What the Silicon Valley Bank Collapse Means for Investors
Last Friday saw the largest bank failure since the Great Recession, as Silicon Valley Bank (SVB) was closed by California's financial regulator. The bank was effectively caught between depositor withdrawals and assets that needed to be liquidated but had decreased in market value due to rising interest rates. This dynamic created a classic "bank run" scenario, and depositors and investors alike are assessing the potential for a similar scenario to play out at other regional and international banks.
How Banks Work
Banks generate revenue by lending money at higher rates than they pay on deposits. The money that banks lend may be in the form of U.S. Treasuries, mortgage-backed securities, corporate bonds, or other types of debt assets. This business model works well as long as deposit balances remain relatively stable, the money lent out by the bank generally maintains its value, or both. If deposits are significantly depleted by net withdrawals and the assets held by the bank decrease in value, the bank may be forced to sell its assets at a loss to pay for withdrawals and end up with less money than it owes in deposit liabilities, thus becoming insolvent.
We have seen few bank defaults in recent decades for two main reasons:
Banks generally maintain conservative balance sheets. They typically tend to avoid excessive exposure to high-risk assets.
The Federal government has many policies to help protect banks against default. For example, the Federal Deposit Insurance Corporation (FDIC) insures deposits up to $250,000. This encourages depositors to avoid making panicked withdrawals. Additionally, the Federal government has provided funds to distressed banks, such as during the banking collapse of 2008.
Why did Silicon Valley Bank Collapse?
In the case of SVB, recent interest rate increases were its demise. Much of its depositors were startups and venture capital funds. Higher interest rates typically slow down economic activity and investments by making money more expensive. This has an outsize impact on startup companies that are not yet profitable and therefore depend on continued capital raises to fund operations and growth. When the startups were hit by reduced cash inflows from investors but still needed to pay their expenses, they made significant withdrawals from their deposits at SVB.
Simultaneously, the value of SVB's assets decreased because the price of an asset that pays a fixed coupon moves inversely to interest rates. As depositors became concerned that the bank would run out of funds, they withdrew more, exacerbating the problem and causing SVB to become insolvent and fail. Here’s a video with more information:
Two days after the collapse of SVB, financial regulators similarly had to take control of Signature Bank, a bank with significant exposure to crypto-related deposits.
The U.S. Treasury Department, in an effort to prevent widespread panic and subsequent bank collapses, announced on Monday that all deposits would be guaranteed. This includes funds not covered by the FDIC standard insurance on deposits up to $250,000. While the depositors are safe, the banks' investors still have full exposure to losses from the collapse.
The losses sustained by investors of SVB and Signature Bank led investors to question their holdings in other banks. This has led to losses in banking sector stock prices. And now many investors wonder if bank stocks should be avoided or if they present a buying opportunity.
How Will These Bank Collapses Affect Investors?
A number of factors determine what happens next for the banking sector. These include the direction and magnitude of future interest rate moves by the Federal Open Market Committee, pricing pressures in the residential and commercial real estate markets (and the associated mortgages and loans), the strength of the labor market, and consumer sentiment and spending.
These factors will be important in assessing whether bank stocks are providing an exceptional buying opportunity, or if this is just the beginning of a painful period of readjustment for valuations based on challenging intrinsic fundamentals.
Many banks are exposed to risk. Some banks hold deposits that are particularly susceptible to massive withdrawals in economic downturns. Additionally, other banks have significant exposure to real estate prices or assets with major duration risk. Accordingly, investors should tread carefully when evaluating these risks in their investment decisions.
