From Friday, March 10, to Sunday, March 12, two of the top 20 banks in the United States, Silicon Valley Bank (SVB) and Signature Bank, were taken over by the FDIC after deposit outflows of $42 billion and $10 billion, respectively. These are the second and third largest bank failures in U.S. history, after Washington Mutual in 2008. Through social media-driven panic, uninsured depositors at both banks got spooked and started what turned into a very rapid—and very old-school—bank run. As in the case of Bailey Building and Loan in It’s a Wonderful Life, everyone rushed to the get their money, but unlike the movie, they used smartphone apps to withdraw funds at an astonishing pace. The FDIC was created to prevent bank runs, of course, and they stepped in and guaranteed 100% of all deposits at both institutions to try to reassure large-balance depositors and prevent a cascade of bank runs.
Since the events around SVB and Signature, banks generally and regional banks particularly have been under pressure, with other problem spots emerging—most recently First Republic Bank. Many market observers suggest this might be the start of another 2008 scenario. While things can deteriorate from here, everything so far points to this being more of a “concentrated fact pattern” but still critically important dislocation. The financial crisis of 2008 was a systemic credit crisis driven by bad underwriting and the complex securitizations of mortgages, which suddenly fell in value due to the rapid deterioration of underlying collateral. The 2023 situation is similar in that it is grounded in deflating bank balance sheets, but today’s events are driven by interest rate policy risk rather than credit risk, and they are occurring—at least so far—at banks that are particularly susceptible to this risk.
When interest rates increase, bond values decrease. The rate risk challenge emerges in banks because they typically hold approximately 30% of their assets in Treasuries and agency mortgage-backed securities (MBS), the most liquid and widely held financial assets. Regulators require banks to hold these liquid assets as available-for-sale (AFS) for their cash needs. When depositors want their money, bank treasurers sell the AFS holdings as the source of funding. AFS accounting requires banks to value bonds—or mark them to market—at each quarter end. As rates have risen, the values of these bonds have dropped, in some cases by 20% or more. Banks can manage mark-to-market exposure for regulatory capital purposes by designating AFS securities as “Held to Maturity”, but they must always realize any losses when they sell the subject securities to fund depositor claims. All banks carry these market valuation risks, but SVB had several characteristics that multiplied their exposure:
- SVB had a relatively concentrated depositor base, meaning depositors were entities and individuals that shared similar drivers—including shared communication channels—for potentially wanting to access their deposits
- SVB had a materially higher percentage of its assets in AFS financial assets as opposed to loans, meaning that its balance sheet was more vulnerable to realized mark-to-market risk.
- SVB’s loan book was relatively concentrated, which made it seem more susceptible to realized credit risk (default potential) as interest rates increase.
- Ninety percent of SVB deposits were uninsured – the highest rate among U.S. banks—meaning that its depositor base was highly vulnerable to the hint of any problem at the bank.
The SVB panic started when reported—but not yet realized—mark-to-market losses on its cumulative financial asset holdings led to social media speculation about the bank’s capital position, which led to a subset of depositors getting nervous and wanting their cash. This forced the sale of $21 billion of AFS bonds at a $2 billion realized loss, which triggered the need for additional equity capital and an escalating and circular panic. The rest is history, except that the FDIC stepped in and insured all deposits and then partnered with the Federal Reserve to initiate a lending facility that allows banks to use their Treasury and agency MBS holdings as collateral for liquidity loans—with the important kicker being that the pledged collateral is valued at par versus market, which means that the banks never have to realize the losses that would otherwise have come from liquidating the bonds.
The critical points are that, first, SVB and Signature (and now Republic) appear to be examples of institution-specific versus systemic risk and, second, the FDIC and Federal Reserve have taken action to address two of the major risks that drove the panic. While any systemic problem appears to be contained, it is still too early to declare this a non-event because—as we have all learned the hard way—things can change quickly. Part of our banking and financial construct is built on confidence, and rapidly dissolving confidence can lead to harsher responses than the facts seem to warrant. We recommend four responses:
- Stay calm and pay attention. Overreacting to a crisis is not a good idea, especially if we don’t yet know if this is a crisis. This may (quickly) evolve into something worse than two bank closures and a bail-out (Republic) and there may be a time to act, but that time will come in response to more and better information. So, continue to pay close attention and try as best as possible to differentiate between chatter and reality.
- Know your counterparties. Our team published guidance on this topic, which you can access here. We can offer support on what we are hearing and can be a conduit to publicly available information, but now is the time to tap into partners (investment and financing) that have access to research resources that cover the banking sector.
- Have a contingency funding plan. If you don’t have this already, identify all cash accounts, including banks, amounts, interest rates, and withdrawal limits (if any). List all available and open credit lines. List and review all short-term investments in place for liquidity needs. What is the current unrealized loss on these holdings, if any? Assess if you have any gaps in your plan, or concentrations. Do you have all your eggs in one basket (i.e., one bank)?
- Assess whether you are in the right place on the concentration-dispersion continuum. There is typically great efficiency in concentration of functions, particularly those like banking that require you to lean on external vendors. But the single best risk management tool is diversification or the dispersion of risk across multiple channels. Dislocation moments like this require you to reassess whether you have concentration risk that warrants adjustment. If, for example, you have all your cash in one bank account or multiple accounts with one bank, it may be time to consider spreading that cash across multiple banks. If you go this route, it may be prudent to have the redundant account with Bank 2 have at least enough cash to make one or two payrolls just in case Bank 1 is temporarily unavailable. Either approach can work, but what never works is not making an informed risk concentration-dispersion decision.
As important as assessing the bank situation, understand that the same mark-to-market issue that brought down SVB is carried by every organization that relies on a balance sheet to succeed, including banks, insurance companies, universities and colleges, and not-for-profit healthcare organizations. Every not-for-profit healthcare and higher education organization relies on its balance sheet to meet critical credit, funding, and return objectives, which means that understanding total balance sheet resource sensitivity and positioning is a critical risk management act. Balance sheets have been under stress; SVB and now Republic are stark reminders of that reality and of the consequences it can have for balance-sheet-led organizations. Even if the SVB or Republic “crisis” proves transitory, the underlying risk will remain and potentially worsen, especially if inflation prints continue to support monetary tightening and higher rates.
We will continue to monitor SVB-related challenges and especially any escalation in risk. In the interim, please contact us with questions or if we can help in any way.