What happened? At the end of 2022 Silicon Valley Bank (SVB) was the 16th largest bank in the United States, with $209 billion in assets.1 On March 9, SVB sold $21bn of bonds and announced a capital raise of $2.25 billion, sparking concerns from investors and depositors. Pressure to withdraw deposits intensified as venture capital funds advised their portfolio companies to pull cash from the bank, which started a “bank run”, meaning that SVB did not have enough liquidity on hand to fulfill all withdrawal requests. This process was also exacerbated by how quickly withdrawals can be made with digital banking. As a result, SVB was taken over by regulators on March 10, making it the second largest bank failure since the 2008 collapse of Washington Mutual. In the aftermath, Signature Bank (SBNY) was also placed into receivership on March 13.
The U.S. government moved swiftly to arrest fears of a modern-day bank run by guaranteeing all deposits at both SVB and SBNY. The Fed announced an emergency facility that allows all banks to post general collateral (treasuries and agency debt) to the Fed for liquidity at near risk-free rates; should deposit flight persist banks will not be forced to immediately liquidate collateral.
Investors fled to safety causing a massive wave of market repricing. The rates market is now pricing only ~60% chance of a 25bps hike in the March FOMC next week, compared with a high probability of a 50bps hike a week ago. Expectations for the Fed’s terminal rate lowered from 5.6% to 4.8%. Front-end rates tumbled as a result, with the 2-year dropping ~90bps from last week’s level.
In the equity market, since the first warning signs from SVB last Wednesday, both large and regional bank stocks have seen some intense downside pressure. It’s worth noting, however, that the broad U.S. stock market has held up relatively well, as growth equities were boosted by lower yields.
Why did SVB fail? Ninety three percent of SVB deposits were from corporations (instead of individuals), compared to a median of 34% among the largest ten U.S. banks. Eighty four percent of their deposits exceeded the Federal Deposit Insurance Corporation (FDIC) $250,000 limit and were uninsured.2 Such corporate deposits are not only more price-sensitive to rising deposit rates, but are also more susceptible to deposit flight due to their largely uninsured nature. Furthermore, the depositors were largely concentrated in the tech sector, which has been seeing increased pressures and tighter liquidity. These characteristics combined made SVB more vulnerable to a traditional bank run.
During the pandemic easy money boom, money flowed into the tech sector and deposits at SVB rose quickly. SVB did not make loans at the rate the deposits were coming in, and invested the funds instead — mostly in high-quality, long-term, fixed-rate, government-backed debt securities. This allocation left them vulnerable to a sharp rise in interest rates, particularly if they had to sell these assets and book losses in a higher interest rate environment. SVB’s exposure to these investments in government-backed securities were disproportionately large, and losses from rising interest rates essentially wiped out their capital.
At the same time deposits began to fall. Higher rates not only impacted SVB’s market value of their assets, but also dramatically slowed the amount of capital flowing into the tech sector. This forced more tech companies and start-ups to burn through their existing cash more quickly and reduce deposits, which in turn pressured the bank given that so much of its deposit base is concentrated in this one sector.
Falling deposits, and concerns about asset concentration in long-dated bonds caused SVB to sell $21bn of bonds. They sold to meet withdrawal demands, but also to reinvest those funds in shorter-duration securities and increase yield. It then needed to raise capital to replace the losses made in those sales. That capital raise failed due to concerns about SVB’s profitability. This is what spooked depositors and caused the run.
In light of the situation, what do we believe has changed?
In our earlier outlook, we thought this year would be the one in which we felt the consequences of aggressive policy tightening. Fed rate hikes are meant to slow growth and inflation. The failures of Silicon Valley Bank, Signature, Silvergate, and the struggles of the entire regional banking complex are both symptomatic of the tighter liquidity environment we’ve expected, and also likely to accelerate this process.
It seems unlikely that the Fed will be able to raise interest rates at its next meeting – and there are many potential outcomes from this change. Our low conviction base case is that the Fed has the tools to correct this bank liquidity problem, but the economy still faces elevated recession risk in the second half of this year. We still expect 2 more rate hikes this cycle, but this situation is fluid.
Recession risk (aka layoffs) remains elevated, and may have been pulled forward. For the last 12 months (almost to the day), the Fed has been hiking rates and tightening financial conditions to slow growth and inflation. The banking sector shock is likely to slow growth and inflation despite a likely less aggressive path of future Fed rate hikes. Here’s how:
- The banking shock raises the cost of capital. Banks have been tightening lending standards at the fastest pace since COVID. We expect banks to tighten lending standards further, which raises the cost of capital and…
- It reduces the availability of capital. We expect deposit migration to systemically important banks at the expense of regional banks. This matters because small banks have provided ~90% of total new loans over the last three months. With less deposits, they will have less capacity to lend.
The Fed’s priorities are shifting. Financial stability is a greater concern than inflation (right now). The Fed needs a properly functioning banking system in order to transmit its policy.
So what might U.S. policymakers do if things get worse? Should another bank(s) fail, we would expect:
- The U.S. government to guarantee all U.S. deposits. To date, only deposits from SVB and SBNY have been guaranteed. The U.S. government did something similar in 2008.
- Policymakers to widen the list of eligible collateral that can be posted to the Fed for liquidity. Presumably this would allow loans to be liquified as well.
Within banks, we prefer global systemically important financial institutions (G-SIBs). A bank has three risks, and G-SIBs are in a good posiiton to mitigate all three:
- Liquidity risk – the risk that their cash position will be insufficient to meet obligations. Think cash on hand to meet deposit outflow in this current shock.
- Credit risk – the risk that bank assets will be impaired or at worse default. Think loan quality.
- Capital risk – the risk that a bank doesn’t have enough capital/equity to protect against credit losses. In this shock, financial assets held by banks trading below par due to the Fed’s hiking cycle have the effect of draining capital.
The FDIC decision to guarantee both insured and uninsured deposits aims to mute liquidity risk concerns. Meanwhile, the Fed’s Bank Term Funding Program aims to mute the capital risk posed from underwater general obligation bonds that were accumulated during the post-COVID low-rate environment. These steps are aggressive and could help restore banking confidence, but bank runs are behavioral experiences, and we prefer to lend where we think deposits will accumulate (likely G-SIBs) over where deposits are fleeing (regionals).
What does it mean for investors?
We encourage investors to stay defensive, but not fearful. The following three approaches reflect our current thinking:
- Bonds are crucial protection. The swift move lower in yields reminds us of the protection that bonds can provide as the growth outlook worsens. We continue to focus on high quality, investment-grade credit. Long-duration core fixed income also remains a high conviction idea.
- The S&P 500 looks more attractive to us in the range of 3600-3700, and we would consider adding more aggressively as we approach these levels. We are focused on companies that are flush with capital, backed by secular growth, and that can offer better relative value. For instance, we are focused on healthcare and industrials rather than financials in the U.S., as well as opportunities outside of the U.S. such as China. Lower bond yields could be supportive to valuations.
- Use heightened volatility across asset classes as a potential opportunity. Expect more market swings. Investors can use this volatility as a potential opportunity by either embedding downside protection when adding risk or by hedging their existing exposures.
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