The demise of Silicon Valley Bank, along with heightened concerns about the banking system, have been in the headlines a lot this past week, and no doubt you’ve already heard and read a lot about it.  However, we thought it would be helpful to provide you with our perspective on what has happened and the ramifications.

What happened?

As you are probably aware, Silicon Valley Bank (SVB) experienced a classic bank run that forced the FDIC to seize control and place the bank into receivership, a sad consequence of the Federal Reserve’s aggressive tightening campaign.  The FDIC subsequently guaranteed all of SVB’s (along with similarly troubled Signature Bank’s) deposits – both insured as well as uninsured – in an attempt to calm fears about the safety of bank deposits and prevent a cascading run on other smaller, regional banks.  The Federal Reserve (Fed) concurrently announced a new one-year bank lending facility (Bank Term Lending Program or BTLP for short) which would allow banks to borrow against their securities portfolios at par value (as opposed to market value) to ensure sufficient liquidity to meet rising demand deposit withdrawals without the necessity to liquidate those portfolios and realize losses, which could require additional capital raises as happened at SVB.  In essence, the Fed once again provided a backstop to the banking system in its role as “lender of last resort” in order to provide financial stability.

Why did this happen?

There is now plenty of finger pointing going on, but as is usually the case in these types of situations, there is plenty of blame to go around.  First of all, it is important to understand the uniqueness of SVB.  Due to its geographical proximity and heavy customer concentration amongst start-up tech and biotech companies, their executives, and the venture capital (VC) firms invested in them, SVB had a heavy uninsured deposit base (over 90% of total deposits) that was particularly sensitive to rising interest rates.  Thanks to the Fed’s extraordinary liquidity infusions during the pandemic, these clients were flooded with cash in 2020 and 2021 that poured directly into SVB, who in turn invested a lot of those deposits into low-yielding, long-duration U.S. treasury bonds and mortgage-backed securities, which were viewed as safe.  This was certainly true from a credit perspective, but not so from an interest rate perspective.  As interest rates rose, the flow of liquidity to their customers quickly reversed, leading to a rapid draw-down of deposits, especially as their customers’ cash burn rates remained elevated.  At the same time, the market value of the bank’s bond holdings declined rather meaningfully.  Essentially, SVB had a huge asset/liability duration mismatch that doubly exposed the bank to a rise in interest rates, which we got in spades last year as the Fed embarked on the most aggressive tightening campaign since the early 1980s in order to combat the 40-year high inflation its extraordinarily loose monetary policy was responsible for creating in the first place.  SVB executives clearly overestimated the duration of their deposit base under these circumstances, which subsequently forced them to fire sale the bank’s available-for-sale (AFS) securities portfolio at sizable losses.  The bank was then forced to raise additional capital to make up for those realized losses, which was made more difficult by the escalating bank run triggered by VCs urging their clients to pull deposits from the suddenly weakened bank – the equivalent of screaming “fire” inside a crowded theater.

So the blame for this situation can be ascribed to the Fed for its monetary policy errors that precipitated this crisis, SVB executives for poor interest rate risk management, regulatory authorities for poor bank oversight, at least some of the bank’s customers for poor cash risk management, and finally those VCs responsible for inciting panic.

What now?

While it is entirely possible, if not likely, that we will continue to experience elevated volatility amongst bank stocks and the broader market for a while as investors probe for weaknesses (perceived or otherwise) elsewhere in the financial system, it is our belief that government authorities (the Fed, the FDIC, and the Treasury Department) acted appropriately to try to stem a potential panic-induced, cascading run on banks.  By way of precedent, they have now effectively provided an implicit guarantee for all deposits which should ultimately ease fears among depositors.  It will be up to Congress now to back it up with adequate insurance funding and additional regulatory oversight, which will of course bring additional costs for all banks and their depositors.  This is an unfortunate consequence of having to protect a financial system made more vulnerable by excessively loose monetary policy and growing moral hazard that resulted in excessive risk taking.  Sadly, this government back stop likely reinforces that moral hazard even further, which is something we will be forced to contend with for much longer.

As for monetary policy, the Fed now finds itself in the difficult position of having to balance financial stability with fighting inflation.  Unlike during the Great Financial Crisis when inflation was not a problem, which afforded the Fed the flexibility to be as accommodative as necessary, now the Fed does not have that luxury with inflation remaining stubbornly elevated at levels well above its targeted 2% rate.  The Fed must deftly navigate these treacherous waters without committing additional policy mistakes, a highly uncertain proposition to be sure.  At a minimum, this situation would seem to argue for a higher equity risk premium, and thus lower P/E multiples for stocks.

Additionally, because this bank crisis will likely lead to a further tightening of credit availability and lending standards, it should cause investors to favor those higher quality, highly cash generative companies with strong balance sheets that are thus less dependent on bank loans.