BREAKING: Lots of things
The demise of Silicon Valley Bank is a renewed reminder that interest-rate hikes can exert a delayed but then all the more staggering impact on the real economy. Proficient swift firefighting by policymakers, the Federal Reserve, and regulatory authorities has averted a banking crisis (thus far), but the risk to economic activity has increased and the Fed’s job has now gotten even tougher.
The collapse in time-lapse view
At the start of March, Silicon Valley Bank (SVB) was the sixteenth-largest bank in the United States, with a market capitalization of USD 17 billion. By March 13, the deposit institution was history. How did that happen? Here’s a quick recap of the most spectacular bank failure since the Great Financial Crisis. An equity bull market and massively rising valuations in the technology sector had caused deposits to surge in recent years at SVB, which was the bank of choice for many startup companies and venture-capital firms. Deposits at SVB tripled from USD 62 billion to USD 189 billion between end-2019 and end-2021 alone. To park that money profitably, the bank invested it in (long-term) government bonds and mortgage-backed securities (MBSs). So far, so normal and no problem – as long as interest rates don’t rise significantly. But they did, severalfold. The bear market in the venture capital sector brought the entire industry back down to earth in 2022: more realistic projects, lower valuations, smaller deals – for one reason or another, startups had been withdrawing billions from SVB each quarter since spring of last year. At the same time, the rapidly increased interest-rate level left the bank sitting on huge book losses on its acquired securities. Its liquidity reserves quickly dwindled. On March 8, the management of SVB disclosed a realized loss of USD 1.8 billion on its securities portfolio and communicated its need to raise capital. That sounded the starting gun for a classic “run on the bank.” Within a single day, customers of Silicon Valley Bank tried to bring USD 42 billion worth of deposits to safety, rendering SVB effectively insolvent. On March 10, the US Federal Deposit Insurance Corporation (FDIC) took charge of SVB. New York-based Signature Bank experienced the same fate two day later. To avert a chain reaction at banks (and a mass panic among bank clients), the FDIC, the US Treasury Department, and the US Federal Reserve quickly shifted into firefighting mode:
- They summarily declared that both banks posed a “systemic risk” despite their relatively small size.
- They guaranteed the security of all deposits at both financial institutions.
- They created a Bank Term Funding Program that enables banks in similar distress to pledge securities that will be valued at par as collateral in exchange for cash injections.
- There was no bailout, though, for the shareholders and managers of both banks (in contrast to the rescues during the 2008 financial crisis). However, it was an indirect bailout for all of the other vulnerable banks that potentially would have faced a similar fate.
Upholding confidence in the existing (financial) system was more important to the FDIC, the Treasury, and the Fed than potential concerns about moral hazard. After all, the bank collapse wasn’t caused by nonperforming loans or complex toxic securities – it was caused in particular by the rapid rate-hiking by the Fed and by the attendant price losses on fixed-income securities.
Biggest bank failure since the Great Financial Crisis | Not without forewarning
Bank failures in the USA
Sources: FDIC, Kaiser Partner Privatbank
Not a conventional savings bank
However, it wasn’t a coincidence that the bank that went under was SVB. In the past, a few critical voices had already pointed out SVB’s vulnerability in the event of rising interest rates. Moreover, SVB wasn’t the “ordinary” bank next door and was particularly vulnerable for a number of reasons:
- As THE bank for startup founders, SVB operated almost exclusively in the most volatile sector imaginable (technology) and in the riskiest business segment (venture capital). Moreover, SVB’s business was ultra-concentrated on a single region and city. Furthermore, over 90% of the bank accounts held at SVB exceeded the maximum covered by federal deposit insurance (USD 250,000). So, SVB gets zero points for risk diversification.
- Managing risk is actually part of a bank’s everyday business, but risk management was completely absent at Silicon Valley Bank in the end. Swap deals in existence for a time that would have reduced the risk posed by changes in interest rates had been unwound in the meantime. The position of Chief Risk Officer had been vacant at SVB since April 2022. A new CRO didn’t join the bank until January of this year. So, SVB also gets zero points for risk management.
- With approximately USD 215 billion of assets on its balance sheet (as of end-2022), SVB remained below the magic USD 250 billion threshold that would have triggered higher liquidity requirements and mandatory periodic stress tests. The bank thus flew partially under the risk-detecting radar of supervisory authorities. Earlier, SVB CEO Greg Becker was the one who often personally lobbied – ultimately with success – to soften the Dodd-Frank Act by raising the too-big-to-fail threshold from USD 50 billion to USD 250 billion. So, SVB gets demerits for its lobbying to weaken systemic stability.
The SVB management’s conduct left a bitter aftertaste in other ways as well. A few weeks before the collapse of the bank, CEO Becker sold USD 3.6 million worth of his own shares in SVB. And a number of bonuses apparently were disbursed at the eleventh hour. So, in conclusion, SVB gets zero points for corporate governance.
Life can come at you pretty fast | The collapse in a single chart
Stock price of SVB Financial Group
Sources: Bloomberg, Kaiser Partner Privatbank
Implications for the banking industry
Skillful rapid intervention by the FDIC, the US Treasury Department, and the Fed have averted a crisis of confidence and a full-blown banking crisis thus far, but the book losses on the balance sheets of US banks, which add up to a total of more than USD 600 billion, remain a dormant risk. Several implications for the banking industry can already be inferred from the turbulent developments in recent days:
- More regulation: The comparatively laxer regulation of small and midsized banks to date will likely be tightened (by means of stress tests, liquidity rules, etc.). This will put downward pressure on banks’ profitability and will lead to stricter lending standards.
- Big is beautiful: Large US banks look set to emerge as the winners of the crisis. Bank of America, for example, received an influx of USD 15 billion in the first five days alone after the collapse of SVB. Smaller banks with weak liquidity positions could get bought up by the big players, furthering the consolidation of the industry.
- Higher costs (for everyone): In the wake of the many rate hikes by the Fed, investors today have a wide choice of low-risk interest-bearing assets in which to park their cash. Competition for deposits looks destined to intensify between banks. They will have to offer higher interest rates in the future to attract depositors, and their financing costs will increase. They will likely pass on part of those expenses to their clients.
- Deposit insurance: A heated debate about the future of deposit insurance is likely to ignite. Has the maximum of USD 250,000 become too little in the meantime? After all, it is not linked to inflation. But even more importantly, should the unofficial guarantee for all deposits, regardless of whether insured or not, be formalized to make another run on a bank less probable?
The operating environment for banks threatens to rapidly worsen further in the near term. For this reason, the rating agency Moody’s has already lowered its outlook for the entire US banking industry from “stable” to “negative.” A number of financial institutions face the prospect of a rating downgrade. In view of this, financing costs look set to rise for the entire sector, but particularly for smaller financial institutions. The latest banking crisis will thus have tangible impacts on US economic activity. Small banks (with less than USD 10 billion of assets) originate around 30% of all loans in the USA. In the quarters ahead, they will likely be preoccupied mainly with repairing their balance sheets and are bound to curtail lending to households and businesses. Over the past week, analysts at Goldman Sachs were among the first to lower the growth forecast for the US economy in reaction to this dimmed outlook. The heightened risk of a “hard landing” has also been reflected lately on the fixed-income markets, where the warily watched yield curve steepened massively in a matter of hours. This, unlike a mere inversion of the curve, is considered a surefire recession signal. Even if this indicator provides little added value for predicting the timing of a recession, one can nonetheless conclude that the risk of a drastic economic downturn has clearly increased over the past two weeks.
Starting shot for a recession? | Steepening of the yield curve as a warning sign
US yield curve (yield spread between 10-year and 2-year Treasury notes)
Sources: Bloomberg, Kaiser Partner Privatbank
Monetary policy is becoming more difficult
The US Federal Reserve’s job is becoming even more challenging than it already was because it has to juggle more and more balls. Monetary conditions have already tightened significantly in recent days without the Fed moving a finger. The central bank now will soon also have to incorporate a stricter regulatory environment into its planning. Tighter regulation acts as an extra rate hike. At the same time, the Fed mustn’t lose sight of inflation. Although it pulled back further in the USA in February, progress on the inflation front is proceeding slowly. If the Fed now immediately stops hiking rates, it could face a credibility problem. The financial market, meanwhile, has conjured up its own (chaotic) picture of the future interest-rate path. On March 8, the market was still expecting the federal funds rate to be raised by another 100 basis points by mid-year. But within the span of a week, it changed its mind by 180 degrees – on March 15, the market expected the policy rate to be cut by a total of 100 basis points by the end of this year. And the situation remains volatile. The yield on 2-year US Treasury notes recently dropped below the federal funds rate, which in the past has consistently signaled the end of the rate-hiking cycle. A wide array of scenarios are therefore conceivable at the next FOMC meeting on March 22. One of them is a “one and done” scenario under which the Fed could switch to wait-and-see mode after raising the policy rate one last time for now. This is likely the only way to somehow keep the minimal chance of a “soft landing” intact. One thing seems certain, though: volatility on the fixed-income and equity markets looks set to stay high, and the Fed risks becoming a pawn of market expectations. During this phase, it is more important than ever to communicate and explain the future monetary policy course, which is a challenge that Fed Chairman Jerome Powell has mostly bungled in the past. The current situation is thus likely all the more to teach US central bankers a lesson not to get so far behind the curve in the future and to react to signs of rising inflation sooner. In the long term, this looks destined to lead to greater volatility in monetary policy decisions and potentially to permanently higher volatility on the financial markets as well.
One and done? | In the market’s opinion, interest-rate hikes are as good as over
2-year US Treasury note yield and federal funds rate
Sources: Bloomberg, Kaiser Partner Privatbank
A glance at Europe
A banking crisis without the involvement of Europe? Such a thing seems impossible. European banks admittedly have far less exposure to the technology sector and the venture capital industry than US banks do. Moreover, they are very soundly capitalized – compared to US banks, they hold more available liquidity in relation to deposits and collectively have less interest-rate risk on their balance sheets. Nevertheless, the crisis spilled over to the weakest link in the chain on this side of the Atlantic: Credit Suisse. Long-smoldering rumors about liquidity problems at the chronically crisis-wracked bank flared after its biggest shareholder, the Saudi National Bank, declared that it would not chip in any additional money. More and more customers, investors, and counterparties threatened to regard Credit Suisse (CS) as the potential next pin to fall. The cost of credit default insurance on CS debt climbed to a new record high north of 10%. The CS management’s plea for a confidence-building sign from the Swiss government then went answered with lightning speed. On Thursday, March 16, CS announced that it would make use of a CHF 50 billion lifeline from the Swiss National Bank to preventively strengthen its liquidity. CS also disclosed an offer to buy back CHF 3 billion worth of debt. The protective shield makes a bank run on Credit Suisse less probable now. But even if the Swiss National Bank can guarantee liquidity, it can’t provide CS with a new business model. CS itself must give customers a good reason to stay on board. The management of CS faces a rocky road to winning back the lost trust. The crisis is unlikely to spread to other European banks, largely thanks to the swift reaction by Swiss policymakers. However, one shouldn’t underestimate the recent events’ impact on sentiment. Volatile financial markets, plummeting bank stock prices, and tightened regulatory controls are bound to prompt European lending institutions as well to issue loans more cautiously. Moreover, just like in the USA, the liquidity situation is also deteriorating for banks in Europe due alone to the fact that the European Central Bank is pressing ahead with quantitative tightening and the era of cheap money is over. The higher that interest rates rise and the longer they stay elevated, the more that the risk to economic activity increases also in Europe.
Higher than during the Great Financial Crisis | Credit risk premium reflects loss of confidence
Credit default swap premium on Credit Suisse
Sources: Bloomberg, Kaiser Partner Privatbank
Conclusion: Until something breaks – in the past, the Fed invariably raised interest rates until the restrictive monetary policy climate took a tangible toll on financial markets or the real economy. In the current cycle, British pension funds last autumn were the first to encounter problems caused by rapidly rising market interest rates and falling bond prices. Now it’s banks that have taken a hit in recent weeks. The most forceful monetary policy sea change in 40 years could soon expose other fracture points. The real estate market and private asset markets rank among the vulnerable candidates and are already showing some isolated signs of weakness. In times like these, investors should stay levelheaded and should stick to their long-term investment strategy in spite of the volatile days of late. Last but not least, bear in mind that turbulent market phases always also present opportunities to exploit.