By Avi Deutsch
March 17, 2023 – The financial infrastructure that enables the modern economy is a work of wonder. A global machinery of banks, brokerage firms, investment banks, stock exchanges, fund managers, and insurance companies hums in the background of our lives. This machinery is governed by a bewildering array of domestic governments and international organizations, but the glue that holds the system together transcends the letter of the law. Trust, in and among the financial institutions, and those providing oversight, underpins not only our economic system, but our entire way of life.
The events of the past ten days are a stark reminder of what happens when this trust is lost, and how fast mistrust can spread in the age of the smartphone. Fortunately, regulators and governments were quick to recognize the threat, and though their response will be rightfully scrutinized for years to come, they deserve credit for swift and decisive action. The failure of a major bank is an unexpected outcome of monetary policy that is bound to affect the Fed’s future decisions. Fortunately for the Fed, this event occurred with the publication of data showing that the Fed’s attempts to tame inflation are working.
The remainder of this blog will discuss the collapse of Silicon Valley Bank (SVB), the regulators’ response, the impact on the broader economy, and tips for keeping your money safe.
What Happened to SVB
Multiple forces came together to bring down Silicon Valley Bank (SVB). The first has to do with the bank’s customer base, namely, startup companies, venture capital funds, and individuals from the venture community. As startup companies burned through the cash they raised in 2020 and 2021 when venture funding was plentiful, they drew down on their accounts held at SVB. This outflow of capital was not matched by a corresponding influx of new capital as startups have been much slower to raise new capital in the current environment, resulting in a net outflow of asset. SVP should have been prepared for this, but was not.
How SVB came to mismanage its assets and liabilities so spectacularly will be studied for years to come. Many historical banking crises were caused by bad loans—either issued directly by the bank or held in the form of a collateralized security like the infamous MBSes. In contrast, as SVB’s deposits grew rapidly in the past years, the incoming funds were invested in treasuries, considered the safest investments. However, risk takes many forms, and as the Fed hiked interest rates rapidly over the past year to combat inflation, the treasuries held by SVB lost some of their market value.
The mechanism at play is as follows: say, hypothetically, that back in 2020, SVB bought a 12-year treasury paying a fixed 2% annual interest for the price of $1,000. Two years later, in 2022, the Fed started raising interest rates and now investors can buy a 10-year treasury paying 3% interest for $1,000. If SVB now needs to sell the original treasury, which is paying only 2% for the remaining ten years until it matures, they would have to sell it for less than the $1,000. A good rule of thumb suggests that if interest rates go up by 1%, bonds lose 1% of their value for each year remaining until they mature. In the above scenario, SVB would hypothetically lose 10% on the treasury they bought in 2020 if they were forced to sell it in 2022.
Many of the treasuries bought by SVB had long durations, presumably in the search for higher yields found in longer-dated treasuries. Normally, the longer you lock up your money, the higher the return. This relationship is currently flipped in what is called an inverted yield curve As interest rates rose, many of these bonds lost some of their market value, and when SVB was forced to disclose these paper losses last week, depositors got spooked and started pulling their money out of SVB.
As famously illustrated in Mary Poppins, the slightest insinuation that a bank will not be able to repay depositors’ money can be enough to cause mass panic that quickly becomes a self-fulfilling prophecy. But bank runs in 2022 look very different than they did in 1910, or for that matter, in 2008. The combination of mobile banking, and amplified fear mongering on platforms like Twitter, brought down SVB at lightning speed. As a point of reference, the largest bank to go under during the 2008 Global Financial Crisis was Washington Mutual, when over a period of 15 days, depositors withdrew $18 billion. SVB saw withdrawals of $42 billion in just 24 hours. At that point, it was game over for SVB.
Regulators to the Rescue?
As multiple banks collapsed during the Great Depression, the Roosevelt administration set up the Federal Deposit Insurance Corporation (FDIC) to protect depositors. This body took over SVB and later announced that it would guarantee not only the $250,000 normally covered by FDIC insurance, but all deposits held at SVB and Signature Bank which was also taken over that same weekend. This step, designed to shore up trust in the banking system, was quick to draw the ire of Republican lawmakers. No doubt regulators did what they believed was necessary to stabilize the financial system, but questions about moral hazard and investor responsibility are warranted. The FDIC’s actions are unlikely to require funding by the government, but instead will be paid for by other banks, meaning ultimately, by consumers.
In another step designed to strengthen banks, the Fed created a new program to lend money to banks against the value of treasury holdings which lost value because of the interest rate hikes. In the example above, if SVB had access to such a program, it would not have to sell the bond it bought in 2022 for $900, but instead could borrow the full $1,000 from the Fed to repay depositors.
The irony of this program, and of the SVP debacle more broadly, is the role played by the Fed in making treasuries a core component of bank balance sheets. In the wake of 2008, international banking regulations designed to improve bank resiliency required banks to hold highly liquid and safe assets, preferably government bonds. The duration of these securities was given little attention, as regulators expected long-term interest rates to remain suppressed, as they did for 15 years. That all changed when inflation reared its ugly head, suggesting the end of a long period of ‘lower for longer’ monetary policy. While SVB is accountable for mismanaging its balance sheet, so is the Fed for failing to consider the risk of long-duration treasuries on bank balance sheets while it raised interest rates.
The issue of long-dated government bonds on bank balance sheets is not limited to the U.S. Fears of undisclosed losses on the balance sheets of European banks sent their stock tumbling on Wednesday. Disclosures by Credit Suisse, Switzerland’s second largest bank, of issues in its financial reporting added yet more fuel to the fire. Credit Suisse has been plagued with multiple issues over the past few years and European regulators are moving quickly to limit the fallout should the bank fail.
Where We Go from Here
Of the many possible consequences of rising interest rates, a bank failure was hardly considered a likely outcome. Once again, we are reminded that the tools of monetary policy are blunt instruments. As the Fed raises the cost of money and withdraws liquidly from the economy, cracks appear in unlikely places, threatening to turn a slowdown into a recession. The good news is that the problems revealed at SVB appear to be limited to mid-size banks with concentrated depositor bases. First Republic may or may not survive this crisis, but the large and more diversified banks appear safe for now, especially with access to the Fed’s new lending program.
Drowned out by the news about the banks were more signs that the Fed’s monitory tightening is having the desired effect on inflation. February’s CPI figures released on Tuesday showed 12-month inflation at 6% (compared to 6.4% in January), and core inflation which excludes food and energy came down to 5.5%. While this is progress in the right direction, inflation is still well above its 2% target. Wednesday brought better news, with the Producer Price Index falling by 0.1% in February, for a 12-month rate of 4.6%. Also on Wednesday, the Commerce Department reported that retail sales fell by 0.4% in February, after rising 3.3% in January.
A slowdown in the pace of inflation is good news for the Fed, whose path toward continued interest rate hikes is severely complicated by the collapse of SVB. As of Wednesday, markets are pricing in 56.5% probability that the Fed will leave interest rates at their current level at the coming meeting on March 22nd, up from 0% just one week ago. In contrast, the markets forecast a 0% probability of a 0.50% hike, down from 78.6% just one week back.[1] How quickly the world has changed. Looking out further, investors see a 50% chance of the Fed lowering rates by June.
Between now and the Fed’s meeting on March 12th, investors will be looking closely at the banking system both in the U.S. and abroad. Equity markets, which have been jittery for several weeks, have now given up much of their 2023 gains. Future volatility is expected, especially if there’s more bad news about the banking system. On the flip side, equity markets are forward-looking, and bad days are likely to be followed by good days, especially if investors suspect a shift toward expansionary monetary policy. As always, long-term investors’ asset allocations should reflect their goals and need for risk rather than an attempt to time the markets. This is also a good time to conduct a financial hygiene review and ensure your assets are protected in case of another bank failure.
Keeping Your Money Safe
Money kept in checking and savings accounts is generally protected by FDIC insurance to the tune of up to $250,000. Though the FDIC took the unusual step of guaranteeing all deposits at SVB and Signature Banks, there’s no guarantee they would do the same should another bank fail. If this sounds odd, recall how Lehman Brothers was allowed to fail in the same year the Bear Sterns was bailed out by the Fed.
Consumers, and businesses especially, should avoid leaving cash in excess of $250,000 in their bank accounts. Such assets are not only generally not covered by FDIC insurance, banks have also been paying savers lower interest rates than those available in alternatives such as treasuries.
Unlike banks, custodial accounts such as those offered by Fidelity and LPL Financial hold client assets are separate accounts for the benefit of the clients. These institutions are covered by the Securities Investor Protection Corporation (SIPC), a federally mandared nonprofit organization that steps in should a custodian fail. In the event that assets are missing from a custodial account, the SIPC insures up to $500,000 in securities, including a cash limit of up to $250,000.[2] Many custodians also carry additional insurance above SIPC coverage, and both Fidelity and LPL carry insurance coverage through Lloyds of London. Unlike checking accounts, cash in custodial accounts can be deployed directly into short-term treasuries or other cash-alternatives such as government money-market funds, both of which are offering their highest return in decades. Consumers and businesses that need to hold large amounts of cash may want to consider moving these assets to custodial accounts.
In sum, the collapse of SVB marks a new stage in the economic cycle as we begin to see the material impact of interest rate hikes on the financial system and perhaps the economy. Fortunately, it appears to come at a time when inflation is cooling, providing the Fed with latitude to relax its monetary policy. In the meantime, SVB may not be the last bank to fall, and the regulators may not be as generous next time. Consumers and companies alike should avoid the unforced error of leaving unprotected assets sitting in their bank accounts.
— AMD
[1] Source: CME Group FedWatch Tool. Retrieved March 15th, 2023.
[2] Source: Fidelity: https://www.fidelity.com/why-fidelity/safeguarding-your-accounts; LPL: https://www.lpl.com/disclosures/sipc-coverage.html.
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