Sat, Mar 11, 2023
SVB Yet Another Example of the Market Volatility That Lies Ahead
Megan Greene is Global Chief Economist at Kroll. Kroll has deep expertise across valuation, financial advisory, related disputes, forensic investigations (both financial and regulatory), forensic accounting, monitorships, cyber investigations, rescue financing and M&A Advisory.
It has been a long time since we’ve had to face a bank run, but in many ways Silicon Valley Bank (SVB) was a special case. SVB’s client base and funding structure both suggest that it is unlikely to trigger a systemic crisis. There may be some contagion to other small, community banks in the U.S.—particularly if depositors aren’t all made whole--but the larger banks are unlikely to follow in SVB’s footsteps. SVB is yet another example that we can expect market disruptions as central banks raise rates and shrink their balance sheets.
SVB specializes in providing banking services to technology-related start-ups. For years as interest rates were at the zero lower bound, these tech start-ups had cash coming in by the truck load from “liquidity events” such as IPOs, secondary offerings, SPAC fundraising, venture capital investments and acquisitions. Many of them deposited their cash at SVB.
Most commercial banks operate by taking deposits (short-term borrowing) and extending loans (long-term lending). SVB was taking in deposits, but it didn’t extend many loans. This was in part because new tech start-ups don’t tend to have the kind of fixed assets and reliable cash flows that make for solid, high-quality borrowers. And it was partly because cash was being handed to them hand over fist from investors in a zero-rate environment.
SVB could have kept the deposits in Fed reserves or Treasury bills, but they paid relatively little. So instead, the bank bought longer-dated, typically safe assets like Treasury bonds and mortgage-backed securities.
When interest rates were at zero, tech start-ups could promise to spend years building AI/machine learning/flying taxis/robots to take care of the elderly and then make a lot of money far in the future, and that was an attractive business proposition. When interest rates rose, a dollar today became better than a dollar tomorrow, and so investors started demanding cash flows. As the Fed hiked rates, the cash being thrown at tech start-ups dried up.
Instead, tech firms had to take their money out of the bank to pay for rent and salaries. SVB’s deposit base fell significantly over the course of 2022. Instead of having its assets tied up in loans (which broadly tend to have floating exchange rates and shorter terms), SVB held bonds (which broadly tend to have fixed interest rates and longer terms). Fixed-rate securities accounted for 56 per cent of SVB’s assets, compared with 25 per cent at Fifth Third and 28 per cent at Bank of America. The average maturity of SVB hold-to-maturity bonds was 6.2 years at the end of 2022.
To redeem client’s deposits, SVB had to sell assets at a big loss. As clients worried about the stability of SVB, they rushed to yank their own deposits, starting a bank run. Unrealized losses snowballed and “completely subsumed the $11.8 billion of tangible common equity that supported the bank’s balance sheet,” meaning that SVB was technically insolvent. The California Department of Financial Protection and Innovation took possession of SVB and appointed the FDIC as receiver, citing inadequate liquidity and insolvency.
Is SVB a harbinger of things to come across the U.S. and global banking system? Not necessarily. SVB was unusually exposed to interest rate risk. This is partly because its clients only thrived in a low interest rate world and cash funding for them evaporated as rates rose. But it is also because higher interest rates hurt the liability side of SVB’s balance sheet more than it benefited the asset side. For most banks, higher interest rates are good news; they have to pay more interest on deposits but get paid more interest on their loans (particularly given how slowly deposit rates seem to be rising these days). This was not the case for SVB because so many of its assets were tied up in long-duration bonds, which saw their market value fall as rates went up.
Regulation put in place after the global financial crisis was in theory supposed to prevent bank runs like this. The Basel III Accords were supposed to limit banks borrowing short to lend long. But when the Federal Reserve implemented Basel III in October 2020, it only applied to large, internationally active banks. Most jurisdictions apply Basel III to their entire banking system, but the U.S. has a powerful community bank lobby. Consequently, only the big, international U.S. banks are subject to liquidity coverage ratios and net stable funding ratios.
The good news is it is unlikely an SVB-style bankruptcy will extend to the large banks that do have to ascribe to the Basel III rules. The bad news is there are other small, community banks that could face bank runs and insolvency. The risk of this is much higher if uninsured depositors of SVB aren’t made whole and have to take a haircut on their deposits. I expect the Fed would insist that any bank purchasing SVB make all creditors whole. If not, businesses will recognize that their uninsured deposits could vanish overnight and will pull their money from smaller community banks and put them in the larger institutions.
Higher interest rates pose a risk to the banking system, but so too does the Fed shrinking its balance sheet via quantitative tightening (QT). Research by former RBI governor Raghuram Rajan and co-authors shows that banks change their behavior when the Fed expands its balance sheet, but do not change it back just because the Fed decides to shrink the balance sheet. Rather than park reserves at the Fed for a very low interest rate, banks extend credit lines that earn them a fee. This increases their liquidity demands. When the Fed engages in QT, banks do not sever these credit lines. Quantitative easing (QE) generates a never-ending ratchet effect on bank liquidity needs. The repo rate spike in the US in October 2019, the dash for cash in March 2020 and the UK LDI pension blow up in 2022 are examples of this. It means that QE may be Hotel California, and QT will be difficult to pull off and will cause market disruptions.
Increasing interest rates and waning liquidity also pose a risk to the non-banking sector. After the global financial crisis, bank regulation was introduced that pushed a lot of activity out of banks into the shadow banking sector. There is little visibility on what exposures lie where in shadow banking, and even seemingly safe investments like liability-driven investments could be rife with risk, as the UK experienced last autumn. Private markets may have a rocky road ahead, as they have taken much smaller paper losses than public markets over the past year. Some might argue this is because private companies were priced at a discount to comparable public companies to begin with. But it could also reflect losses that have yet to be crystallized in private markets.
With inflation stubbornly remaining above the Fed’s target of an average of 2 per cent and demand remaining strong despite aggressive rate hikes, investors have priced in a higher terminal interest rate for longer than they had expected even just a month ago. With crucial macroeconomic indicators like the non-farm payrolls (NFP) released last Friday and consumer price inflation (CPI) data released March 14th, market participants have been on a hair trigger to revise their interest rate projections. A bank run was not expected and will increase market volatility further. The good news is that because SVB was particularly interest rate sensitive, it is a special case. There may be contagion to other small community banks, but the systemically important banks are unlikely to follow in SVB’s footsteps. The bad news is that SVB is yet another example of the market volatility we can expect as global monetary policy tightens and liquidity wanes.
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