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Is the Silicon Valley Bank (SVB) hiccup somewhat of a grey rhino?

24 March 2023 Gareth Stokes

The unexpected collapse of US-based Silicon Valley Bank (SVB) sent investors running for the hills as they relived memories of the Global Financial Crisis (GFC) of 2008-9. Yes, dear reader, you have to wind the clocks back almost 14-years for the last time a heavyweight US-bank went to the wall. At the time, the global financial market collapse was due a sub-prime meltdown, described by website Investopedia.com as “the sharp increase in high-risk mortgages that went into default beginning in 2007, contributing to the most severe [global] recession in decades”. This time, the ‘hiccup’ was caused by a combination of banks’ liability mismatches and inflation.

A barrage of interest rate hikes

This writer understands the problem as follows. SVB took billions of dollars’ in depositors’ funds, as most mid-sized global banks do. And since banks make their money by lending out depositors’ cash for a higher yield than what they pay out in interest, SVB was heavily invested in Treasuries or, as South Africans prefer to call them, government bonds. This was all good and well; but when the US Federal Reserve responded to record high inflation with a series of aggressive interest rate hikes, the bank was caught short: the value of bonds, held to cover depositors’ funds, plunged rapidly, leaving it unable to meet its liabilities. Voila; the simple liability mismatch and inflation explainer introduced in the opening paragraph of this piece. 

Of course, there are asset managers better placed than this writer to unpack the problem. Case in point, the great explainer video shared by Rezco’s CEO and Chief Investment Officer, Rob Spanjaard. “Banks have to hold high liquidity assets on their balance sheet and ensure that they have liquid assets to cover about 30-days of withdrawals,” he said. These assets are typically Treasuries or high-quality bonds. You may hear an audible sigh of relief as the writer celebrates his fact-checking win. The problem is that when interest rates go up, the value of two- and five-year Treasuries fall, leaving the bank ‘short of funds’ if depositors make a run on it. “The bank’s risk control department should have insured against the risk of interest rates going up and hurting [its balance sheet] using something called interest rate swaps,” continued Spanjaard. All good then? Surely SVB had sensible risk controls in place? 

Choosing profit over risk mitigation

Alas, no… You see, dear reader, the sensible risk management strategy costs the bank money in that it loses some of the yield or profit it would generate from its Treasuries. And so SVB had opted not to insure against rising interest rates. Perhaps the executive at the bank had been lulled into complacency by the Fed’s decade-long, lower-for-longer, near-zero, interest rate stance? But as with most tales of financial contagion, things soon go from bad to worse. It turns out that US-listed banks, which must report their earnings on a quarterly basis, can declare their bond holdings and values quite creatively. According to Spanjaard, the banks can report bonds under three headings: held for trading; available for sale; or held to maturity. 

He explained that ‘bonds held for trading’ are visible on both the balance sheet and income statement while ‘bonds available for sale’, although flying under the radar on the income statement, would reflect on the balance sheet. But ‘bonds held to maturity’ are messier. “The attitude [taken by these banks to the latter category] is that they are going to hold the bonds till they mature, so they do not need to declare the loss … it is only a loss if they sell it,” he said. Reducing the SVB collapse explainer down to its component parts, we find that interest rates have gone up a lot; banks should have insured the risk of interest rates going up, but not all have done so; and banks like SVB, instead of declaring unrealised losses, have simply buried them. Tick, tick, boom! 

Rezco had factored in a 10% probability of a ‘fat tail’ scenario afflicting financial markets in the first half of 2023. In a year-opening investment note they cautioned clients about the risks associated with the rapid rise in US interest rates and the negative impact it could have on markets by “causing something to break suddenly”. And that is exactly what happened: high interest rates aimed at addressing near-record levels of inflation sent bond prices into the toilet, placing tremendous pressure on uninsured banks’ balance sheets… Spanjaard conceded that SVB was the biggest US bank failure since Washington Mutual in 2008; but pooh-poohed it as “a bit of a grey rhino” before adding that “a grey rhino is something you keep your eye on; if it starts stomping around or coming towards you, you need to react!” Is the grey rhino charging? 

Banks rely on depositors’ confidence

Well, the Dow Jones U.S. Banks Index was down a fifth over the first three weeks of March, prompting fears that the contagion could spread to other developed markets. Andrew Williams, Investment Director: Value Equities at Schroders offered some insight into the post-SVB fallout. “A banking shock that started in California, has reminded the world that banks are businesses that critically depend on the confidence of depositors and investors,” he wrote. “SBV’s issues were specific to the US technology-focused lender [and caused by] a combination of weak capital, weak liquidity and depositor concentration”. The ramifications of that collapse have yet to fully play out, but Mr Market wasted no time in probing other banking shares for weaknesses, whether in plain sight or hidden. Signature Bank, another tech-focussed US bank has also since been taken over by receivers. 

European investors were spooked by the prospect of another bank-led financial crisis too, with a major deal announced within days of the SVB collapse. UBS agreed to acquire Credit Suisse at a price of 1 UBS share for every 22.48 shares in Credit Suisse, meaning Credit Suisse shareholders will own just 5% of the combined group, with the deal representing a 60% discount to [the pre-deal] closing price. “Credit Suisse was in a much stronger position from a capital perspective, but yet again the recent events serve as a reminder that a bank run is fundamentally about confidence; if you do not trust the bank to be able to pay your money back, you take your money out … and if everyone does that simultaneously, it can be fatal for any bank,” wrote Williams. 

In his opinion, this deal does not hint at a repeat of 2008 because the balance sheets of banks are ring-fenced within a regulatory framework designed explicitly to protect against these kind of issues. But things were sketchier than many investors imagined. “We take some comfort that no other major European bank is in Credit Suisse’s position,” Williams said. “The market was worried about the risk of contagion; the deal over the weekend has removed the risk of a messy collapse of Credit Suisse, which should be positive for the sector. What a shocker! 

Major losses on safe assets…

What happens next? Schroders reckons that the bigger risk from the banking sector fallout is “a broader collapse in financial market confidence feeding into a lack of economic confidence, a recession, spiking unemployment, collapsing real estate prices and a sharp downswing in rates; this does not seem probable today, and if it does happen the consequences will be felt far beyond the banking sector”. This sounds a bit alarmist but stems from the craziness of banks’ financial reporting. For this writer, the following line from the Rezco video has to be the clincher: “Oh goodness, banks are sitting with major losses on their [supposedly] safe assets”. 

Follow the writer on

LinkedIn: https://www.linkedin.com/in/gareth-stokes-media/

Twitter: @stokesmedia

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