Ever since the U.S. Federal Reserve began hiking the Federal Funds Rate from zero, there has been a lot of talk about how the higher cost of debt will negatively impact a financial system that has become reliant on constant net debt issuance.
However, few expected it to bubble over into the second-biggest bank failure in U.S. history. On Friday, Silicon Valley Bank, which operates under the holding company SVB Financial Group (SIVB, Financial), was shut down by regulators after an equity offering announcement triggered a run on deposits from panicked venture capital firms.
The FDIC announced insured depositors will be able to access their deposits no later than Monday morning (standard FDIC insurance covers up to $250,000 per depositor per bank in each category). That does not mean everyone will get all their money back, though – only FDIC insured amounts are guaranteed, though the FDIC did say it would pay uninsured depositors an “advanced dividend.”
Despite being the second-largest bank failure in U.S. history and the largest since the financial crisis, the Silicon Valley Bank fallout is extremely unlikely to spread through the financial system. Most likely, it will remain confined to the startups and technology firms that were Silicon Valley Bank’s bread and butter. However, it will still have far-reaching effects on the stock market and the financial system.
What triggered the collapse?
On March 8, Silicon Valley Bank announced its intention to issue additional equity worth $2.25 billion. It made this move after suffering $1.8 billion in losses from asset sales as Silicon Valley startups and technology firms have drawn down their deposits due to the worsening economic situation.
The announcement tanked SVB Financial’s stock more than 60% on Thursday, and panicked venture capital firms urged portfolio companies to pull their money from the bank. The stock tanked another 60% in pre-market trading on Friday before being stopped out pending news. As per Nasdaq’s rules, the stock will be delisted from the exchange, and even if shares begin trading again, they will trade over the counter.
The problem here is a simple mathematical one. Banks are big investors in Treasury bonds because they need a safe place to park their cash, and they piled into these assets during the period of historically low interest rates in the first couple of years of the pandemic as deposits rose. Then, when the Fed started raising interest rates, the values of these Treasury bonds decreased. This typically is not a problem – unless a bank is forced to sell off Treasury bonds at a loss due to a run on deposits, in which case it becomes a big problem.
Silicon Valley Bank bore the brunt of this problem because the majority of its Treasury bonds were purchased when interest rates were low, as this was when the bull market was in full swing and startups were cropping up left and right. When interest rates began to rise and startups began to struggle, they drew on their deposits, forcing Silicon Valley Bank to take continuous losses as it sold assets to get customers their cash. Its cash ran out following the panic on Wednesday.
Which stocks might be impacted?
Approximately half of all venture capital-backed technology and life sciences companies bank with Silicon Valley Bank. The bank held a total of $342 billion in client funds and $74 billion in total loans as of the end of the fourth quarter of 2022.
While the bank does have a segment that focuses on corporate banking for late-stage private and public companies, the majority of its business is focused on startups and young companies that are part of the “innovation economy.”
According to SVB financial, 44% of the venture capital-backed companies that had an initial public offering in 2022 banked with it, and more than 790 technology and health care companies valued at over $1 billion “trust SVB as their long-term financial partner.”
Some of the bank’s prominent customers include Wayfair (W, Financial), HLS Therapeutics Inc. (TSX:HLS, Financial), Cloudera (CLDR, Financial), ZipRecruiter Inc. (ZIP, Financial) and Teradyne Inc. (TER, Financial). However, that does not mean investors in these companies should panic just yet. Fiscally responsible companies should be keeping proper track of their risk-reward profiles and have a backup plan for what to do if non-insured deposits are endangered. The companies most at risk are the early-stage ones that have yet to get on their feet.
The contagion is unlikely to spread
The collapse of one bank naturally has the market worried that other banks could be toppled as well. It is a real possibility that should not be ignored; if enough customers make a run on deposits and a bank has to sell enough assets at a loss, it could follow the same direction.
However, the general public is not as prone to panic as venture capital startups, and neither are large well-established companies. As long as there is not a big enough run on deposits, the vast majority of banks seem unlikely to follow the same route as Silicon Valley Bank. In other words, the best strategy to avoid a widespread bank crisis is for as many people as possible to do nothing.
Even if trouble does come for other banks, banks are much more well-capitalized after regulations put in place following the financial crisis. According to Wells Fargo’s (WFC, Financial) Mike Mayo, the biggest banks are more liquid than they’ve been in the last 50 years.
For example, as of the end of 2022, SVB Financial reported $211 billion worth of assets on its own balance sheet compared to $342 billion in client assets and total loans of $74 billion. Its liabilities-to-assets ratio is 0.92, which is about the same as 91% of other companies in the banks industry and indicates its fully liquidized assets should be enough to pay off all liabilities if the need should arise. The main problem with SVB Financial, aside from the run on deposits, was that it had an outsized portion of its assets in investments such as Treasuries.
A Treasury liquidity crisis is brewing
Since interest rates have an inverse relationship with Treasury bonds, this naturally means that higher interest rates make it more likely that banks will not be able to cover a run on deposits. Banks have spent the past few years positioning themselves for a virtually risk-free economic environment, but now that Treasury bonds are declining in value, it is not as if they can just sell them. For one, where else would they put their money? Moreover, with liquidity in the Treasury market already so low, a freeze-up in Treasury bonds is a one-way ticket to a collapse of the global financial system.
Lowering interest rates again could be one way to help mitigate this issue, but considering that there are multiple other factors contributing to lower demand for Treasury bonds, most prominently a pullback in the typical big buyers such as Japanese pensions, life insurers, foreign banks and even U.S. commercial banks, a more effective route could be an easing of quantitative tightening. It is possible that the Federal Reserve could even reinstate quantitative easing if the demand for Treasury bonds falls low enough.
On paper, it may seem like everything is under control because the Fed could come to the rescue with quantitative easing or interest rate cuts. However, there are good reasons why the Fed has taken a hard-line stance against inflation. As long as the market does not panic, it wants to keep rates high enough to dampen inflation.
Perhaps more crucially, it is likely that the Fed would not be able to halt a Treasury liquidity crisis anyway, at least not without government intervention. Who knows, perhaps we will finally see the legendary trillion-dollar coin come to the rescue.
On the other hand, economist Peter Schiff provided an interesting prediction in a Twitter post on Friday:
“The U.S. banking system is on the verge of a much bigger collapse than 2008. Banks own long-term paper at extremely low interest rates. They can't compete with short-term Treasuries. Mass withdrawals from depositors seeking higher yields will result in a wave of bank failures.”
While depositors pulling vast amounts of money out of savings to pour into Treasuries would certainly solve one problem, it would create another. Whether that would cause a banking system collapse, though, is up for debate.
Takeaway
For now, the bottom line is that panic is the biggest danger to banks and investors alike at the moment. The Silicon Valley Bank crisis is unlikely to spread elsewhere unless larger companies and the general public join venture capital in making a run on deposits. The woes of liquidity-starved startups are also unlikely to spread to larger companies.
A crisis in the innovation economy will likely lead to the destruction of jobs, which could harm the overall economy and slow down innovation for years to come. For tech and health care giants, this could even lead to valuable takeover opportunities drying up, which is something to keep an eye on. Given the Fed’s focus on keeping a lid on wage growth, it probably does not see this as a downside, though.
