On March 8, Silicon Valley Bank (SVB), America’s 16th largest bank, announced it was seeking to raise $2.5 billion to provide capital in the wake of its clients withdrawing their cash. SVB’s stock plunged 60 percent on the news. On March 10, the bank’s shares slid another 70 percent in pre-market trading before trading was halted. Business news media reported that SVB had not been able to raise the capital it needed and that the bank was seeking to sell itself to a larger institution. Later that day, the Federal Deposit Insurance Corporation (FDIC) announced the bank had failed. Here is a summary of how it happened and what it could mean for other financial institutions.
SVB’s primary customers are technology startup companies that mostly reside in California. It lent money to them early in their life cycle, well before other banks, as they had very few assets to use as collateral. These same companies also have large cash deposits at SVB, which grew rapidly as venture capital flowed into Tech startups over the past several years. As a result, SVB’s deposits more than quadrupled, far outpacing the growth of its loan book. Banks earn their revenue by lending out at higher rates than they pay depositors. However, its deposits grew so fast that they could not make loans fast enough. So to generate income, SVB bought mortgage and treasury bonds, and at a much faster rate than funding loans. As well, they bought longer-term bonds in an attempt to maintain profitability.
However, when the Fed began raising rates rapidly in an attempt to crush inflation, it also crushed the flow of venture capital, leading SVB clients to withdraw their deposits. SVB was forced to sell off its entire liquid bond portfolio to fund the withdrawals. Bond prices had plummeted, with longer-term bonds falling in price more than shorter maturities. As a result, there were not enough proceeds from the securities sales to fund all the withdrawals, which led to the initiative to raise capital, the inability to do so leading to a classic “run on the bank” scenario.
Will other banks fail?
How likely is it that this scenario could be repeated at other financial institutions? It’s possible but unlikely, except for a very limited number of smaller institutions that cater to a specific clientele. SVB had a highly concentrated clientele. It catered to a very small niche of clients who were very susceptible to the current climate. The tech bubble had burst, and startup companies were unprofitable and burning through cash. They had relied on venture capital, which had dried up. They were vulnerable and would not be able to continue operating if they could not access their cash. Finally, the bank’s clients were mostly companies, not individuals. Those companies typically keep cash amounts well in excess of FDIC-insured limits. At SVB, 93 percent of its deposits were uninsured. As such, its customers had a greater incentive to withdraw all their cash than most bank customers, and they did.
Many banks have bond portfolios with large unrealized losses. But they also have a diversified customer base with a higher percentage of individuals than businesses. Their clients also do not have as dire a need for cash as a venture-starved tech startup would. This gives them the time they need for their bonds to mature and to be made whole.
The drop in the share prices of some other financial institutions seems unwarranted. For example, Charles Schwab stock (SCHW) is down more than 37 percent since March 8. That might concern some investors because Schwab also has a large amount of unrealized losses in its securities portfolio, which could put it at risk if the firm’s banking clients decide to withdraw their deposits. However, Schwab is very well capitalized and has sufficient securities to fund a run on its deposits, even at depressed prices. They also have a diverse customer base.
Swift action taken
Still, the financial system is stressed, which necessitated swift action by the U.S. Federal Reserve, FDIC, and Treasury Department to address the liquidity pressures that have surfaced in the banking system. They issued a statement assuring all SVB depositors would have full access to their funds on Monday, March 13, and the Fed made additional funding available for banks to safeguard their deposits. HSBC Holdings Bank purchased SVB’s U.K. unit, and the FDIC began an auction process for the remainder of the failed SVB.
These steps should prevent additional banks from facing huge outflows of deposits. Still, the earning power of many financial institutions will be impaired going forward, so we can expect their stock prices to remain volatile in the near term.
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