Brief Background on Recent Events Impacting Silicon Valley Bank (“SVB")

Facing pressure from declining deposits and a loss on the sale of securities in its portfolio, SVB attempted last week to raise capital to mitigate a Moody’s rating downgrade on Wednesday. However, it was unable to complete the capital raise before markets opened on Thursday, which resulted in a precipitous drop in its stock price that day. Interpreting SVB’s stock price weakness as a referendum on its financial stability, depositors fled, ultimately withdrawing $42 billion in a single day. The bank’s concentrated client base and the highly networked nature of Silicon Valley likely contributed to the severity of this run on the bank. For context, Washington Mutual faced $17 billon in withdrawals over two weeks in 2008. SVB quickly experienced severe liquidity issues, as it was unable to draw upon its hold-to-maturity (HTM) portfolio without recognizing severe losses. Regulators took the extraordinary step of seizing control of the bank Friday morning, prompting fears of contagion in the banking sector, particularly for regional banks.

What Happened This Past Weekend

After the collapse of SVB, which was followed by a second bank failure, this time New York based Signature Bank (“SBNY”), on Sunday, the Federal Reserve, Treasury and Federal Deposit Insurance Corporation jointly announced a backstop of the uninsured deposits at both banks. To further support the broader banking system, they also announced the creation of the $25 billion Bank Term Funding Program (“BTFP”). Under the BTFP, banks will be offered loans for up to one year secured by Treasuries, agency debt and MBS, and other qualifying collateral. This move is intended to provide liquidity through the discount window to eligible banks, with collateral valued at par (i.e., without haircuts), and is designed to eliminate a bank’s need to sell securities during a time of stress. The Fed does not anticipate that it will be necessary for banks to draw on those backstop funds, which will be in the form of credit protection from the Treasury (i.e., like equity). In addition, banks can get the same terms from the Fed’s discount window, further increasing lendable value at the window. The combined actions should prevent banks from having to sell securities at a loss like SVB did last week to meet deposit outflows/funding shortfalls. We think that the Federal regulators’ actions makes sense, since these are assets that the banks will eventually redeem at par. Importantly, this is a liquidity issue and not a credit issue as there is no credit risk here, unlike in the Global Financial Crisis (GFC).

Market Reaction

We believe that this layered response should help to restore confidence in the banking system and help to reduce the potential exodus of deposits from banks that are perceived as more vulnerable. The steps announced by the Treasury, Fed and FDIC are reminiscent of the various programs that were instituted during the GFC to restore confidence in the banking industry. All depositors at SVB and SBNY will be made whole and will be able to access their deposits. The costs will not be borne by taxpayers, but instead any losses will be covered by a special assessment on the banking industry, while equity and bondholders in those issuers face significant losses. The backstopping of all depositors, both insured and uninsured (i.e., those with over $250,000) of SVB and SBNY, and the implicit extension to other banks that might be in trouble should help to ease the run on the banks. That said, the fact that the insurance deposit is not explicit (and the substantial related losses for equity and bondholders) may lead to some ongoing concerns and tests of confidence in the government response as some bank clients look to move deposits regardless of recent actions. Reactions to market stresses are often not linear, and we are likely to see some ongoing volatility in the financial sector as market confidence is tested. For the stocks, once the current volatility subsides, the implications are negative for both earnings (smaller balance sheets, higher funding and operating costs) and valuations (regulatory risk, less attractive returns), as discussed below.

Implications Going Forward

The events last week have significant implications, both near-term and longer-term, for the United States banking industry. In particular, we would highlight the following:

  • Increased Bank Regulations: We are likely to see increased regulation of smaller banks to ensure liquidity and capital resilience (tougher stress tests, liquidity rules, forced capital raises, etc.), which we expect to pressure earnings and likely lead to tighter lending standards.
  • More Consolidation and Flows to the Biggest Banks: Potential investor and customer preference for traditional and larger banks may drive M&A and consolidation in the industry. We would not be surprised if smaller banks are acquired by larger, more diversified banks.
  • Higher Deposit Costs: With the rapid increase in the fed funds rate and quantitative tightening, the cost of deposit funding increased over the past several quarters. Investors now have more alternative investment choices with relatively low risk to deploy liquidity. Core deposits are now even more valuable for banks. Competition for those deposits will likely increase, resulting in higher deposit rates to retain and attract deposits. This is likely to lead to increased costs of capital for banks and is likely to get passed on as higher costs for some of their clients.
  • Increased Wholesale Funding for Regional Banks: Regulators are considering Total Loss Absorbing Capacity (TLAC) rules for regional banks. TLAC acts as an additional layer of longer-term funding to meet potential strains on liquidity and to absorb losses should a bank fail. Regulators may consider tougher TLAC requirements following the events over the weekend. If regional TLAC rules are stricter than initially proposed, wholesale funding for regional banks will increase, further increasing their funding costs.
  • Reevaluation of Deposit Insurance Cap: It appears that the $250,000 deposit insurance cap is insufficient to prevent bank runs. The cap has been in place for decades, and is not indexed to inflation. Following the failure of IndyMac in 2008, the U.S. adopted the unofficial policy of guaranteeing deposits, insured or not. Regulators may need to consider formalizing this unofficial policy.