‘Gradually, then suddenly.’
The biggest story of the 1st quarter was the collapse of Silicon Valley Bank (SVB) and the ensuing regional banking crisis in the US. It took just two days for SVB to collapse after the announcement that they needed to raise capital. Depositors lost confidence in the bank, triggering a run on deposits and cementing SVB’s fate. This followed news that crypto bank Silvergate was closing its doors. Then Signature Bank, roughly half the size of SVB, was also shut down by regulators that weekend. This sent shockwaves through the broader regional banking industry with the shares of banks like First Republic and Western Alliance down 90% and 60% respectively since then. Even the shares of financial services giant Charles Schwab have lost 35% in the wake of SVB’s closure.
So how did this happen? As Ernest Hemingway would say, ‘Gradually, then suddenly.’
The seeds for the present regional banking crisis were already sown in the 2008 financial crisis. To prevent the technical insolvency of the banking industry, regulators changed an accounting rule which allowed banks to carry certain assets at their original book value instead of their prevailing (and much lower) market value. These assets were marked as ‘held-to-maturity’. The idea was that if the banks could hold these assets until they matured several years later, they would ultimately realize their book value, so they needn’t recognize the sizeable losses they were carrying in the meantime. This didn’t do anything to change the underlying reality of what those assets were worth at the time, but it did mean that the banks could satisfy regulatory requirements for capital adequacy without raising fresh capital. This accounting stroke of the pen apparently worked…
Fast forward to 2020 and the COVID/lockdown crisis. The US administration flooded the market with trillions of dollars of stimulus, resulting in a wave of new deposits for the banking institutions. Deposits held with Bank of America (by way of example) jumped from $700bn to $1.2tn between 2020 and 2021 – an increase of 70% in 1 year. What do you do with all this excess cash in a zero interest rate environment? Apparently you invest it in longer-dated ‘held-to-maturity’ securities with interest rates marginally above zero and pocket the difference. This is risky, since any increase in interest rates would decrease the value of those assets, only not on paper since they were marked ‘held-to-maturity’. This is what almost every US bank did with the wave of stimulus-driven deposits that came their way. Almost all of it was invested in longer-dated securities.
‘… then suddenly.’
The unprecedented stimulus, combined with global supply-chain upheaval in 2022, led to resurgent inflation and consequently the fastest interest rate hiking cycle for decades. When interest rates go from 0% to 4% in a year, something must give. The market value of these ‘held-to-maturity’ securities decreased by ~20% in some cases. If these losses were reflected on bank balance sheets, their equity would be severely impaired.
This brings us back to Silicon Valley Bank: Between 2020 and 2021, SVB’s deposit base more than doubled. Virtually all the new deposits were invested in longer-dated ‘held-to-maturity’ securities. In 2022, roughly 45% of their balance sheet was invested in these longer-dated assets (vs 20% in 2020). This is 2x-4x more than most other banks. Add to this that SVB had a very narrow deposit base, focused on the flagging tech startup space, and you have a recipe for collapse. As cash strapped tech startups began to withdraw deposits, SVB was forced to liquidate a portion of their ‘held-to-maturity’ assets at a sizeable loss to meet the withdrawals. This in turn impaired their capital, hence the need to raise new capital, which spooked depositors… and that was the end of SVB.
While SVB was in the most precarious situation, there remains an underlying solvency issue with the overall US banking system. If every bank were suddenly forced to realize the losses on their ‘held-to-maturity’ assets, there would be serious implications. While regulators have managed to stem the immediate liquidity crisis (which exposes the underlying solvency issues), it remains to be seen whether time will take care of this problem or not. Either way, US banks have taken a big misstep which cannot simply be waved away because an accounting rule allows them not to reflect it in their financial reports.
In our portfolios we have limited exposure to the US banking sector. We are avoiding exposure to institutions with large ‘held-to-maturity’ exposures, even larger institutions such as Charles Schwab and Bank of America. Finally, when it comes to banks (and insurers) we avoid the smaller regional players since the largest players are usually better regulated and more diversified.