March 15, 2023
The collapse of Silicon Valley Bank and others earlier this month has prompted concerns among investors that the broader financial system may be at risk. But while these concerns are understandable, investors should feel more secure that recent developments can help protect depositors and strengthen banks’ ability to meet cash needs.
Here’s a breakdown of the recent bank failures, what they mean for investors and why we’re confident in the underlying strength and stability of the U.S. banking system:
Why Silicon Valley Bank failed
The basic business model for a bank is straightforward: pay savers to keep their money at your bank and lend that money out at a higher rate to borrowers while you collect the spread. As with any business, however, the formula is certainly not guaranteed. Make enough bad loans and the bank may very likely fail.
Bad loans, however, are not the only avenue to insolvency for a bank, just the most common — a reminder that became clear this month. Depositors can also demand their money back and if a bank does not have the cash on hand to give them, it can be deemed insolvent.
Having enough “liquidity” available for just such situations is a very important part of bank risk management. A lack of available liquidity was the primary driver behind the high-profile collapse of Silicon Valley Bank (SVB). Many of the bank’s young technology company depositors were drawing down their balances, stressing the bank’s short-term liquidity position. The stream of outflows, however, surged after the bank announced on March 8, 2023, that it sought to issue new equity shares in order to raise cash. According to a California regulatory filing by the company, depositors withdrew a massive $42 billion by the end of Thursday.
Too much of the bank’s capital was held in longer-term investments, investments that couldn’t be sold immediately without incurring a loss. Outside of loans, most of the bank’s assets were reportedly held in low-risk Treasury securities or Mortgage-Backed Securities — but with longer maturities than the immediate need for cash required. The sharp rise in interest rates of the last year had reduced the market value of these securities given that bond prices move inversely to bond yields.
The SVB situation was largely resolved once federal officials took control of the bank and expanded the federal guarantee on deposits to cover both secured (deposits at or below the FDIC guarantee limit of $250,000) and unsecured balances (i.e., above the $250,000 insured threshold). Federal officials also opened a new lending facility to make liquidity available to other banks that might see their short-term cash needs stressed.
Impact on the banking systems: Is there risk of a domino effect?
Financial markets are now left wondering how many other banks might be in a similar situation. Banks in general are seeing pressure from withdrawals as higher-yielding investments entice funds elsewhere, and the sharp jump in interest rates over the last year weighs on the value of longer-dated investments.
A full evaluation of the situation may not be fully answered until regulators do a more thorough examination of mid-sized and smaller banks, but we believe the banking system in general remains sound — especially with the installation of the Fed’s new short-term lending facilities.
The nation’s large banks are primarily seen as less at risk given the stringent stress tests they undergo annually. We also note that SVB had a fairly concentrated deposit base of young start-up companies that were very quick to act when the company announced its stressed liquidity position. In our view, most banks have a much more diverse deposit base of consumers and small business relationships, which are typically more “sticky” than was seen in the SVB case.
Key takeaways for investors
The events of March may have some investors spooked, but it’s important to take a long-term view during periods of uncertainty. Here are a few key considerations to keep in mind:
1. Our view: The underlying strength and stability of the major U.S. banks are not an issue
Capital reserves across the major U.S. banks are on solid footing, and each has multiple levers to pull to maintain liquidity and meet depositor needs., including a new loan facility created by the Federal Reserve. As a result, investors and depositors should feel confident the U.S. financial system can weather higher rates and a potential recession. In our view, years of stringent Federal Reserve stress testing against various adverse economic scenarios and higher required capital cushions compared to pre-financial crisis levels have placed major U.S. banks in a position of strength with the ability to weather multiple headwinds.
2. Regulators are taking action to maintain trust in the financial system
In response to the recent bank failures, regulators and the Federal Reserve swiftly employed measures to restore confidence in the financial system and make all depositors at SVB and Signature Bank whole — even depositors with balances/accounts above the $250,000 threshold. The Fed will also provide a loan facility to all banks, if needed, to help prevent similar runs.
3. Recent events are a reminder that confidence underpins the foundation of all financial institutions
Importantly, the strength of a financial institution often comes down to the underlying confidence the market, investors, and customers place in said entity. The lightning-fast collapses of SVB and Signature Bank should remind investors how precious that confidence is and how critical it is for financial institutions to maintain trust and liquidity — especially during times of stress.
4. Bank stocks could come under further selling pressure
Rising interest rates, growing fears of a recession, deposit risks, and potential losses on security holdings eroding bank stability/profitability have weighed on the financial industry in recent weeks. SVB’s unexpected need to raise capital, losses booked on low-risk security holdings, and ultimate failure (at a time when others in the industry are warning about deposit pressures) are putting investors on a higher alert.
Over the past several quarters, most major U.S. banks have recognized the macroeconomic environment (including threats from higher interest rates) could become more challenging. Thus, most banks have set aside earnings to reserve against potential loan losses or unforeseen risks. As a result, while we expect Banks as a group to face increased volatility over the near term and as the rate/economic environment evolves, we believe the system is well capitalized and positioned to weather incoming challenges.
Your financial advisor is here to help you weather uncertainty
With mixed economic signals and uncertainty in the markets, investors should prepare for more volatility ahead. Please contact your Ameriprise financial advisor for personalized advice on investment strategies that can help you feel more confident during a challenging environment.