Silicon Valley Bank fails. Is there a contagion risk?

Executive summary:

  • SVB had a concentrated depository base and an asset portfolio with a higher percentage in bonds than loans, making it different than an average bank
  • Because of these differences, most industry experts do not view the specific risks that led to the collapse of SVB as representing a large systematic threat to the banking system as a whole

On Friday, financial regulators shut down Silicon Valley Bank (SVB), making for the largest banking collapse since the failure of Washington Mutual in 2008. How exactly did this happen—and is there a risk of a broader contagion in the financial industry? Let’s dive in and take a look.

How did Silicon Valley Bank differ from the average bank?

Silicon Valley Bank’s customer base largely consisted of private equity and start-up firms, so in many ways it was not a typical bank in terms of customers. As we all know, banks typically take deposits and then loan that money to individuals and businesses. Through this process, they also invest some of those depository assets into publicly traded bonds, so the asset base of the average bank is both loans and securities. In the case of SVB, there were some important differences between it and the average bank:

  • A concentrated depository base both in terms of privately held companies—many in early stage—and the average size of the deposits. The average deposit size of the roughly 37,000 clients that made up approximately 74% of the bank’s assets was greater than $4 million.1
  • An asset portfolio that had a higher percentage in bonds than loans.

These two differences are key in understanding why most industry experts do not view the specific risks that led to the collapse of SVB as representing a large systematic threat to the banking system as a whole.

Key difference #1: SVB had a concentrated depository base

First, let’s take on the issue of a depository base that was focused on private equity and venture-backed start-up firms. These firms generally raise capital by issuing equity, then they deposit those funds and use them for operations. When they draw down those deposits, they typically re-access the market and sell more equity to raise capital, and replenish their depository accounts. In the current market, with the decline in technology and late-stage venture valuations, capital raises have declined and companies have continued to draw down their deposits. These withdrawals from SVB needed to be funded, so SVB had to sell securities from its asset portfolio to meet the demand. In essence, the more your depositors withdraw, the more securities you have to sell. When you have larger depositors, their withdrawals are usually larger as well.

Key difference #2: SVB had a large bond portfolio invested when interest rates were low

This is not all that unusual, but here is what the problem was for SVB. The bank owned a bond portfolio likely purchased before the steep interest-rate rises of the last year or so. For example, in 2019, SVB had much higher growth in deposits than most banks, meaning a good portion of the bond portfolio was purchased then at comparatively low interest rates. In addition to this factor, as Michael Cembelest at JP Morgan points out, a very large portion of its portfolio was designated as “held to maturity bonds,” which tend to include bonds that have longer-than-average durations. We all know what happens to a bond portfolio’s valuation when interest rates rise: it goes down, and longer duration portfolios go down more than shorter duration portfolios. Of course, if you don’t sell those bonds, those losses are unrealised. The way the regulation for the banking industry works, a bank carries these unrealised losses and reports them to the regulator. However, when it realises those losses by selling the bonds—which is what SVB was doing—the realisation of those losses affects its regulatory required capital ratios.

In the case of SVB, this erosion of capital was significant enough to have to raise capital through the sale of equities, which is what SVB planned to do in the middle of last week. Once this became known, you can guess what happened next. Depositors of the bank saw that their assets were in jeopardy, and a run on the bank commenced. At that point, the FDIC (Federal Deposit Insurance Corporation) entered, shut the bank down and took control. This is normally how a bank fails—due to a dramatic loss of liquidity.

The bad news for depositors was significant on Friday, much less so on Sunday. SVB’s assets were in doubt until Sunday, when the U.S. Federal Reserve (Fed) announced that they would make all depositors whole and that those customers would have access to their funds on Monday. The vast majority of the deposits were above the FDIC coverage limit of $250,000—estimates are that 80%-90% of deposits exceeded this amount.2 For those deposits above the FDIC limit, they were likely to incur substantial losses before this latest Fed and FDIC joint announcement. The move by U.S. regulators is clearly designed to create greater confidence for those who have deposits in excess of the current FDIC guarantee. The Fed/FDIC also announced a new facility where banks can take out loans from the Fed while putting up those U.S. Treasury bonds in their portfolios as collateral, which will help them more effectively manage their capital ratios at this time. These steps are likely being taken in recognition of the pressures facing all banks due to rapid interest-rate rises. Banks want to do all that they can to limit withdrawals, which would make the pressures much more pronounced, as evidenced by the SVB experience.

That is the very simplified story of what happened.

Is there a contagion risk?

Most banks don’t have the same highly concentrated deposit base or the same asset portfolio. It is true that many banks do have unrealised losses in their securities portfolio—a recent FDIC report estimates that $750 billion of unrealised losses exist in bank asset portfolios. While this is no doubt a big number, it’s not big enough to likely represent a systematic threat to the industry and economy as a whole. No bank is completely immune to the pressures of dramatically rising interest rates, but most banks do not look nearly as exposed to this pressure as SVB was. Concentrated depository bases and asset portfolios will be scrutinised heavily by the market in the coming week. Two more similar banks, Silvergate Bank and Signature Bank, have already failed. Questions will be asked as to why regulators did not identify the risks in these banks earlier, but it’s important to understand that their risks are not exactly the same as the risks facing most banks.

Sunday’s Fed/FDIC announcement will help to lower contagion risk by assuring depositors that their money is guaranteed by the government, but as stated, there are likely some banks more vulnerable than most.

The bottom line

SVB was unusual among most banks due to its highly concentrated depository base of private-equity and venture-backed start-up firms, as well as its large longer duration bond portfolio. Both of these factors appear to have contributed heavily to its demise amid today’s rate-tightening environment. Sunday’s Fed/FDIC announcement will help to lower contagion risk by assuring depositors that their money is guaranteed by the government, but as stated earlier, there are very likely some banks more vulnerable than most. We are working with our community of investment managers to determine which banks are more vulnerable, in anticipation that some more idiosyncratic bank failures are likely in this environment. 

As this situation develops, we will provide updates.

1 Source: https://24hoursworlds.com/market/383953/
2 Source: https://time.com/6262009/silicon-valley-bank-deposit-insurance/

 

Any opinion expressed is that of Russell Investments, is not a statement of fact, is subject to change and does not constitute investment advice.