Markets crave stability, especially when it comes to the banking system. When confidence is questioned, volatility, confusion and panic can be the result. The current episode of bank failures will likely be no exception. Much depends on the effectiveness of the government’s response to this crisis.
Last week saw the second largest bank failure in US history, as 16th ranked Silicon Valley Bank (SVB) collapsed and was taken over by the Federal Deposit Insurance Corporation (FDIC). And on Sunday, New York regulators proactively shut down Signature Bank, after the FDIC said that the bank posed a systemic risk to the entire financial system.
Both banks suffered from concentration risk and poor investment management, which led, in the case of SVB, to a classic run on the bank. Bank runs, by their nature, are not orderly. Panic breeds panic, as depositors seek the security for their assets by moving them from one institution to another.
On Sunday and Monday, the Federal Reserve, US Treasury and the FDIC stepped in to prevent further erosion of confidence by guaranteeing both insured and uninsured deposits at the two failed banks. At the same time the Federal Reserve set up a new lending facility (Bank Term Funding Program) with favorable loan provisions to help banks, in general, shore up their capital and diversify their client base. These loans do not come from taxpayers and will be funded by a special assessment on the banking industry itself. At the same time, investors who bought equity shares or bonds in the failed banks are not protected.
In the United States one could say that the most important economic institution is the banking system. Because our banking system is comprised of a very large number of individual banks, there is an opportunity for risky or speculative behavior by a few to translate into concerns about other banks with similar characteristics.
By taking aggressive action over the weekend, the US Treasury, Federal Reserve and Federal Deposit Insurance Corporation sought to quell panic withdrawals from the banking system and encourage depositors to leave their money where it is.
Here is how it went down.
During 2020 and 2021 when technology companies boomed, SVB was flush with cash deposits. A good proportion of these deposits ended up in longer term US Treasuries and government bonds, whose principal does not fluctuate if the securities are held to maturity. The company indicated that it had no intention of prematurely selling any of these long bonds. At the time, SVB had enough cash to make the loans it needed, pay depositors ongoing interest and cover withdrawals.
Flash forward to 2022 and the post pandemic reopening, when tech companies struggled. Over recent months a number of these companies and their venture capital sponsors began drawing down their deposits to cover expenses while fewer companies had excess cash to make new deposits. When withdrawals exceeded cash, SVB was forced to sell some of its government bonds before they reached maturity. These early sales resulted in significant losses, as bond prices have been hit hard by rising interest rates. Last Wednesday SVB announced that it was realizing losses totaling almost $2B. The company was looking to raise $2.25 billion in new cash by selling additional assets and newly issued shares.
At that point venture capitalists and private equity firms, who backed many of SVB’s technology start-ups, and were depositors themselves, began recommending companies pull their money from SVB for fear of future insolvency. On Thursday, SVB customers attempted to withdraw $42 billion from the bank and overwhelmed the system. On Friday the Federal Deposit Insurance Corporation stepped in and took over SVB. On Sunday, regulators proactively closed a second bank, Signature Bank, which had recently encouraged large deposits from the crypto markets and suffered from the same excess of uninsured business deposits and long duration exposure.
While most individuals will not be personally affected by the actions of SVB and Signature Bank (other than general market reactions), this dislocation within the banking system can have broader financial and economic implications. For one, monetary policy is likely to be affected. Specifically, the Federal Reserve could become less aggressive in raising interest rates and may pause sooner than expected. It could also find its job of fighting inflation more difficult. This, in turn, would impact the bond markets. In addition, credit markets could tighten, affecting economic growth, as banks institute more stringent underwriting and venture capital/private equity firms hold back on investing. And equity markets could experience short term instability in the financial sector if more banks seek the protection of the federal government.
It should be noted, however, that the overall banking system (particularly the larger banks) is well capitalized, and that bank depositors already have $250,000 in FDIC insurance. For now, actions by federal regulators have removed risks for uninsured depositors as well, and thus have reduced risks from future bank closures. Still, we never like to see it when banks take on too much risk and need help unwinding their mistakes. We have seen this before. A bit more accountability would be appreciated.
Betsey A. Purinton, CFP® is Managing Partner and Co-Chief Investment Officer at StrategicPoint Investment Advisors in Providence and East Greenwich. You can e-mail her at firstname.lastname@example.org.
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