Timely regulatory action mitigates surging systemic risk. The joint announcement on March 12 by the Treasury, Federal Reserve, and FDIC that all depositors at both SVB Financial and Signature Bank would be made whole, along the establishment of a new liquidity facility for depositories, have hopefully ended the incipient banking crisis. The new liquidity program, the Bank Term Funding Program, will make advances up to the value of pledged collateral, with collateral valued at par, priced at the one-year overnight index swap rate plus 10 basis points.
The extent to which this action constitutes a bailout (or adheres to Walter Bagehot’s rule for central bankers of “lending freely against good collateral at a penalty rate”) is in the eye of the beholder; equity holders aren’t getting any relief, but depositors with uninsured balances are. The long-term costs of underwriting moral hazard remain to be seen, but the short term costs of not doing so appeared very dire indeed. While the immediate crisis has been averted, the heightened awareness of risk will hopefully persist; banks still face
plenty of challenges from higher rates and investors are likely to remain more attentive to liquidity and other risks that had arguably been getting less attention than they were due. The purpose of this report is to offer a high-level review of how we came to this pass, and where we go from here.
How We Got Here
The 2021-22 venture capital boom. The core of SVB Financial’s business is the venture capital ecosystem, taking deposits from, and making loans to, VC-funded companies. As shown in Figure 1, VC deployments spiked in 2021 and then declined in 2022 as interest rates rose.
Figure 1: VC deployments surged in 2021 and early 2022, then fell as rates rose
Source: Company Filings
The steepest tightening cycle in memory. Critically, interest rates didn’t just rise a little bit. As shown in Figure 2, coming off the COVID-driven extension of ZIRP, inflation in 2022 catalyzed the fastest, highest increase in the Fed Funds rate in over 40 years. Notably, the two cycles with the closest trajectories to the current one were those of 1988-89, which presaged what, until 2008, was the worst banking crisis since the Great Depression, and of 1994-95, which also came after a long period of low rates, and thus also created large losses in bank securities portfolios.
Figure 2: The current tightening cycle is the steepest in over 40 years
A bad situation, badly managed. As quickly as venture capital funds poured money into start-ups, the start-ups poured the money into their bank accounts, fueling heroic deposit growth at SVB Financial. Between year-end 2020 and March 31, 2021, total deposits at the bank rose 94% (and since VC funds typically invest sums larger than $250,000, very little of the deposits are insured by the FDIC). Lacking commensurate lending opportunities, the bank bought securities, mainly stretching for yield by deploying 81% of the increase in deposits in longer term mortgage-backed securities (MBS) in the held to maturity (HTM) portfolio. Unfortunately, as shown in Figure 3, the 2021 growth in the securities book was immediately followed by the rise in interest rates, leading to enormous unrealized losses. While these losses don’t flow through the AOCI line like losses in the AFS portfolio do, they are just as real.
Figure 3: SVB grew the MBS portfolio right before interest rates started rising
The failed capital raise. All this set the stage for last week’s failed capital raise. We’d be lying if we said we fully understood how it happened; hindsight is always 20/20 but on March 8 SVB’s proposed capital raise didn’t look like the catalyst for a bank run, let alone a systemic banking crisis. The losses in the HTM book were massive relative to SVB Financial’s equity base, but had been fully disclosed all along. The bank’s depositors were largely uninsured, but there again, no new news. The ratings downgrade was brewing and the mid-quarter update did point to continued VC cash burn and related deposit outflows, neither of which was trivial. The next day, in an echo of 2008, the stock fell below tangible book value, entering a spiral that took the prospective capital raise from accretive to book, to dilutive, to impossible.
Where Do We Go From Here?
Dosis sola facit venenum (only the dose makes the poison). The table below summarizes some crucial risk factors for SVB Financial (and Signature Bank), and also lends some comfort that other banks don’t face the same magnitude of risks. Every bank has uninsured deposits, and securities losses and deposit outflows are facts of life for the entire banking system in 2023, but only at SVB Financial and Signature were the doses lethal (setting Silvergate aside as having been likely unsurvivable for idiosyncratic reasons).
To arrive at this list, we sorted banks based on the share of deposits in accounts with balances above the insurance ceiling, removing G-SIBs and non-customer-facing banks. What remains is, unsurprisingly, a list of business-oriented banks. To be clear, we do not suggest that these banks are poised to follow in the footsteps of SVB and Signature. Some have large HTM losses, some have seen significant deposit outflows, some have valuations that could make equity issuance challenging, and all have a high share of uninsured deposits, but generally don’t have all those issues, and not of similar magnitude. These are, however, data to which the market is likely to remain more attuned than it had been prior to last week.
Figure 4: SVB Financial and Signature Bank Were Outliers
Mid-quarter updates from the survivors. Of the nine surviving banks on the above list, five have provided mid-quarter updates, including two since the regulators’ announcement Sunday evening. First Republic disclosed total available liquidity exceeding $70 billion, including incremental liquidity available from the Federal Reserve and JP Morgan Chase, but excluding liquidity from the just-announced Bank Term Funding Program. East West Bancorp disclosed a 1% decline in deposits quarter-to-date, attributed to a planned
reduction in brokered deposits, and noted unused borrowing capacity amounting to over 50% of total deposits. First Foundation, Western Alliance, and Preferred Bank each released updates prior to the regulatory announcement.
Heightened focus on concentrations and exposures. While the immediate danger has receded, we anticipate that markets will become more vigilant about bank concentrations and exposures. Some types of concentration are obvious and easily observed, such as geographic concentrations that, for depositories, tend to be revealed by deposit share data. (Link access is limited to FactSet workstation subscribers.)
Other forms of concentration can be more challenging to get one’s arms around; consider SVB’s venture capital concentration; VC-funded companies aren’t evenly distributed across SIC codes – there are rather more in life sciences than in, say, iron smelting – but they are nonetheless spread out across many industries in many sectors. For banks, a review of relationships disclosed in term and revolving credit agreements can be useful; SVB, for example, is listed on 245 agreements, with the industry distribution shown in Figure 5. (Link access is limited to FactSet workstation subscribers.)
Figure 5: Silicon Valley is a creditor on 245 separate loan filings, grouped here by industry
The post-ZIRP adjustment is still in the early innings. SVB’s deposit decline was sharper than most, but deposits have been declining on an industrywide basis for several quarters now and that source of stress has surely not run its course yet. And even though uninsured depositors are being made whole in these recent failures, the long term reaction of depositors to the events of the past week remains to be seen; some shift of market share, likely toward the too-big-to-fail cohort, wouldn’t be shocking. As a result, the metrics that have
suddenly gained so much currency in the past few days seem likely to retain much of that attention for the foreseeable future. At least until, inevitably, credit quality rears its ugly head
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