It is often said that the Federal Reserve raises rates until something in the economy breaks. It seems like after the recent failures of two of the largest US banks, the voluntary liquidation of the largest bank in the crypto space, and the struggle of one Europe’s largest banks, the Fed has finally broken something. The last two weeks have provided a whirlwind of banking concerns not seen since the Great Financial Crisis, which has both bank investors and bank customers on edge. Thankfully, looking at each of the current issues that have arisen in the last week, we believe that there is much less contagion risk to the financial sector than the current panic being seen.
To help understand what has transpired, it is crucial to understand the banks involved and the issues that caused the panic we are seeing. We will touch on a few major problems that have caused the recent banking panic:
· Lack of Cash Deposits- one common theme between the banks that have been of the significant concern the last few weeks is that all of them were considered ‘cash poor’ based on recommended deposit levels. The lack of cash deposits on each bank’s balance sheet made it very difficult for the banks involved to survive a period of excessively high customer withdrawals.
· Cryptocurrencies- primarily an issue with Silvergate Capital and Signature Bank of New York, the collapse of crypto prices in the last year caused extreme stress upon each company’s balance sheets. The collapse of FTX and other crypto exchanges destroyed any chance of these banks surviving.
· Lack of Retail Customers- deposits are considered ‘insured’ under the $250,000.00 FDIC limit. While some companies may have deposits under this limit, most insured accounts are made by retail customers. Almost all the deposits at the failed banks were uninsured, which means the bank relied too much on fewer, but larger customers, and could not maintain any risk management control.
· Price of Held-to-Maturity Assets- With the Federal Reserve’s massive increase over the last year, many of the US Treasury assets held by all banks are trading at a significant discount to their par or issued value. As liquidity has become a concern over the last year, having to sell US Treasuries at substantial discounts caused weakness to the bank’s bottom line. It also caused dislocations between current and valid pricing in the bond market. This self-inflicted wound is due to the Federal Reserve’s high focus on inflation.
· Compounding Problems- the removal of deposits by customers in mass is usually the result of the bank not properly managing risk over the years and allowing certain problems to continue to compound due to arrogance or incompetence.
These issues represent problems specific to each of these institutions and are not a new normal for the banking industry. To better understand how we have ended up where we are today, it’s important to understand the banks involved, how the Federal Reserve reacted, and how everything has played out from a timeline point of view:
Silvergate Capital (SI)
Silvergate Capital was initially a small three-branch community bank in San Diego that was one of the first banks to begin serving cryptocurrency clients in 2016. The company grew exponentially between 2017 and 2021, with deposits reaching a peak of $12 billion in the middle of 2022. Silvergate became the first regulated bank to offer a real-time payment system for cryptocurrency exchanges, institutions, and customers to exchange fiat currencies such as the dollar. Their largest client was FTX.
Reason for Failure
Throughout 2022 as the price of cryptocurrencies continued to collapse, concern grew that Silvergate would run into a liquidity issue due to a lack of deposits and their credit operations that lent out thousands of loans that used cryptocurrency as collateral. After the fall of FTX in November, Silvergate saw a massive run on its deposits, including several players in the crypto sector moving their business to Signature Bank. By the end of 2022, deposits at the bank had dropped by more than 8 billion dollars, leaving the bank in a dire position. Attempts to raise funds and find other investors had failed and the company decided to shut down operations.
Silicon Valley Bank (SIVB)
Silicon Valley Bank was founded in 1983 to focus on the needs of startup companies. The bank saw substantial growth as technology startups, and the dot-com bubble provided a massive influx of business. In 2002 the bank entered the private banking industry and expanded into international markets. While growing in size over the years, the company maintained its niche in dealing with startups and the technology sector. At one time, the company served 65% of all US startups. One of the significant issues with the bank is that it needed a more retail customers of similar-sized banks.
Reason for Failure
As interest rates continued to spike in 2022 and there was a massive downturn in startup growth, the bank had to mark to market unrealized losses of their highly concentrated portfolio of Treasury bonds. Unlike most other banks of a similar size, Silicon Valley books were hefty in security ownership while being relatively cash poor. As shown below, the bank held double the number of securities on its books than any other major US bank.
Then when the company announced it would be looking to raise almost 2 billion dollars in fresh capital, panic set in, and customers began a bank run by withdrawing their deposits.
On Friday, March 10, the California Dept of Financial Protection and Innovation shut down the bank, citing inadequate liquidity and insolvency. The FDIC was appointed as the receiver of the bank. There are a couple of reasons for the failure of Silicon Valley, but most notably was poor risk management of the bank’s assets, as the lack of cash deposits made it difficult for the bank to survive after customers withdrew their deposits.
Signature Bank of New York (SBNY)
Founded in 2001, Signature Bank operated six branches in New York City and catered to wealthy clients and businesses. As with most banks, Signature Bank began to offer several different financial services as it grew but remained within its focus on relationship banking.
In 2018 the bank finally expanded out of the New York area and opened operations in San Francisco before expanding throughout California. Along with its move into other geographic locations, the bank also made a significant push into the cryptocurrency sector. By February of this year, cryptocurrencies represented more than 30% of the bank’s deposits.
Reason for Failure
Even though the value of cryptocurrencies crashed in 2022 and many crypto exchanges went out of business, Signature Bank continued to gain deposits. Due to liquidity concerns, most of the bank’s growth in crypto deposits came from customers moving assets to Signature from Silvergate. Starting in the summer of 2022, the bank began to experience outflows as customers were concerned that Signature was becoming a “crypto bank.” Liquidity concerns were amplified after the FTX bankruptcy in November 2022 and subsequent failures of other crypto exchanges.
As the news broke about Silvergate and Silicon Valley, customers began to withdraw their deposits from Signature Bank similarly. At one point, the bank lost deposits so fast that it was forced to request money from the Federal Home Loan Bank twice in 90 minutes. Designated as a systemic risk, the New York Department of Financial Services took the bank over and appointed the FDIC as the receiver.
Credit Suisse (CS)
Founded in 1856, Credit Suisse is the world’s largest investment bank and financial services company, providing investment banking, private banking, asset management, and several shared services. The bank has long been known for its strict bank/client confidentiality and banking secrecy. They are considered a “global systemically important bank” because they operate as a primary dealer and counterparty for numerous central banks, including the Federal Reserve.
Although Credit Suisse was considered one of the best-positioned institutions coming out of the Great Financial Crisis, the company’s stock price was never able to regain much ground, and market participants lost trust and confidence in the space. As of March 13th, the US shares of Credit Suisse have lost more than 97% of their pre-financial crisis price.
In 2011, Credit Suisse was accused of assisting wealthy Americans in avoiding taxes.
Over the next few years, the company was sued by several other countries, which resulted in billions of dollars in tax evasion settlements. The issues with tax evasion are just one of the many issues that the company’s investment banking arm has faced over the years. As an example, in 2022, the company was found guilty of laundering money for a Bulgarian cocaine drug ring. Controversies and scandals have been the norm with Credit Suisse over the last decade.
Reason for Failure
Credit Suisse’s largest shareholder, the Saudi National Bank, with almost 10% ownership, announced that it would no longer invest in Credit Suisse due to regulatory and statutory reasons. The spokesperson for Saudi National Bank stated that owning more than 10% of any company would force new rules and regulations to kick from both their regulators and regulators in other countries.
Comments from the Saudi bank caused the stock price of Credit Suisse stock and bonds to drop significantly, while daily withdrawal demand spiked to over $10 billion Swiss francs daily. The Swiss National Bank provided a $50 billion emergency line of credit to help backstop the bank. Regulators from the EU, the US, the UK, and Switzerland were highly concerned that the bank would quickly become insolvent if the bank was not bailed out or acquired by a fellow bank.
Over the past weekend, there were discussions that Swiss competitor UBS would take over Credit Suisse. On Monday morning, the official announcement was made that UBS would take over Credit Suisse in a sweetheart all-stock deal worth $3.2 billion. And just like that, 166-year-old bank was gone.
United States Federal Reserve Response
On the evening of March 12th, shortly after the failure of Signature Bank, the Federal Reserve Board announced the creation of the “Bank Term Funding Program,” which would make available additional funding to eligible institutions to help with the ability to meet the needs of their depositors. The program allows loans of up to one year to banks, savings associations, credit unions, and other eligible depository institutions who pledge US Treasuries, agency debt, mortgage-back securities, and other qualifying assets as collateral.
The funding program was established specifically to help banks with liquidity by allowing them to use “hold-to-maturity” assets on their books as collateral and can be pledged at par value, which means that the borrower can use the total value of the underlying security that is being pledged to get a short-term loan with the goal of covering deposits without having to sell securities at less than par value.
The Bank Term Funding Program should not be viewed as a new form of quantitative easing (QE) as the Treasury is not buying assets and trying to stimulate easy money; this program should be viewed as a short-term offloading of assets to help bank liquidity.
This is basically a short-term transfer of one balance sheet asset for another and saves the bank from having to liquidate securities.
Concluding Thoughts for Investors and Banking Customers
There is a lot of concern when the US has two of its three largest bank failures in history occur within a three-day period, and then one of the world’s oldest and largest investment banks is forced into an emergency takeover. However, what we are currently experiencing is not a repeat of The Great Financial Crisis.
· The banking crisis of 2008 was a generational event caused by highly leveraged institutions owning exotic and complex securities, backed mainly by mortgages, that resulted in a global credit crisis. The recent issues we have experienced are the result of an overall lack of risk management at the institutions that have failed, which has a lot to do with the value of their US Treasury positions held at paper losses due to the Fed aggressively pushing rates higher over the last year. Developing the Bank Term Funding Program helps reduce the risk of a bank having to liquidate these securities at losses to raise cash to meet depositors’ needs.
The Bank Term Funding Program represents a zero-risk Federal Reserve and US Treasury loan program. Since the qualified securities are pledged through the program, the Fed is taking back into position their investments. If there are any additional bank failures, the Fed will take over the collateral and maintain it on its books until maturity.
· There is no additional systemic risk associated with the Funding Program.
· Whether in a banking crisis or not, it is always vital for banking customers to maintain deposits below the $250,000 FDIC limit. Even though the government guaranteed all Silicon Valley and Signature Bank depositors, they may still need to do the same with any additional bank failures moving forward. Keeping deposits under the FDIC limit guarantees that your deposit will likely be available the next business day.
· Depositors in a bank failure whether insured or uninsured, are almost always made whole. While FDIC-insured deposits will automatically be covered and available the following business day, uninsured deposits are almost always covered once the FDIC sells the failed bank assets to a new institution. In the event of a bank failure, the individuals that are most harmed are the investors in company stock or debt securities, which are wiped out through bankruptcy.
· We cannot overlook social media usage as it provided a platform to spread panic across the entire banking sector, increasing the overall fear of a much larger bank run. Specifically, a few social media posts by prominent venture capitalists significantly accelerated the withdrawal of deposits from Silicon Valley. While some important information may be found on social media, we must remember that most social media and, sadly, traditional media, are opinion-based these days.
At this time, we cannot guarantee that there will not be additional bank failures over the coming months. With the establishment of the Bank Term Funding Program, many liquidity risks have been removed from the sector, but there are still bank-specific risks. These risks will be along the lines of traditional banking factors, such as mismanagement of balance sheet risk or the overextension of credit. Investors as well as bank customers should not be overly concerned with contagion fears both within the sector and the global economy.
One major positive that should come from the recent banking crisis, is that it should act as an eye opener for the Federal Reserve and their ultra-aggressive monetary policy over the last year. While controlling inflation and returning price stability to the US economy is the Fed’s major goal, their policies should not cause more harm than the issues they are trying to control. With the global financial system having been built around extremely low interest rates over the last decade, the Fed needs to realize the consequences of their aggressive policy. In our opinion, the Fed would be well suited to use the recent banking panic as an opportunity to pause their rate cycle and allow the economy to adjust to the significant monetary changes over the last year.