One of the nation’s largest banking institutions collapsed last week in what turned out to be the second-biggest collapse in U.S. history. The bank’s failure occurred amidst a slew of released economic data points that showcased resiliency across consumers and a likely continued path of higher interest rates. The combination of those two events triggered a sentiment-based volatility cycle within global capital markets that we believe is short-lived. It’s important to note that Credent Wealth Management did not maintain an exposure to the stock of Silicon Valley Bank across our actively managed strategies.
Bank failures are not uncommon – why is Silicon Valley Bank significant?
Historical data from the Federal Deposit Insurance Corporation (FDIC) provide a glimpse as to the frequency of bank failures since 2001 (Chart 1). It is no surprise that the Global Financial Crisis of 2008-2009 proved to be a catalyst for catastrophic bank failures across the globe. This occurred amidst an era of risky lending, minimal accountability, and questionable management decisions, all of which led to over 300 bank failures in the U.S. alone. The regulatory backdrop that emerged post-Global Financial Crisis, mainly referred to as the Dodd-Frank Act, was designed to eliminate certain practices tied to trading and lending activities and establish guidelines on stress tests for each bank’s financial health. The tests ask: if another crisis were to emerge, how likely is it that a bank will survive? The results of the Dodd-Frank Act proved rather positive after 2008-2009, yet questions are now arising as to how the 16th largest bank in the U.S. collapsed in a
matter of 48 hours (Silicon Valley Bank). It’s that sheer fact that makes this collapse significant in the eyes of the media and in the eyes of banking consumers and investors. The size of the bank’s assets and overall deposits (Chart 2) further exacerbates the question of how regulators missed the potential for its collapse. The answer appears to be hidden in the details ofits lending and depositor practices. Let us unpack that and reveal why we believe the Silicon Valley Bank’s failure is not a systemically significant event.
Did regulators miss blatant red flags on Silicon Valley Bank’s health?
In short, we believe the objective answer is no. The blatant issues that led to the bank’s collapse, as viewed from a retrospective lens, are likely tied to two factors:
- Poor management of loans and deposits within a homogenous industry base. (The company had full control of this component.)
- Rising interest rates amidst an inflationary environment. (The company had no control over this component.)
Prior to focusing on the items above, let’s briefly gauge the health of Silicon Valley Bank as viewed from the perspective of an investor (and even, perhaps, a regulator). The major guardrails embedded within the Federal Reserve’s stress test ratios are designed to gauge broad risk, both as a means of bank failure and as a means of risk to depositors. At the forefront of those stress test ratios is a data point referred to as Tier 1 Capital Ratio, and it is a key measure of a bank’s financial strength. In technical terms, it measures a bank’s equity capital and disclosed reserves relative to its risky assets (i.e., loans and other liabilities). You may be surprised to know that Silicon Valley Bank’s Tier 1 Capital Ratio, relative to some of the largest banks in the U.S., was highly acceptable. In fact, post-COVID, the bank’s Tier 1 Capital Ratio surpassed that of all banks listed in Chart 3. Under such a ratio structure, the bank would have (presumably) the lowest probability of failure. Even so, could regulators have done more to protect consumers, borrowers, and depositors?
From the perspective of the Federal Reserve’s publicly available stress test results on Silicon Valley Bank (all data can be accessed here), it appears that regulators did everything they were required to do, which begs the question of whether this recent failure will introduce scrutiny to the Dodd-Frank Act. The answer is likely yes. One area that may receive attention is the why behind the 2018 removal of added liquidity and credit quality disclosures for banks with less than $250 billion in assets. If such a requirement remained in place, we believe the collapse of Silicon Valley Bank would not have been a surprise. The requirement imposed an internal test on fleeing deposits, which is exactly what happened in this case.
Why did Silicon Valley Bank fail?
Recent data indicates that Silicon Valley Bank may have largely failed due to its loan base concentration within a targeted segment of the technology sector, depositor concentration, and overnight fleeing deposits. In other words, poor diversification caused serious issues amidst a rising interest rate environment that has impacted technology companies. This was likely exacerbated by the bank’s loan growth over the recent past (Chart 4) and by the fact that most of those liabilities remained off-balance sheet. Although “off-balance sheet” may sound odd, it’s important to note that off-balance-sheet funding (for both assets and liabilities) is an acceptable accounting structure in the U.S., and it’s a method accepted by the Federal Reserve. What’s critical to note about the bank’s failure is that it was not a credit quality-based issue amidst the growth of loans. The quality of the loans remained favorable, and it was assessed and reported on by management regularly. It was also a concept addressed with the bank’s investors on a quarterly basis, unlike the structure that caused the 2008-2009 financial crisis. The bank’s failure remained tied to market risk amidst its concentration of loans and depositors and lack of ample cash flow due to short-term liquidity requests. Chart 5 provides a staggering overview of the bank’s immense loan base concentration.
Loan concentration and rising interest rates
As interest rates rise, bond prices drop. Such a simple relationship can wreak havoc on a bank’s financial strength because a bank tends to hold numerous bonds on its balance sheet. This is especially true in an environment where internal management fails to appropriately plan for higher interest rates and fleeing deposits. In the case of Silicon Valley Bank, the bonds on the balance sheet were showcasing significant losses throughout the early part of 2023, and the bank’s management team faced tremendous pressure to sustain reserve and capital ratios. On Wednesday, March 8th, 2023, the bank announced that it would need to raise $2.25 billion to sustain operations, an announcement that would eventually cause a run on the bank’s deposits alongside a 60% downturn in the stock price. A mere 48 hours later, the bank collapsed. The concentration of its depositor and loan base could not in itself provide ample liquidity for a self-funded bailout.
Are depositors insured?
We definitively know that deposits less than $250,000 are insured, and the Federal Deposit Insurance Corporation (FDIC) indicated that money would be distributed as early as Monday, March 13th.
In a rather interesting turn of events, headlines on Sunday evening, March 12th, indicated that the Biden administration will allow all depositors to have access to their funds, even those that were uninsured. Such an action will amount to billions of dollars in recoveries, and it will likely mitigate contagion risks to other banks. (Source: Forbes, NPR, Bloomberg News, The Washington Post, Wall Street Journal).
If all such deposits are returned to each respective individual/corporation, then the Silicon Valley Bank collapse leaves lasting scars for only the investor base of the bank (bond and stockholders) and the 6,500 employees that find themselves unemployed.
Are other banks at risk?
We do not believe that Systemically Important Financial Institutions (SIFIs) are at any risk of failure. They maintain a diversified depositor and loan base and ample cash flow and provide stress test assessments above and beyond the guardrails imposed by the Federal Reserve. Moreover, loan growth with SIFIs has been methodical, intentional, and largely neutral. (Chart 4 provides examples of various SIFIs, except for Silicon Valley Bank.)
Investment advice offered through CX Institutional, a registered investment advisor.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. The economic forecasts set forth in the presentation may not develop as predicted.
All data is sourced from Bloomberg, through the release of monthly figures from the U.S. Bureau of Labor Statistics or from the Federal Reserve and any of its affiliated regional location.