Abstract:
On March 10, 2023, the financial markets were affected by the receivership of the Silicon Valley Bank (SVB), now under the control of the Federal Deposit Insurance Corporation (FDIC). This unexpected bank failure is the largest since 2008 in the United States. This event caused US and European banking stocks to fall and triggered a rise in the risk premiums associated with these issuers in the bond markets.
However, this failure does not pose any systemic risk to the sector, particularly following the decision by the FDIC and the Fed on Sunday to refund all customer deposits. The SVB case illustrates the negative consequences of central bank monetary tightening, as well as the persistent regulatory weaknesses regarding small US banks.
What is SVB?
SVB Financial Group (SIVB US Equity) is the holding company of Silicon Valley Bank, which, as its name suggests, specializes in the niche segment of Silicon Valley venture capital funds in the tech and healthcare sectors. Its client base included half of all U.S. start-ups and 44% of all U.S. venture-backed technology and healthcare companies going public in 2022.
It was the 16th largest U.S. bank by balance sheet size, despite having only 17 branches. This shows how small the institution was in the retail banking market and how highly concentrated it was, both geographically (Silicon Valley) and in terms of client base (venture capital funds in the technology and healthcare sectors). Only 3% of its deposits were FDIC-covered (deposits under $250,000), meaning that 97% of its deposits were from businesses.
SVB has grown dramatically over the past 20 years, with its balance sheet size increasing from $4.5 billion at the end of 2003 to $212 billion at the end of 2022. Between the end of 2018 and the end of 2022, SVB’s balance sheet has grown almost fourfold, from $57bn to $212bn. This growth has been further boosted by the Covid-19 crisis as the bank’s deposit base has grown from $62bn in Q1 2020 to $198bn in Q1 2022, the peak of SVB’s customer resources. Since then, SVB has lost about $25bn in outstanding deposits, mainly due to the consumption of cash by venture capital-backed companies (tech and healthcare start-ups).
Between Q1 2020 and Q1 2022, SVB massively increased the size of its bond portfolio in order to “invest” the deposits collected from its clients. The bond portfolio has grown from $27bn to $127bn during this period. These investments were made in government bonds or MBS guaranteed by the US government. The quality of these assets is therefore not in question. However, these investments were made when interest rates were very low.
The graph below illustrates the growth of its balance sheet (green), deposits (yellow) and financial investments (orange) over the last 5 years, quarter after quarter.
What happened?
Last week, SVB’s management decided to sell almost all of its bond portfolio recorded as “Available for Sale”, i.e. $21bn. This sale generated a capital loss of -$1.8bn, which the bank wanted to offset with a capital increase of a total amount of $2.25bn.
This capital increase was jeopardized by the sharp fall in the share price following these announcements and its subsequent suspension from trading. The bank was then placed under FDIC supervision.
Is the bank solvent?
Theoretically, yes. SVB’s $211 billion balance sheet is divided as follows:
- $14 billion in cash deposited at the Fed;
- $21 billion in bonds classified as AFS and sold on the market (duration of 3.6);
- $91 billion of bonds classified as “Held to Maturity” (HTM) on which an unrealized loss of -$15 billion existed at 12/31/2022 (average duration of 5.7);
- $74 billion in customer loans.
Rather than selling its securities on the market, SVB has repo agreements with bank counterparties, the FHLB or the Fed, allowing it to provide collateral for its investment grade bonds in exchange for cash. However, the management has decided to quickly sell a portion of its bond portfolio.
What decisions have been made by the FDIC and the Fed?
Many U.S. technology and healthcare companies had their deposits frozen at the SVB and were concerned about access and recovery in its entirety.
On Sunday, March 12, the FDIC and the Fed announced that all depositors (insured and uninsured, i.e., with deposits over $250,000) will be able to get their money back as of Monday morning. This is an exceptional decision.
In addition, the Fed launched a new facility called the Bank Term Funding Program (BTFP), which is a one-year loan facility for banks against a range of securities such as US Treasuries or Agencies MBS. The BTFP lends on the face value of the securities and not on their market value. The BTFP is large enough to cover all uninsured deposits.
Why is SVB a special case?
This case is certainly not unique to the United States, but it is specific and very different from that of European banks.
SVB is a category IV bank (<$250bn in assets). It is therefore not subject to LCR or NSFR liquidity ratios as are the large US banks and all European banks (small, medium and large).
Finally, US Tier IV banks have the option of not recognizing unrealized losses on their bond portfolios classified as AFS as a deduction from capital for the calculation of their regulatory ratios. SVB’s CET1 ratio was therefore distorted by the non-recognition of an unrealized loss of -$1.9bn at the end of 2022, whereas the major US banks and all European banks include these unrealized losses in their CET1 regulatory capital ratios.
It is likely that other US Tier IV banks are in the same situation as SVB with a greater or lesser stock of unrealized losses on bond portfolios classified as AFS and not recognized in capital ratios. On the other hand, this risk is well excluded for the other larger American banks and all European banks.
Indeed, in Europe, banks do not face these problems:
- All banks (small, medium, and large) meet the LCR or NSFR liquidity ratios and factor the market-to-market valuation of their AFS bond portfolios into their capital ratios.
- We do not observe any hyperbolic growth similar to that of SVB among European banks.
- Retail deposits in Europe represent between 40% and 80% of total deposits (no outlier as small as SVB’s 3%).
- The bond portfolio did not increase much between 1Q2020 and 1Q2022, while cash placed at the ECB increased a lot.
- European banks are pursuing interest rate hedging policies to reduce duration risk. They are subject to liquidity ratios (LCR and NSFR in particular). SVB, on the other hand, was distinguished by very short financing, concentrated on a very specific segment, and a high proportion of its assets invested at fixed rates over long durations.
Is SVB a specific case or does it pose a systemic risk?
SVB does not pose a systemic risk, but it does negatively influence “sentiment” towards the financial sector as a whole, and US regional banks in particular.
The bank has good asset quality with safe but overpriced bonds. It is therefore conceivable that it will soon be backed by another American banking group that will take over SVB’s assets and liabilities but will apply fair value to all these assets.
On the other hand, the SVB case illustrates the need to regulate all banks equally, large and small, by making them apply the same liquidity and capital rules.
More generally, SVB appears to be an indirect victim of the sudden rise in interest rates in the United States and of the “Quantitative Tightening” plan initiated by the Fed, which is withdrawing liquidity from the markets, and therefore indirectly from the financial sector.
What impact on the macroeconomic environment and on the Fed’s monetary policy?
It is well known that in such circumstances, one must always be cautious about the possible ramifications within the financial system and about the ability of panic to feed on itself and become self-fulfilling.
The U.S. regional banks are not central nodes in the financial system as Lehman Brothers was. Their failures can be explained by poor risk management, which was “enabled” by fewer regulatory constraints due to the small size of these institutions. The promise to ensure access to all deposits and the provision of additional liquidity should limit contagion and the effects on economic activity.
Central banks have different tools at their disposal to accomplish their various tasks of inflation control and financial stability. Indeed, one must distinguish the issue of liquidity provision from its cost. In this case, the Fed’s actions are aimed at maintaining a good level of liquidity to ensure that these problems remain limited to the offending banks and do not lead to a spiral of defiance among healthy players. The issue of the cost of liquidity will continue to be determined by central bank action to fight inflation.
These events reduce the probability of a 50-basis point hike at the next meeting but should not cause the Fed to change direction.
Ten years of zero interest rates may have generated excesses in the markets, now emerging as rates rise. However, the problems already encountered by British pension funds have not prevented the Bank of England from continuing its rate hike cycle. Central banks are trying to tighten financial conditions without causing a systemic crisis. If the current situation remains under control, it is very unlikely that they will question their monetary policy.
It is worth noting that this event caused a sharp drop in sovereign rates: in the space of two trading days, the U.S. 10-year went from 4.00% to nearly 3.50%, showing that the market very quickly integrated the risks of the situation getting out of hand. However, if the contagion manages to be limited under the Fed’s action, inflation should not be long in coming back to the forefront. We will therefore remain vigilant and adjust our allocations according to future developments in the coming weeks.
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Autors:
François Lavier, CFA, Managing Director, Head of Financial Debt Strategies
Julien-Pierre Nouen, CFA, Managing Partner, Head of Economic Research and Multi-Asset Allocation
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Article written on March 13, 2023.
Source: Lazard Frères Gestion, March 2023. For more information on the other characteristics and risks of the investment policy, please refer to the documents available on request from the company or on www.lazardfreresgestion.fr
This document has no pre-contractual or contractual value. It is provided to its recipient for information purposes. The analyses and/or descriptions contained in this document should not be construed as advice or recommendations by Lazard Frères Gestion SAS. This document does not constitute a recommendation to buy or sell, nor does it encourage investment. This document is the intellectual property of Lazard Frères Gestion SAS.
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