Banks collapsing? What the heck is going on?

If you went to bed on Thursday night working through the mundanity of daily worries in your head, Did I switch the laundry from the washer? Is that early morning appointment going to hold? Did I confirm our dinner reservations for Saturday night?, then it was likely a surprise to go to bed Friday night worrying about a potential meltdown of the entirety of the US banking system. 

Whether through breathless prognostications on social media or by way of the sober reporting of august publications like The Wall Street Journal, you now know that a number of banks have been taken over by the federal government following a run on those banks when depositors began to fret that their deposits were no longer safe. 

Silicon Valley Bank is the largest bank to have failed since 2008, and it is the second largest bank failure in the US ever. The speed with which its shares plummeted and its insolvency became apparent was stunning, and even while it searched for a suitable buyer the government stepped in to ensure an orderly liquidation and quell the panic. 

Two other banks have also collapsed, and given the Federal Reserve Bank’s precipitous rate hike schedule last year, more will likely follow. 

Is the risk of contagion to the entirety of the banking system possible? 

Absolutely. 

Am I panicking and pulling my cash from the bank and investments from the market? 

No way. 

I will share with you why I’m not deeply concerned about a systemic risk here, but first let’s take a look at how it happened 

How did It happen? 

If we’d met at least once over the last six months, you’d have heard from me about how epically terrible 2022 had been for bonds.  

Sure, stocks performed terribly on a calendar year basis, but from a peak to trough perspective the stock market turned in an historically average bear market last year. Meanwhile, the hemorrhaging in the bond market was anything but routine. 

With a trough of around 16% in losses at its worst and given the bond indexes’ 2022 approximate losses of 13%, last year was one of the worst years on record for bond performance. 

If you’re wondering what all of this has to do with the risk of a banking crisis, just hang in there with me, I promise to land this plane shortly.  

When a bond is issued at a fixed interest rate, say 4% for 30 years, and it is purchased directly from the issuer, traditionally for $1,000 a bond, the interest rate is guaranteed by the company or governmental entity issuing the bond.  

Assuming that the issuing entity remains solvent, you are guaranteed to receive what you paid for the bond when it finally matures (in this instance $1,000 in 30 years). What isn’t guaranteed is whether or not you will be able to sell the bond for $1,000 to someone else before it matures. 

Now imagine that the Federal Reserve decides to hike rates from near zero to 4.75% in one year. A company that issued a bond for 4% prior to the rate hikes will need to issue new 30 year bonds at a much higher rate, say 6%, only one year later. 

If you want to sell the bond you purchased 12 months ago for $1,000, you will likely not find a buyer willing to pay you that. You might be able to unload it for $870, if you really needed to sell it, but selling at that kind of loss might not be preferable to just holding it to maturity. That bond should still mature at $1,000 in 29 years, so why rush? 

This turns out to have been a weak spot for Silicon Valley Bank, and it was one of the reasons that the bank was unable to remain solvent.  

Why did it happen? 

The recipe for SVB’s failure is pretty clear already: 

Add one cup of Hyperfocus in One Sector 

Two tablespoons of Risk-Taking in Deposit Acceptance 

Half a cup of Devalued Bond Assets 

A dash of Old Fashioned Panic 

Now shake the contents of the mason jar, and congratulations! You’ve now got the perfect dressing to drizzle over your favorite banking institution while it wilts and fails. 

Silicon Valley Bank presented a unique set of risks to investors and depositors that aren’t shared across much of the banking sector. 

Primarily, it is worth acknowledging that SVB’s geographic location made it the institution of choice for venture capital firms and technology companies to park cash for payroll or other operational needs after they had received funding from investors.  

This led to a hyperfocus in one sector, a considerable risk, and it also led to many savers placing far larger deposits with the bank than the FDIC insured $250,000. 

Now consider the fact that banks are tasked with balancing, per banking regulations, lending against assets held at the bank.  

Remember that foray into the world of bond pricing we took a few paragraphs ago? Cue sound effects of landing gear touching down on the runway.  

When bonds are priced in the markets as if they are going to be sold at any minute, they represent considerable losses in value on paper that are only realized when sold.  

If depositors suddenly decide to take their money out of the bank en masse, that money needs to come from somewhere, and even though banking regulations are much stronger today than they were in 2008/2009 precisely because of the systemic risk to the financial system back then, if a panic cannot be quelled and the bank is required to sell assets, they end up selling their bond holdings at a considerable loss. 

Add to all of this the fact that the venture capital community is a tight knit one, and when a VC firm suggests that its partner companies would do well to liquidate their deposits in a bank those companies tend to comply. 

The very risk that VC firms were concerned about, the risk of a run on deposits, became a reality because of the actions the VC firms took to help their partner companies avoid becoming embroiled in a liquidity crisis should the bank fail. They literally communicated to their partner firms to take their money out of the bank, causing the panic that lead to SVB’s failure. 

Why not a contagion? 

Fear is fear. 

Deep, I know, but it’s true. 

You cannot manage out the risk of a panic, no matter what you do, because emotions don’t follow logical pathways. Fear tends to feed on itself, which could put a lot of banks at risk of a run on deposits. 

That said, SVB was a relatively unique case given its hyperfocus in startups in the tech sector, taking greater risks in lending at which other banks might have scoffed.  

One fundamental reason that SVB’s failure shouldn’t become another contagion to the financial system, a la 2008, is the fact that banking regulations have become more strict requiring far greater capitalization since then. Big banks are much healthier, on the whole, than they had been back then. 

Additionally, the FDIC has now agreed to cover all deposits at SVB, even those above the $250,000 maximum previously insured. This should help to stave off some panicked liquidations at other banks. 

What shouldn’t get lost in all of this is the fact that the government has set up a $25 billion fund to support banks should depositors request considerable distributions. Rather than selling off bonds at huge losses to meet their deposit liquidation requests, as in the case of SVB, banks can request a short term loan from this new fund to cover the requests. This measure will give banks quite a bit of time to raise additional funds and, again, to reduce the risk of a panicked run on another bank. 

Anthony M. Conte is managing partner at Conte Wealth Advisors based in Camp Hill. He can be reached at [email protected]. 

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