting the Fed could reaccelerate rate hikes. On Sunday, the Fed was promising to hose the system down with emergency liquidity to head off any deterioration of confidence in other institutions. Next, ahead of their March 21-22 meeting, Fed policymakers will have to reconsider the future course of interest rate hikes and quantitative tightening.
What This Means?
The federal government stepped in to forestall the worst-case scenarios for a potentially broader financial sector (and tech sector) issue, but it also creates moral hazard. The response has been notable and will have both intended and unintended ramifications down the line. With deposits at US banks having essentially been backstopped by the actions of the Federal Government, one could argue that the banking system has been de facto nationalized, and the consequences of that are completely unknown. In turn, this event will only benefit bigger banks, which we are less concerned about for systematic failure. We anticipate more idiosyncratic problems, but big banks are still much better capitalized than 2008.
However, when banks fail, it is hard to be confident about the trajectory of the economy, even if these are idiosyncratic problems and not signs of banking system collapse. As a result, unless the Fed’s policymakers want to end up making another policy mistake (rates too low for too long following COVID), they are likely to press pause on rate hikes and quantitative tightening, if not on March 22, then soon after. Fed Funds Futures are pricing a dramatic shift in expectations.
If the Fed does pivot, this episode might have seen an accelerated bottom for the cycle. If the Fed pushes back, and reaccelerates rate hikes, the market will potentially need to see more pain. Upcoming inflation data will be more important than ever. We will continue monitoring financial conditions during this pivotal spot for asset markets.
John A. Forlines III
Chief Investment Officer
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