The Slow, Sudden Collapse of SVB

“So we beat on, boats against the current, borne back ceaselessly into the past.”

F. Scott Fitzgerald (The Great Gatsby, 1925)

i.                The Story of SVB

Until last weekend, most people had not heard of Silicon Valley Bank or SVB. At its peak in late 2022, it had a market capitalization of roughly $45bn. SVB now ranks as the second-largest bank failure in US history and the biggest bank failure since the global financial crisis. The bank was dreamt up over a poker game – and then had money thrown at it as the pandemic-born boom that rolled through Silicon Valley led to a remarkable three-fold increase in SVB’s deposits, from $62 billion in 2019 to a peak of $191 billion in December 2021. But the curious thing is that the bank’s loan book (an asset for banks) only grew from $23 billion to $66 billion. There was simply no prudent way to scale up lending proportionally.

As a result, new loans only covered 25 cents of every new dollar of deposits, and SVB’s loan book fell from 57% of total deposits at the start of 2019 to less than 35% at the end of 2021. This was a problem for the bank because their business model is to borrow short, lend long, and pocket the difference. But in the case of SVB, their Silicon Valley-based clients already had boatloads of money from other sources, including start-up funding, venture capital, initial public offerings, booming business platforms, and more. What they needed was a place to store their cash while they built businesses that were going to change the world. They did not need to borrow money from their bank.

To solve for the fact that their clients did not need loans, SVB channelled their deposits towards long-dated Treasuries, residential mortgage-backed securities, and corporate and foreign bonds. One might argue that this was a very sensible approach – investing deposits into safe assets that could be easily liquidated. But as every Cluedo player knows, there is always a “however” that comes along with the murder weapon. And in this instance, the “however” is that, as interest rates went up, the market value of Treasuries, mortgage-backed securities, and bonds went down.

Eventually, the situation became intolerable for SVB. To meet its obligations, the bank was forced to sell a $21 billion portfolio with a 1.79% yield into a market where 10-year Treasury yields hovered near four percent and mortgage-backed security yields reached 4.75%, up from 2.47% a year ago. To say 2020-21 was an inopportune time for a four-fold increase in holdings of these securities is an understatement. And, as the saying goes, the rest is history.

In selling its bond book, SVB realized a $1.6 billion loss, with the intention being that it would make up the difference with a capital-raising exercise. But it did not happen that way; the word got out, and depositors rushed to the bank to withdraw their money in favour of deposits with larger multinational banks, short-term US Treasuries and/or money market funds. As Ernest Hemingway’s bankrupt war veteran, Mike Campbell, noted, the way that you go bankrupt is slowly, then suddenly. This is exactly the case of SVB. In a classic bank run, the Wile E Coyote moment arrived, and it was the end for the bank.

ii.               Contagion: It’s Not Me, It’s You

But banks bring with them another risk – and that is the risk of contagion. They seldom fail alone. And the collapse of SBV was joined by the collapse of Signature Bank. In response to recent crises, policymakers have implemented numerous measures to bolster the banking system. These include increased capital requirements, stricter regulations on risk-taking, and enhanced supervisory frameworks. While these measures have undoubtedly improved the system's resilience, they also underscore the inherent fragility of the banking sector which remains vulnerable to shocks, despite a decade of post-global financial crisis reforms.

Given the contagion risk, policymakers moved swiftly over the weekend to reassure depositors and markets. This included the US Federal Reserve (Fed) announcing emergency measures to backstop banks facing short-term liquidity pressures. Banking regulators also said they would protect all SVB depositors, including those above the $250,000 deposit insurance limit provided by the Federal Deposit Insurance Corporation (FDIC). In this, the Fed stressed that the system had been protected “for the good of the economy” and, also, that we should rest assured that the shareholders, bondholders, directors, and executives of the failed institutions will suffer severe financial consequences. We leave the latter point for another discussion.

For now, it is important to recognize that the policy steps and regulatory pronouncements have not stopped the rumbling. In the aftermath of SVB, other regional banks, including First Republic Bank and Western Alliance Bancorporation, have come under pressure. The prices of these banks’ shares fell 70% and 50%, respectively, over a few days. And, at the time of writing, the anxiety has spilled to European Banks, with the price of global investment bank Credit Suisse Group falling by a third over a few days.

According to Erica Jiang, Gregor Matvos, Tomasz Piskorski, and Amit Seru, the cause for concern about system-wide risk is well placed. Their paper, Monetary Tightening and US Bank Fragility in 2023, was published with immaculate timing, arriving in inboxes on Friday of last week. Their work analyses US banks’ exposure to recent rises in interest rates and explores the implications for financial stability.

Amongst other things, the researchers observe that accounting for loan portfolios held to maturity, the US banking system’s market value of assets is $2 trillion lower than suggested by their book value of assets; marked-to-market assets have declined by an average of 10% across all banks, with the bottom fifth percentile experiencing a decline of 20%; and if uninsured deposit withdrawals cause even “small fire sales,” there is substantial risk baked into the banking system.

This leads the researchers to conclude that the US banking system is a lot more fragile than commonly assumed. Before the interest rate increases of 2022, all US banks had positive bank capitalizations, compared to 2,315 banks, accounting for $11 trillion of aggregate assets, that now have negative capitalizations. This significantly heightens the fragility of the US banking system to uninsured depositor runs and is cause for real concern.

iii.              Structured Products: The Risk that Lies Beneath.

Beyond the first-order risks of bank runs, there are myriad second-order risks that come with banking crises. At least one worth flagging in this episode are risks faced by owners of so-called structured products, which have become extremely popular under the guise that they offer ‘guaranteed’ returns, downside protection, upside ownership, and all other types of free lunches that generally do not exist in investments. The specific risks that come with these investment products include index market risk, which refers to the performance of a reference index; illiquidity, which relates to the ability of the investor to sell their investment prior to maturity; and counterparty credit risk, which usually comes in the form of a bank bond that is meant to provide a level of capital protection to the owner of the structured product.

The last of these three risks is especially material in the case of SVB, where administration officials have said the regulatory intervention does not constitute a bailout because stockholders and bondholders would not be protected. As a result, structured products underpinned by SVB bonds would be at risk of 100% capital losses. This should be pause for thought for owners of structured products everywhere. And while this risk always appears remote at the oustet, as can be seen in the SVB case, the risk materialises quickly and unpredictably with potentially devastating impacts on owners of these investments. 

iv.             Lessons for Policy and Practice

The collapse of SVB, Signature Bank, and subsequent rumblings would not be the first rodeo for many investors. Every Fed hiking cycle has usually ended up causing some sort of turmoil, with the saying going that in every cycle, the Fed hikes until “something breaks”. Are SBV and Signature Bank the “things that broke”, or are they the canaries in the coal mine? Under either scenario, this begs the further questions: “What are the implications for policy; and what are the implications for investors?”

In 2018, at the end of the hiking cycle, there was a big market sell-off late in the year, which was followed quickly by a pivot away from rate hikes. The US housing collapse followed a series of rate hikes over 2004-06, and the bursting of the dot.com bubble followed a series of rate hikes over 1999-2000.

At this point, it is not altogether clear if the failure of SVB and Signature Bank are the extent of the financial rumble, or that the swift policy action has cut financial sector contagion off at the pass. As suggested above, there is good reason to suspect this is the first – and not the last – rumbling, and even if it is no more than a storm in a teacup, it equips us to be alive to the prospect of substantially greater risk and system-wide impacts that could permanently damage investors’ capital.

What SVB shows is that higher interest rates hurt. And, importantly, they are meant to; that is the point of monetary tightening – to take the froth and foam out of the system and to return asset prices to sane territory without breaking the economy. However, what SVB has underscored is the high interconnectedness and fragility of the banking system.

 v.               Stay the Course, Or Fold?

These recent events also question the extent to which the Fed will stay the course in fighting inflation. At least one view is that the tightening in financial conditions caused by market reactions over the last few days may have done what, just one week ago, was the Fed’s unfinished business. In the aftermath of SVB, investors have rapidly priced out the chances of aggressive rate hikes from the Fed this year, with the futures-implied rate for the December 2023 Fed meeting down by more than 100 basis points (one percent) since the SVB episode began.

Even more than that, a 2023 rate cut is now expected. This is remarkable because consumer price inflation – one of the slower but surer destroyers of wealth – continues to run hot, coming in at 6.0% year-on-year in February. While this recent inflation number matched expectations, the New York Fed’s Underlying Inflation Gauge was still running at 5.1% in January – a long way above the Fed’s target. On this point, the Federal Funds rate has not yet exceeded the rate of inflation in this tightening cycle. In every other tightening cycle in recent decades, the Fed has not stopped hiking until they have passed that point and taken the policy rate into positive territory in real terms. If the uncertainty surrounding the financial system led the Fed to opt for an easier interest rate stance, rather than going bankrupt quickly, some investors may find their wealth slowly confiscated by the stealth of stubbornly high inflation.

Given the strong economic data over February, there had been growing hopes that a US recession in 2023 could be avoided, even though it was the consensus forecast among economists. But after the SVB collapse, those recession risks are higher, even if the Fed stops hiking. Keep in mind that the Fed has never tightened this much this quickly without a recession happening, so avoiding one would require several historical precedents to be overturned in order that “this time is different.”

This puts three risks squarely on the table: the fragility of the financial system; the corrosive force of inflation; and the threat to earnings, incomes, and valuations that are brought by recession. Whether these risks materialise quickly, or slowly, we have our eyes on all three risks.