US-Domiciled Silicon Valley Bank Fails - How? Why? What Next?

On Friday, March 10^th, US regulators closed Silicon Valley Bank (SVB), a 40-year old bank that catered to the tech industry. The bank’s failure was abrupt, with concerns only really arising the day before, on March 9^th, when the company’s stock fell over 60%. The speed of the collapse was driven by high-profile venture capitalists (e.g. Peter Thiel) urging their portfolio companies to pull funds from the bank. SVB had over US$200 billion in assets at the time of closure, making it the 16^th largest bank in the US and the 2^nd largest bank to ever bank failure in US history.

How could a large bank fail so quickly?

Typically, banks can avoid a bank run by selling assets or loans to cover any withdrawal requests that come in. In the age of online banking, where users can submit withdrawal requests from anywhere, and those requests can be processed in hours, the time required to sell a large portion of a bank’s assets to cover withdrawals could be longer than withdrawal processing times. Most large banks have access to a large amount of highly liquid and stable assets available to meet withdrawals requests so the risk of a bank run is incredibly low.

In the case of SVB, a large portion of its assets were held in long-term mortgages and US Treasury bonds. While these are very high quality assets and are highly liquid (i.e. saleable), the value of these assets can vary materially over time. The rapid rise in US interest rates over the course of 2022 and early 2023 had pushed the value of some of SVB’s assets below face value (i.e. interest rates go up, pushing the value of the bonds and mortgage loans lower to reflect higher interest rates). With withdrawal requests amounting to almost one-fifth of total deposits in one day, SVB was looking at having to sell a large portion of its assets below their acquisition cost, and if it were pushed to sell all of its assets, it was possible that it would not have been able to cover all deposits. A key reason for the urgency to withdraw funds from SVB is the fact that a high percentage (~86%) of SVB’s deposits were uninsured (i.e. not covered by FDIC insurance because many balances were above the US$250,000 limit) so there was a real possibility that depositors could lose part of their uninsured bank deposits.

A New York based cryptocurrency focused bank, Signature Bank (SBNY), was also closed by regulators over the weekend, as a similar asset-liability mismatch existed. There are a number of US regional banks in a similar situation as SVB, holding a high percentage of their assets in long-term mortgages and US Treasury bonds and with a high percentage of uninsured deposits, making them susceptible to a bank run. To prevent additional bank runs, the US Federal Reserve launched the Bank Term Funding Program (BTFP), providing a US$25 billion backstop for US bank deposits to re-establish faith in the US financial sector. This emergency response by the Federal Reserve should help quell any fears about depositors losing any of their bank deposits reducing the urgency to pull funds from US banks. This is a classic case of an asset-liability mismatch and the management of these banks are to blame. Depositors will be made whole by the US government and the shareholders of SVB will bear the brunt of the equity loss.

To paraphrase Paul Reilly, CEO of Raymond James Financial, these US regional banks intentionally set up their balance sheets this way – low cost short-term liabilities in the form of deposits and higher yield long-term assets in the form of long-term mortgages and US Treasuries to boost near-term earnings at the expense of long-term business sustainability.

“This is the opposite of how Raymond James Bank works. We always keep the long-term focus.” – Raymond James CEO Paul Reilly

Where do we go from here?

This problem appears to be a US regional bank problem only. With the support of governments, these banks will need to adjust their balance sheets to account for the risk rapid withdrawals. Large US and Canadian banks do not face the same asset-liability mismatch that exists on the balance sheets of many US regional banks. In fact, large banks will likely become the template that US regional banks use to restructure their businesses. Some regional banks may merge and become larger and more highly regulated banks, while others may be acquired by larger banks.

The effect that this predicament has on the greater economy is unknown at this time. Consumer confidence may be affected by the news and the transition from the old US regional bank model to a more sustainable one may temporarily affect new lending volumes. That said, this predicament has also sparked a drop in interest rates which adds some stimulus to the economy as a whole.

Equity markets in general have underperformed since early 2022 and part of that underperformance was attributable to rising interest rates and the issues that rising rates create in the world economy. Issues like the one with SVB and US regional banks are bound to pop up every now and then. With the US government now having fully backed depositors, it appears that the risk of loss for depositors has been avoided. Great news for depositors, but the future for US regional banks remains uncertain.

From an investment management point of view, maintaining a well-diversified portfolio, customized to your risk tolerance is integral. We are always evaluating risks that exist in the broad equity markets and adjusting portfolios appropriately to maximize return while managing overall portfolio risk exposure.