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A Simple Explanation of Recent Bank Failures

A Simple Explanation of Recent Bank Failures

October 27, 2023

What is going on with banks? As you may have seen in the news recently, a handful of bank runs (most notably Silicon Valley Bank) have led to a few bank closures, and concerns about the stability of the broader US financial system. While bank runs and bank closures are never good, we do not believe there is any systemic risk to the US or global economies (see below for more analysis into these specific situations). Overall, while banks like SVB are large regional banks, they are nowhere near the size of the J.P. Morgan, Citigroup, or Wells Fargo banks of the world, whose counterparts like Lehman Brothers had issues during the Great Financial Crisis of 2008 and led to a global recession. Additionally, over the weekend the Fed stepped in to backstop all depositors at SVB. So, the risk for depositors has been contained. Only equity and bondholders of these banks will feel the pain of their mismanagement. As such, we have seen the volatility around other banking stocks begin to subside already, although it may take some time to return to a more normal state fully

What does it mean for our clients? For our clients and the portfolios that we manage, we have had no direct exposure to SVB and only very modest exposure to other smaller regional banks. With our focus on diversification and risk management, we invest mostly through ETFs. Because of this approach, the largest single company exposures in our portfolios will always remain extremely muted (e.g. the largest position in our equity portfolio today is Apple at only 1.29% of the portfolio and it trails off quickly from there). Additionally, our focus on risk management has led us to recently increase the amount and type of bond exposure in our portfolios. Now, even our most aggressive portfolios can layer bonds on top of their more aggressive equity holdings. Additionally, most of our bond exposure is in treasury bonds, where credit risk is as close to zero as it can be and prices are generally unaffected by the events of banks and other corporations. This position has been extremely helpful in recent days, as interest rates fell precipitously, and bond prices rallied as an offset to equity risk.

From a macro perspective, the banking industry is experiencing some pressure as checking deposit withdrawals are increased after businesses and individuals flooded banks with new deposits during the pandemic. Figure 1 shows deposits at commercial banks rose from $13.2 trillion at the end of 2019 to a peak of $18.1 trillion in the first half of 2022. The increase in deposits occurred as the Federal Reserve doubled the size of its balance sheet by $4.5 trillion, the federal government distributed multiple rounds of stimulus checks, and social distancing restrictions limited consumer spending on services. More recently, Figure 2 shows deposits at commercial banks decreased in 9 of the last 12 months. The decline in deposits is occurring as the Federal Reserve shrinks its balance sheet and inflation weighs on consumer savings. Banks complained about too many deposits in the past few years, but now declining deposits are starting to pressure some bank balance sheets.

As mentioned, last week saw the failure of two California banks and one New York bank serving niche industries that benefited from the recent period of 0% interest rates. Silvergate and Signature Bank operated as bankers to the crypto industry, and Silicon Valley Bank (SVB) catered to the venture capital and startup ecosystem. All three banks experienced a surge in deposits during the pandemic for industry-specific reasons. Silvergate and Signature Bank took in deposits from crypto exchanges and other industry participants that lacked access to banks due to regulatory constraints. SVB’s deposits grew rapidly as startups raised money from venture capital firms and parked it at the bank.

Bank analysts point to the three banks’ business models and lack of diversification as the cause of their issues. From a business model standpoint, the banks quickly took in a surge of deposits. Instead of using those deposits to make new loans to consumers and businesses, the banks purchased U.S. Treasury bonds and agency mortgage-backed securities with relatively long maturities. The banks primarily purchased bonds with long maturities because the bonds offered significantly more interest income than short maturity bonds, which offered relatively low income due to the Federal Reserve keeping interest rates near 0% during the pandemic. The risk for the banks was that the Federal Reserve increased interest rates and the bonds lost value, which is exactly what happened.

Fast forward to the start of 2023, the three banks experienced a flood of withdrawal requests. To meet the deposit withdrawal requests, the banks were forced to sell assets, including the Treasury bonds and mortgage-backed bonds the banks bought when interest rates were lower. The problem for the three banks is interest rates are significantly higher than when the banks bought the bonds, which resulted in the banks realizing billions of dollars of losses. The realized losses drained the banks’ capital cushions, making the banks technically insolvent. Silvergate voluntarily ceased operations and plans to liquidate its assets, while Signature Bank and SVB were both taken over by the FDIC.

The three bank failures are a unique situation, because the banks did not have bad assets in the form of risky loans or complex derivatives. To the contrary, the banks primarily held safe assets in the form of U.S. treasuries and mortgage-backed bonds. The banks’ undoing appears to be related to a mismatch between their liabilities (which were the concentrated deposits from niche industries) and their assets (which were the bonds with long maturities). In our view, the lesson from the three bank failures is not that banks are sitting on risky loans and complex derivatives but rather that aggressively raising interest rates from 0% to above 4% stressed the banks balance sheets and could stress the wider financial system.

While the banks’ failures are concerning, it is important to note bank analysts believe this is a unique situation due to specific client bases and their balance sheets. Although other banks could face similar isolated issues, analysts believe most banks managed and matched their assets and liabilities better than the three banks that failed. However, investors, the Federal Reserve, and regulators will be watching for signs of stress across the financial system this year.