How Will the Bank Crisis End?

By Co-Founder & Chief Investment Officer, Dr. Charles Lieberman

Government officials did what they needed to do by guaranteeing Silicon Valley Bank and Signature Bank’s deposits to restore confidence and stem the deposit outflow from those banks.  But the loss of investor confidence is still shaking the industry.  It may be that more needs to be done.  Or, confidence may return if no other bank requires large scale support.  We do think this bank crisis will end fairly soon.

Is Silicon Valley’s failure a unique event?  Yes.  No one mismanaged their balance sheet as much as they did.  They took in very large deposits from early-stage tech and health care companies that would withdraw those funds to cover operating losses or for capital investment.  While they took no credit risk, they locked up those funds in long-term Treasury bonds at very low interest rates. The vast majority of those assets were designated as “held to maturity,” as permitted by regulators, and so the idea was that they would not sell those assets in the interim. As interest rates rose, those assets fell in value.  Out of an asset base of $212 billion, $91 billion was held in such bonds, about 43% of the entire asset base, vastly more than any other bank.  The paper loss as of 12/31/2022 was $15.2 billion against $12.5 billion in equity capital and $3.6 billion in preferred capital, so approaching 100% of its total capital base.  They took no credit risk, but a vast amount of interest rate risk.  This action was highly irresponsible and it was exposed when depositors fled.  This was a total failure of risk management at SVB.

Do regulators bear some responsibility with this failure?  Absolutely.  The circumstances at SVB were known to the regulators.  Yet, they failed to step in and require SVB to raise capital many months ago or to scale down sharply the bond position to reduce risk.  SVB’s failure could have been avoided.  Why didn’t regulators act?  We don’t know.  The investigation that will occur should answer this question.

Were there other contributing factors to this failure?  Some of the venture capitalists who advised SVB’s tech firm depositors to pull their deposits out of SVB triggered the run.  But they were acting to protect those firms.

Are other banks exposed to the same risk in their portfolios?  It is possible, since there are several thousand banks (and I haven’t reviewed them all), but it is highly unlikely that any other banks have the outsized risk of SVB.  The failure of risk management at SVB is almost beyond comprehension.  For example, First Republic, FRC, a bank also in the market’s crosshairs, held a far more modest $28.3 billion in its held-to-maturity portfolio relative to $212.6 or just 13.3% of assets, and its loss was only $4.7 billion relative to $13.8 billion in capital and another $3.6 billion in preferred capital, so just 27% of its total capital.  SVB was in a league of its own and it is highly doubtful anyone else was even close.  From what I know, SVB didn’t break any laws.  There’s no law prohibiting stupidity.  However, there were several stock sales by senior officers in the month before all hell broke loose.  This will surely be reviewed by authorities to determine if it constituted illegal insider trading.

How do the problems at Credit Suisse factor into the U.S. banking situation?  For the most part, they don’t.  Sure, having another banking problem at a large bank doesn’t help, but CS is a Swiss bank and the Swiss National Bank is already involved.  As of this morning, they have been sold to UBS.  Moreover, the problems at CS have been playing out over some years now and are unrelated to SVB.  If anything, market concerns over SVB may have turned investors even more cautious about CS than vice versa.

What is the nature of the problem today?  It is coming from the loss of investor confidence in banks that leads to deposit outflows.  As depositors pull deposits, banks may need to sell assets at depressed prices to come up with the cash, thereby realizing losses.  The ensuing run on bank deposits requires new policy support.  There are a number of mechanisms in place to handle this.  Banks can always go to the discount window, pledging their securities in exchange for cash.  But this mechanism was supplemented a week ago by the newly introduced Bank Term Funding Program, BTFP, which allows banks to pledge securities at par instead of the lower marked-to-market value.  This will enable a bank to convert much of its investment portfolio into cash without taking any losses.  They would have the time needed for those securities to mature and recover the total value to be able to repay the borrowings in full.

Is First Republic at risk of failure?  The BTFP should enable First Republic to fund itself.  But a dozen banks also announced they will place $30 billion in deposits with FRC.  This vote of confidence in FRC may be sufficient to assure investors their deposits are safe and stem the deposit outflow.  Investors didn’t seem to like the decision to suspend dividends, but along with quarterly profits, the bank will be able to reduce leverage and become visibly safer.  FRC is taking action to relieve depositor concerns.  It has been rumored that FRC has suffered large outflows, but the bank indicated outflows slowed sharply after the deposit injection of other banks. 

Why doesn’t a large bank acquire FRC to resolve all uncertainties very quickly instead of placing deposits with FRC?  First, our largest banks are now precluded from any acquisition activity to prevent them from becoming even larger.  Second and more importantly, after Bank of America acquired Countrywide and Merrill Lynch and J.P. Morgan acquired Bear Stearns and Washington Mutual to help the government during the 2008 financial crisis, Bank America was hit with $76 billion in fines for the misdeeds of its acquisitions before they were acquired and J.P. Morgan was hit with $44 billion in fines.  Apparently, no good deed goes unpunished.  It is far safer for them to invest a few billion in FRC than acquire it and avoid the risk of being hit with another round of fines for deeds committed before any acquisition.

What else can be done?  Actually, plenty.  The BTFP will enable banks to meet deposit outflows.  But something more can be done to make such outflows unnecessary.  For example, the FDIC could announce it will insure deposits up to $1 million instead of $250,000, or even go to full insurance regardless of the amount on deposit.  Such announcements should immediately halt any need for depositors to move accounts to other banks.  The increase in insurance coverage could be paid for by adjusting the insurance fee currently paid by all banks. 

Will more regulation help?  One new regulation that would have prevented SVB’s behavior would simply tie bank capital to unrealized losses.  At certain levels of unrealized losses, the banks could be required to raise more capital or reduce the size of its portfolio at risk.  Such a rule would have prevented SVB from letting its losses build or required regulators to enforce the regulations.  But as noted, better behavior by regulators under existing regulations would have avoided this situation entirely.  Bank regulators were already in a position to prevent SVB’s failure; they just failed to do so.  Or, simplistically as politicians are wont to do, banks could be required to hold all securities in a marked-to-market portfolio, although this would have some undesired effects.

What do we expect going forward?  It is possible actions already taken will soon calm the situation.  If discount window borrowings stop rising, it would indicate deposits outflows are slowing down and the banking system is stabilizing.  If not, expect more steps to be taken soon, such as those suggested above.

Will more banks go out of business?  We think more mergers are likely, especially for smaller banks, to give depositors more confidence in their viability.  Policymakers will not like that outcome.  The Fed (and government) does not want ever more of the nation’s banking system concentrated in just a small number of large institutions.  If FRC feels the need to merge with a larger bank to assure its depositors it is safe after taking the risk-reducing steps it has announced, the government should see a clear need to do more.  Increasing deposit insurance is one way to help small banks remain competitive.

Will more banks fail?  Likely, not.  it is doubtful any other bank pushed their portfolio risk as irresponsibly as SVB.  (I exclude crypto banks.)  Moreover, the Fed will want to resolve this situation as quickly as possible.  The BTFP should enable banks to fund any deposit outflows.  But more fundamentally, it would be desirable for the Fed to do what is needed so depositors feel safe with their current bank and deposits remain in place.

Rumors have circulated that Warren Buffett may get involved.  His practice has been to swoop in with capital to help out a distressed firm, but only when he sees relatively little risk and he always extracts very favorable terms for his investment.  These circumstances don’t fit that model, since banks can get cheaper financing from the discount window or the BTFP, so he is unlikely to get involved, at least in our judgment.

Government officials are acting quickly and responsibly to address the turmoil.  Because of the credit crisis in 2008, banks were forced to become highly capitalized, to undergo annual stress tests, and are subject to many more regulations under Dodd Frank.  Those actions will be very helpful today.  Indeed, enough may have been done already.  But if not, I suspect more actions soon. 

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