Declining Confidence in the Banking System
The effect of bank runs will typically play out over weeks and months and the expectation is the deposit run on Silicon Valley and Signature Banks will be no different. The collapse of these two banks does not equal that of the Financial Crisis of 2007-2009, but the underlying reason is the same: an evaporation of confidence in first, the banks themselves and, second, in the banking system overall.
What caused the decline in confidence in the banks? The regional banks’ business model was built around the idea that interest rates would be low for an extended period and if rates increased, the rise would be gradual and then would quickly decline close to prior levels, at least. This outlook led to bank investment portfolios to hold bonds with maturities of 10 or more years and a reliance on uninsured deposits. However, the Fed increased rates more rapidly than expected and announced that rates would be higher for longer. Since bond prices decline when rates increase, unrealized losses started to appear on the balance sheet of the banks. This broke the business model of the regional banks, and they did not adapt the model to incorporate shorter maturity bonds and reduce the reliance on uninsured deposits.
When rates started to rise a year ago, Silicon Valley Bank (SVB) held onto the long maturity bonds on the balance sheet rather than selling at small losses and buying shorter maturities, thus avoiding big losses. This was a managerial misstep that was compounded, until this month, when the bank was forced to sell bonds to meet deposit redemption requests. Unfortunately, these bonds were sold at a big loss and the bank had to raise equity capital. The need to raise capital spooked remaining depositors and since most SVB deposits were uninsured (above $250,000), these deposits are the first to leave a bank. A large depositor pulled several billion dollars out of the bank which started a feeding frenzy of declining confidence and deposits. At the close of business on March 9th, SVB lost $42 billion in deposits and the government sent SVB into receivership. Signature Bank followed two days later after deposit outflows of $10 billion.
The deposit runs on Silicon Valley and Signature Banks put other regional banks in play, and First Republic, Pacific Western, and Western Alliance Banks all suffered from declining confidence and deposits because they had large balance of uninsured deposits. This then temporarily infected the entire banking system with questions around the investment portfolios and the percentage of uninsured deposits. Most banks, even the big money center banks, JP Morgan, Citigroup, Bank of America, and Wells Fargo have large uninsured deposit balances and losses on their investment securities.
We don’t believe, currently, that the problems in Silicon Valley, Signature, and First Republic Banks is the start of a contagion spreading throughout the banking system. We do believe, though, the effect the loss of confidence has had over the past week and will have in the immediate future is a reduction in loan creation as banks focus on conserving capital, improving liquidity, and restoring confidence. Unfortunately, the reduction in loan creation will slow economic growth because of the tighter financial conditions. Financial conditions have been tightening given the Fed rate increases, and the reluctance of banks to give out loans will likely work in concert with the rate increases to kick-off a recession.
All is not lost; despite our continued belief that we are headed into a recession, the market declines in 2022 and over the past few weeks are creating buying opportunities across the equity markets. If a recession does hit, interest rates are expected to decline as they have in past recessions, so bonds are also an attractive investment class. With that said, we believe selectivity of purchase will be required because not everything will be a buy. We have been looking through those investment possibilities that will add value for clients and are zeroing in on some attractive opportunities.