Brad Stewart, CFA, Associate Vice President, Senior Research Analyst
The failures of Silicon Valley Bank (SVB) and Signature Bank (SB) over the course of a few days in early March raised concerns about the solvency of regional banks around the country. Customers pulled hundreds of billions of dollars in uninsured deposits out of regional banks over the following weeks, moving those funds to either larger money center banks deemed safer because of their “too big to fail” status, or to higher-yielding securities. SVB was the second largest bank ($212 billion in assets1) to fail in United States history after Washington Mutual in 2008 ($328 billion in assets2), which raised concerns about a second version of the Global Financial Crisis (GFC) of 2008 and 2009. A little over a month since SVB failed, regional banks are reporting earnings and sharing more details about their respective financial situations. Not all of the regional banks’ earnings reports have alleviated investors’ fears, but it appears for now that much of the panic causing customers to remove their deposits from regional banks has passed. We believe this is largely due to the Federal Reserve and Treasury’s actions to set up new lending facilities for regional banks, in addition to an implied guarantee that all bank deposits are insured against losses.
We are not concerned that the specific issues that caused the failure of SVB and SB in early March will induce a U.S. recession, let alone cause a banking crisis like the ’08/’09 GFC. That said, we are not convinced that the probability of a U.S. recession over the next 12 months has declined just because bank deposit outflows slowed down. Ultimately, the bank failures in March resulted from two banks taking too much risk during a period of low interest rates and failing to consider that the interest rate environment might change dramatically in the future. Unique deposit practices at SVB and SB forced the banks to pay for their mistakes quickly, but other banks, businesses, and even consumers might not be prepared for the possibility that interest rates remain higher for longer. If we are correct, it seems likely that more surprises lay ahead. To understand the potential risks ahead, it is important to understand how banks work and the events that we believe caused SVB to take on too much risk.
The Fractional Reserve Banking System
The U.S. banking system is a fractional reserve banking system, which simply means that all the money customers deposit in a bank does not stay in the bank’s vault. Customer deposits are a source of capital that banks pay interest on for the right to use a portion of the deposits to earn money, or a “spread.” A spread is the difference between the interest a bank earns from loans and other investments compared to the cost of its source of money (or capital). For example, a bank might offer to pay its savings account deposit customers 1% interest on their money if they keep a minimum balance of $20,000 dollars in the savings account every month. The bank can then use $10,000 of that savings account money to write a car loan at 3% to one of the bank’s other customers. The difference between the 3% earnings on the auto loan and the 1% paid to the savings account (3% -1% = 2%) is what the bank earns as a spread.
One challenge for banks is that an auto loan might have a five-year life, while a customer with the savings account can take part or all of their money out of the bank at any time. This is called liquidity risk, and it is a big part of why SVB failed. To minimize liquidity risk in the U.S. banking systems, President Franklin Roosevelt signed the Banking Act of 1933 into law and created the Federal Deposit Insurance Corporation (FDIC)3. FDIC policies have evolved over the past 90 years, but the FDIC’s purpose is to insure bank deposits up to $250,000 in any FDIC-insured bank from loss if the bank holding the account fails. It does this by charging all banks an insurance fee on their insured deposits, and this system has worked well to reduce liquidity risk inside the banking system for almost a century.
With FDIC insurance in place, banks are in a better position to earn their spread by focusing on two other types of risk: 1) credit risk – the risk that a person or company receiving a loan does not pay it back; or 2) interest rate risk – the risk that rates move higher or lower and impact the bank’s profits. SVB failed because it took too much interest rate risk, expecting interest rates to remain low well into the future. One measure of interest rates, the 10-year Treasury yield, was 1.17% in August of 2021 but rose to a high of 4.23% in October of 20224 (higher yields means bond prices decline). For SVB, that meant declines in value of -20% to -40% on some of their bond holdings. Large depositors at SVB learned about the bank’s mistake and feared it might fail, causing them to lose their deposits over $250,000 (which are uninsured by FDIC). When those depositors decided to take all of their money out of the bank, SVB did not have enough liquidity to cover those requests and the bank was put into receivership. D.A. Davidson has many helpful reports that cover the failing of SVB, SB, and the regional banking system in detail. For the sake of simplicity, this report focuses just on the high-level issues and what they might mean for the rest of the economy.
Over a Decade of Easy Financial Conditions
One of Mark Twain’s most famous quotes is, “history doesn’t repeat itself, but it often rhymes.” Economic cycles of growth, recession, and recovery tend to mirror Twain’s quote. Decisions made during the good times do not often appear risky until much later. In fact, early success usually encourages market participants to take more of the risk that led to their early success. It is only when the environment changes that investors learn the full extent of the risks they were taking.
A little more than a month since SVB and SB failed, we have learned some important information about regional banks. Many regional banks took too much interest rate risk in the good times when interest rates were lower. Very few, however, took as much of the same risk as SVB and SB. Because of the events in early March, remaining banks are going to have to offer their customers a higher rate of interest on their deposits in order to keep their money at the bank. Consumers and businesses have a lot of attractive options to earn 4% or more on their money; why should they keep it in a bank and make less than 1%? Banks, in turn, are likely to be more discerning about who gets a loan (credit risk) and require a higher interest rate on the loans they write so they can earn a spread after paying more for their deposits. If you have not felt the impact of this already, you likely will soon.
Answering two questions consumes most of our time. The first is, “after over a decade of easy financial conditions and low interest rates, is it likely that more than just two banks took too much risk during the good times?” Most businesses and consumers will struggle to adjust to higher interest rates the longer they last. Commercial real estate companies that own office buildings with lots of tenants working from home after the pandemic could face higher vacancies when contract renewals arise and be forced to refinance old debt at higher rates. Higher rates might impact the demand for things consumers often use loans to purchase (cars, homes, remodels, etc.). In the end, high rates seem likely to impact almost everyone, so we are confident the answer to our first question is “yes.” Our second question is perhaps the more important, “how do we ensure that we take the right risks for the new environment ahead and any others that we might not expect?” Mark Twain’s quote is as true about recoveries as recessions. Businesses that limited the risk they took during the good times will emerge stronger from any challenges that lay ahead. Now is a good time for investors to review their investments and allocations with their advisors. Make sure you are earning a fair amount of interest on your savings accounts, invest in companies with low leverage and the ability to maintain high returns on capital, and manage your personal expenses conservatively.
1 SVB Facts at a Glance
2 SEC Form 10-K/A, Amendment No. 1
3 History of the FDIC
4 FactSet Data on 10-Treasury Yields (US10YY-TU1)
This material is being provided for educational and informational purposes only. D.A. Davidson & Co. is a registered broker-dealer and registered investment adviser that does not provide tax or legal advice. Information contained herein has been obtained by sources we consider reliable, but is not guaranteed and we are not soliciting any action based upon it. Any opinions expressed are based on our interpretation of the data available to us at the time of the original article. These opinions are subject to change at any time without notice. Copyright D.A. Davidson & Co., 2023. All rights reserved. Member FINRA and SIPC.