When Banks Fail

Posted by Jacob Radke

On Wednesday, March 8th, 2023, Silicon Valley Bank ($SIVB) announced that it would need to raise $2.25 billion in stock to stay afloat. The news sent shockwaves through the financial system.

The next day, the bank’s shares plummeted over 60% as investors panicked about its liquidity and solvency. On Friday, the situation worsened as the bank’s shares were halted before the market opened and the FDIC took over the bank by the end of the day.

What Went Down

Here’s what happened to Silicon Valley Bank:

Silicon Valley Bank has long been the most popular bank for start up companies, offering a broad range of banking solutions to those companies.

But Silicon Valley Bank operates as any other bank. It takes customer deposits and lends/invests those deposits to other companies or the government.

Because Silicon Valley Bank’s customers are risky start ups they took the safe route investing deposits in government treasuries - long considered to be the safest asset class. But that’s where it ended, in a world of 0% interest rates, a bank that lent to companies that thrived in 0% interest rates had to invest deposits in longer term government securities and get a return of say 1%-1.5%.

But in 2022 those long dated government securities did not perform they way they generally did before. Mainly because rates were scraping the bottom of the barrel in 2020-2021 and so they only had one way to go, up. When bond yields rise, prices fall, and the farther their maturity date is away the more it falls.

Many start ups, especially companies raising money, are tech companies. When tech entered a recession in 2022 due to the rising interest rates, those companies stopped raising and started pulling cash from their checking accounts at the bank.

So the bank had to start selling it’s bond portfolio to satisfy it’s customer withdrawals. But that bond portfolio, filled with a lot of long dated treasuries, was 20% off of it’s highs.

It doesn’t take very long before the customer withdrawals start eating away at the banks assets.

Banks are subject to reserve requirements, or the amount of reserves they are required to have to satisfy customer withdrawals. As of January 2020, it ranges from 0% for deposits under $16.9 million to 10% for deposits over $127.5 million. Meaning on $150 million dollars in deposits the bank would need to have $15 million in reserves.

Once they cross that reserve ratio requirement they need to sell asset to build it back up.

Silicon Valley Bank ran out of bullets at the table and was forced to raise an additional $2.25 billion to satisfy customer withdrawals.

When the bank did that, it spooked depositors. It told investors that the bank was experiencing a liquidity crisis, which spooked more depositors. In today’s world of online banking, however, deposits could leave the bank faster than the bank could even sell it’s bond portfolio. At the peak about $1 million was leaving the bank every second.

When their capital raise failed they explored a sale, and when that failed the FDIC and financial regulators took over deposits.

Essentially the bank and its customers were highly interest rate sensitive, meaning both the banks assets and liabilities were sensitive to interest rates. So when rates rose at the fastest rate in history it caused a crisis.

About $150 billion of SVB’s $175 billion in deposits were uninsured by the FDIC. Meaning the bank will need to be liquidated and, as of writing this, the government is focused on making depositors whole. If they didn’t thousands of people would be laid off, not just bank employees, but the employees at the companies that had deposits that are now in limbo waiting for the liquidation.

What it Means for You

It's okay to support your local banks, but make sure you have deposits at a large bank (presumably most of your uninsured deposits).

Essentially, we operate in a two-tiered banking system.

Tier one banks are the systemically important banks. These are the "too big to fail" biggest banks. If you have money there, it's a true deposit. You can't lose it.

Tier two is everyone else, the regional/local banks. If you have money there, it's not a true deposit. It's an unsecured loan to that bank. You can lose uninsured deposits in a bank failure.

Although it feels like the insured deposit limits are infinite, the government wants to reinstall consumer confidence in the banking system. If they don't, they risk further and worse financial distress.

But that's not the only way this can affect you. The ripple effects in the financial markets are already being felt.

Signature Bank and First Republic Bank, two other regional banks (based in California) are in the hot seat. First Republic Bank this morning, Monday, is down 60%+.

First, these banks are in the S&P 500, meaning they are in your 401(k)s. The weight won't be felt that much there, however.

Where it will be felt is in the $150 billion dollars of deposits that will have to make it back into the hands of companies for payroll.

Another thing is when large companies and people take the alternative route and start hiring teams to buy treasuries rather than holding deposits at banks.

When Apple gets concerned that its $180 billion cash position is in trouble, what does it do? It starts buying treasuries and pulling deposits.

The problem with that is it sparks another liquidity crisis and it spirals, causing Google, Microsoft, Amazon, etc. to start following suit along with all of the people they employ, and everyone watching. Full contagion.

What it Means for the Future of Economic Policy

Interest rates are the main thing that this chain of events affects. It's the whole reason we are in this mess, for the most part. I mean, if people would've chilled out, everything would've been fine, and if SVB would've managed its risk better.

The Federal Reserve, which sets a lot of regulation on the banking industry, has to take this matter incredibly seriously. A crisis like this can spiral out of control and take the economy down with it. That means high unemployment and deflation.

Oddly enough, Jerome Powell, Chairman of the Federal Reserve, testified before Congress last Tuesday and Wednesday, and the markets priced in higher rates. Once news broke that SVB was collapsing, the futures market priced in rate cuts in the very near future.

This, to me, feels like capitulation of sorts, maximum bearishness. The return on government bonds in the last several days has been incredible.

Next week, the Federal Open Markets Committee will meet and give the US their expectations for the future of monetary policy and their rate decision.

As of right now, I believe there is a reasonable chance that the Fed does not hike rates and instead pauses, in which case the next move would likely be a rate cut somewhere down the line.

This is a great thing for bonds in the short run and a wonderful thing for stocks in about 2-3 months.

I believe we are in the end stages of this bear market.

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