Are we having another banking crisis?

Juliet Schooling Latter 15/03/2023 in Equities

Silicon Valley Bank was taken over by regulators last week in the second-largest bank failure in American history.

In this short guide, we explain what happened and why, and discuss if investors should be worried about further contagion in the banking sector.

What happened to Silicon Valley Bank?

The way banks usually make money is by getting paid more on the interest on the loans they grant, than the interest they pay to attract deposits.

Silicon Valley Bank was different. It focused on a very unusual niche: “highly unprofitable tech start-ups that used to be force-fed money like foie-gras geese,” as Rathbones eloquently put it.

Basically, its clients received money from investors and venture capitalists, who were excited by these companies growth prospects, and deposited this money at the bank. They would then steadily drain their money as they spent and invested. If they were successful, they would secure more money from their backers and the cycle continued.

“These tech customers didn’t have as much need for borrowing though – they much preferred selling equity to investors at steep values,” said Rathbones. “That caused an imbalance: Silicon Valley Bank had a bunch of money from depositors, but not enough people and businesses to lend it to. Instead, the bank invested in huge amounts of long-dated government bonds. It had parked more than twice as much money in these bonds than it had lent out to its customers.”

The prices of government bonds with many years till maturity are very sensitive to changes in prevailing interest rates. “So if interest rates rose, the value of these bonds would fall markedly,” explained Rathbones.

“In its accounts, Silicon Valley Bank had categorised most of them as ‘held to maturity’, which meant that it didn’t have to report the big losses it was making on these bonds as interest rates rose swiftly. The reason for this is that the bond’s price will rise to its face value as the maturity date approaches, so the capital won’t necessarily be lost. Held-to-maturity assets allow companies to keep short-term fluctuations from obscuring their underlying performance.

“However, if the bank starts to run low of cash, it becomes a forced seller and will need to crystalise these losses today to provide the money for its depositors to scamper away with to another bank. Added to this, because its customers were more business-savvy than typical depositors, Silicon Valley Bank had to increase its deposit rates more than typical banks to try to keep customers. In retrospect, it was a bomb waiting to go off.”

Silicon Valley Bank wasn’t the only bank to go under last week. Two other, smaller, banks – New York’s Signature Bank and San Diego’s Silvergate  – that were close to the tech industry generally and the cryptocurrency boom specifically, are both now defunct.

In the UK, in talks brokered by the Prime Minister and Bank of England, HSBC agreed to buy Silicon Valley Bank’s UK arm, SVB UK, for $1. SVB UK has £5.5 billion in loans and £6.7 billion of deposits, mostly to companies and investors in the UK’s digital technology sector. However, American regulators couldn’t find a rescuer of Silicon Valley Bank proper.

Will the problems spread to other banks?

M&G’s Financials Credit Research Team says that while there will be challenges for SVB clients and potentially meaningful pressure on other specialty lenders or banks with particularly weak deposit franchises, “in our view the events of last week do not pose a material risk for bond investors in large, diversified US banks, and they pose even less risk for bond investors in European banks.”

This is because several key factors in Silicon Valley Bank’s demise relate to its unique business model and also because several broader factors that contributed to its stress aren’t as prevalent in Europe as they are in the US.

Increased regulation

As the managers of Aegon Strategic Bond pointed out, after the global financial crisis (GFC), the European Central Bank went on an extremely hawkish offensive to over-regulate the banking sector in order to avoid future public sector bail outs. “It was a painful but natural consequence of the European Sovereign Debt crisis and was aimed at breaking the sovereign–bank nexus that nearly broke the European Union,” they said.

“As a result, the sector as a whole went on a massive transformational journey in the past 15 years. High-quality capital that banks were required to hold, increased more than three times. Depositor funds were ring-fenced from proprietary risk-taking activity. The amount of liquid assets required to be available at any given time, quadrupled. A pan-European Deposit Guarantee Fund was implemented to safeguard further client moneys, self-funded by the sector.

“Unrealised losses on most of their government bond holdings were immediately visible, either through the P&L or the capital position (unlike in the US), therefore room for large and unexpected Unrealised losses related to government bond portfolios is limited. Annual stress tests were introduced, where the regulator ‘stressed’ banks’ balance sheets to gauge their financial health and ordered remedial (capital raising) actions as needed.

“During the same period, US banks managed to secure several exemptions from the globally accepted Basel III capital rules, and even more so when it came down to their regional banks. From having a few laps lead on EU banks in terms of financial strength, a lot of US banks became laggards (except for the big 6 with a ‘too big to fail’ status). Regulation was not overly hawkish to begin with following GFC, and was subsequently further relaxed during mid 2010s. Return on Equity soared, and benefits continued to accrue to equity holders at the expense of creditors and this was fine for as long as money was free, but it isn’t anymore.

Shares fall for European banks

However, the share prices of many large European banks have fallen today (15 March 2023) and the shares of Credit Suisse, Société Générale, BNP Paribas, Monte dei Paschi and UniCredit were all suspended.

This comes on back of steep falls in the value of Credit Suisse shares after management basically admitted that they have no idea what is going on within the company.

“The situation with Credit Suisse is very different to Silicon Valley Bank,” commented James Yardley, senior research analyst at FundCalibre. “Banking analysts for Credit Suisse point to the bank’s strong capital and reasonable liquidity ratios, but the confidence is completely gone, and clients will not be feeling particularly comfortable. Once a bank loses confidence, it is very hard to regain it.

“Would the Swiss government let it fail? It’s probably unlikely, but the lack of any comment from the Swiss National Bank today has not inspired much confidence. If it did fail, the consequences would be severe.”

Rob Burnett, manager of LF Lightman European has been reducing his holdings to the banking sector. “We began reducing our weight in banks a month ago, and continued further last week and today,” he said on Monday.

According to Rob, “Whilst [SVB] is not a systemic event, there are important lessons that have implications for US bank earnings immediately and for European bank earnings in the future.”

“The major read-across to other US banks is that deposit competition is heating up,” Rob continued. “The competition for capital is rising. If you can generate high returns investing risk-free in US Treasuries, this puts pressure on low-yielding bank deposits. Those banks that do not have strong retail deposit franchises are having to pay up for deposits or lose them. The technical term for the relationship between deposit pricing and interest rates is “deposit beta”.

“In Europe, deposit beta remains low for now. The competition for capital is not as intense. The alternative to bank deposits is short-dated bond yields offering 2.5% – 3%. Whilst this is quite attractive, it is not as compelling as US rates at 4.5% and higher. European banks are also helped by a system-wide loan-to-deposit ratio that is below 100%. There has not been much evidence of European deposits moving out of the banking system into money market funds as yet. Most European banks have solid retail deposit franchises that are sticky.

Given this backdrop, why still own any banks? “In Europe the runway for earnings growth is shortening but there is still some distance left,” said Rob. “Valuations are low, and dividends and buybacks are high. The shareholder yield from dividends and buybacks is close to the best in the market. Only oil companies are better. We also see the lending standards of the last decade being solid and so we expect loan loss provisions to be contained, even in a more difficult macro environment.”

This article is provided for information only. The views of the author and any people quoted are their own and do not constitute financial advice. The content is not intended to be a personal recommendation to buy or sell any fund or trust, or to adopt a particular investment strategy. However, the knowledge that professional analysts have analysed a fund or trust in depth before assigning them a rating can be a valuable additional filter for anyone looking to make their own decisions.Past performance is not a reliable guide to future returns. Market and exchange-rate movements may cause the value of investments to go down as well as up. Yields will fluctuate and so income from investments is variable and not guaranteed. You may not get back the amount originally invested. Tax treatment depends of your individual circumstances and may be subject to change in the future. If you are unsure about the suitability of any investment you should seek professional advice.Whilst FundCalibre provides product information, guidance and fund research we cannot know which of these products or funds, if any, are suitable for your particular circumstances and must leave that judgement to you. Before you make any investment decision, make sure you’re comfortable and fully understand the risks. Further information can be found on Elite Rated funds by simply clicking on the name highlighted in the article.