What Does The Collapse Of Silicon Valley Bank Mean For The Banking Industry?

Banking collapses are scary. They shake our foundation and trust in the financial industry as a whole. The thought of our checking, savings, and/or investment accounts being gone overnight is terrifying.

Originally this week, I planned on writing on a completely different subject. However, I believe timely events require a timely response and a major bank failing is definitely a timely event. Let's start with a bit of an overview on how and why Silicon Valley Bank (SVB) failed and then go into the questions we as consumers should be asking as we look forward.

Why Did Silicon Valley Bank Fail?

Like any Monday Morning Quarterback, looking at what lead to SVB's collapse seems exceedingly simple with hindsight. There were 3 major reasons that combined lead to the banks failure:

1. SVB Was Investing Deposits in Long Term Treasury Bonds
2. SVB Did Not Have a Diversified Client Base
3. SVB Had a Large Number Of Clients Not Fully Covered By FDIC Insurance

Let's break each one of these events down individually.

1. Investing In Treasury Bonds With Long Maturities:

The collapse of SVB finds its roots back in 2020. In 2020, despite all that was happening with the Pandemic, there was a large influx of cash into our economic system via vehicles such as PPP Loans. The Fed was doing everything it could to keep our economy strong including lowering interest rates to some of the lowest levels in our country's history. Also at that time, the tech industry was booming and seeing extremely high valuations and returns.

All these events led to what would seem like a good problem for a SVB - deposits skyrocketing in 2020. Silicon Valley Bank was known for specializing in working with tech startups. Where many more "traditional" financial institutions would say "no" to lending to what are considered more risky ventures, SVB was known for being a "non-traditional" bank who would do all it could to say "yes" to these start-ups. As deposits came in, SVB had to decide what to do with such a large influx of cash.

What the bank decided to do was invest large amounts of these deposits into Treasury Bonds. Normally, these bonds are not seen as risky investments as they are loans to the Federal Government. However, SVB elected to invest substantial amounts in to long term treasury bonds at a time where interest rates were exceedingly low. This decision would ultimately begin their downfall. The reason being is that long term bonds of all types are much more sensitive to interest rate changes when sold on the secondary market. When interest rates go up, the price a bond sells for on the secondary market goes down. Thus, with rapid rate increases we simultaneously saw a rapid decrease in the value of long term bonds.

As the price of the bonds were going down, it lead to SVB receiving a call the week of March 6th from Moody's - which is a credit rating service. At that time, Moody's informed SVB that their credit rating score would be lowered. SVB tried to get ahead of this issue by putting into place a plan to sell off their lower yielding bonds at a loss (around $1.8 Billion), and then raise new funds from investors so they could re-purchase higher yielding bonds to replace the ones they sold off. By Wednesday, March 8th, SVB had put the first half of their plan into action and began selling off their bonds at a loss. However, they were unable to raise the funds needed to repurchase new bonds to replace them. With half of their plan in action, the investment world was able to see what was going on and that SVB was in trouble. As this information became public knowledge, venture capitalists began pulling out their money as quickly as possible. This bank run lead to a staggering $42 Billion dollars being withdrawn from SVB in a single day. By Friday, March 10th, the FDIC took over the bank and all accounts.

2. Having a Non-Diversified Client Base

The second factor that contributed to SVB's failure was its client base. As previously mentioned, SVBs focus was on working with startups, especially in the tech industry. Over the past year, tech companies have been struggling with the economic climate. As The Federal Reserve Board has been taking drastic actions to keep inflation from running out of control, many tech companies have had a hard time remaining profitable with the changes in the economy.

More often than not, tech companies are categorized as "Growth" companies meaning that they hope to grow at a pace faster than other similar size businesses in the market. Such companies operate on the idea that they will re-invest their profits into the business to continue an accelerated growth pattern over time. This can lead to astronomical increases in share prices when it works meaning those who bought in low can sell for a substantial profit down the road. When money is "cheap" to borrow (i.e. a low interest rate environment), maintaining this type of business strategy is easier to handle as loan payments are low and borrowing money is relatively inexpensive. However, when money becomes more "expensive" (i.e. rates go up to borrow money), and an industry is lagging, it can exasperate a company's financial issues. This is what has been happening to many start-up tech companies over the past 12-15 months. The changing economy has put them in a position where their profits are down and, at the same time, it's harder and more expensive to get funding to continue operating day-to-day expenses as we're in a higher interest rate environment.

As these factors compounded for tech companies, more of them we're having to pull money out of their accounts while no new deposits were coming in to SVB. Because SVB's client base was so unilateral, as the tech industry got hammered so did their bank. With a greater number of deposits leaving than those coming in, it put additional financial stress on SVB that contributed to its collapse.

3. Having a Large Number Of Clients Not Fully Covered By FDIC Insurance

The final major issue for SVB was the amount of clients they had with deposits over the federally insured amount of $250k. Most banks have about 50% of their deposits covered by FDIC Insurance. However, SVB had less than 10% of their deposits covered as a result of higher account balances for their tech start-up clients. This lead to a mass panic from their client base as so many of them knew they had deposits exceeding the FDIC covered amount. As the SVB ship started to sink, clients did all they could to get out with their funds as fast as possible. Thus, the $42 billion dollar one day selloff ensued.

What Does It All Mean?

The logical question after a bank failure is "what does this mean moving forward?" Let's look at the following questions individually:

1. Will this lead to more regional banks failing?
2. What is the risk to the big money center banks?
3. Will the Fed postpone raising rates?

1. Will This Lead To More Regional Banks Failing?

Over the weekend, regulators took action to protect all insured and uninsured depositors affected by the collapse of SVB.  The Fed also stated that they would increase available liquidity to banks through a new program called "The Bank Term Funding Program (BTFB)." This facility will offer loans of up to one year to banks that pledge U.S. Treasury securities, mortgage-backed securities and other collateral at their face value (also known as "at par").

What this means for banks is that they will be able to obtain liquidity without having to sell treasuries and mortgage backed securities which have lost value due to the significant rise in interest rates over the past year. These actions are designed to limit the risk of further bank runs on small and mid-sized banks around the nation.

While these actions do not remove the underlying loss created from rising interest rates, they do give affected banks a year to get their balance sheets in order. U.S. Banking Analyst Aleks Ivanova stated "The expectation is that the combination of deposit guarantees and the provision of liquidity will be enough to stem the contagion and avoid additional deposit runs."

All these changes are not without consequence though. The regulatory environment will likely tighten moving forward for small and mid-sized banks. Regulators may require these banks to hold more capital which will lower their available funds for investing and ultimately lower their profitability. Historically, smaller banks have generally traded at a premium to large center banks as they generated higher growth rates and were subject to lower capital requirements and less regulation. Moving forward, additional regulations may impact that norm while also upsetting banking relationships as corporate treasurers rethink and/or diversify their banking relationships. Many companies may elect to move their deposits to larger, more regulated institutions - making it more challenging for even the best small banks to attract and retain their deposits.

2. What is the risk to the big money center banks?

Big money center banks will most likely be largely unaffected by SVB's failure. The reasons being that these institutions are better diversified, well capitalized, more liquid (generally) and subject to much more stringent regulations than small banks. Large banks are required to maintain much higher capital and liquidity requirements as well as subject to leverage limitations and more frequent stress testing. All these factors combined help larger institutions avoid he kind of asset liability mismatch that brought down SVB.

3. Will The Fed Postpone Raising Rates?

In the near term, the Fed may take their 50-basis-point rate hike off the table. The shock to the banking sector as a result of SVB's failure will likely accelerate the tightening of financial conditions and make economic slowdown more likely. However, once financial markets stabilize, the Fed will likely pivot back to inflation fighting as elevated inflation remains a significant risk.

How We Work To Protect Client Assets

At Link Financial Advisory, we view protecting our client's assets with the utmost respect and as a top priority. As such, we search out strategic partnerships to offer our clients solutions to best fit their needs. One solution we'll offer to our clients is that of utilizing a private trust company to serve as custodian for holding their assets.  Utilizing this model allows us to offer clients a solution where, unlike a bank or broker, their funds are never commingled with the financial institution or with other investors. We'll also search out partnerships that operate as a Federal Savings Association which means that client funds cannot be used in the institutions own account because all client assets are held solely in the client's name. Lastly, we'll seek out partnerships where the financial institution does not participate in margin lending - a practice where client assets are used as collateral for the financial institutions lending activities. We want to make sure that our strategic partners cannot pledge, lend, or margin client assets that are held in their custody.

Ultimately our aim is to help our clients accomplish their financial planning goals. As an independent financial advisory firm, we do all we can to ensure our clients receive independent and objective advice that moves them towards their objectives while protecting them from catastrophic losses.

If you'd like to learn more, feel free to email me at Robert@LinkFinancialAdvisory.com or call me direct at 406-369-3396.