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As of 14 March 2023
Silicon Valley Bank (SVB), which focused on lending to technology startups, announced a common stock offering on March 8 in conjunction with a large bond sale from their investment portfolio in order to raise cash and equity capital. The bank had been facing liquidity challenges amid deposit outflows. The bond sale from their investment portfolio crystallized unrealized losses as a result of rising interest rates and negatively impacted capital ratios.
In response, US regulators placed SVB into receivership on March 10. This came after the announced liquidation of Silvergate Bank (SI), which focused on providing banking services for the cryptocurrency industry. Amid sharp increases in interest rates over the past year, the market value of these banks’ assets declined. This wouldn’t necessarily be a problem under normal circumstances, as many of the assets were marked as "held to maturity." The trouble is that both banks also experienced pressure on their liquidity positions as their niche industries — crypto for SI and tech for SVB — concurrently suffered deposit outflows. This forced the banks to sell their available-for-sale securities at losses in order to rebuild their liquidity positions. We believe these two events to be idiosyncratic, but they do highlight one side effect of central banks' rapid increase in short-term interest rates after a lengthy period of low rates.
To restore public confidence, US regulators swiftly invoked a “systemic risk exception” two days later, allowing the Federal Deposit Insurance Commission (FDIC) to backstop both insured and uninsured deposits at SVB and another recently failed bank, Signature Bank. Importantly, none of the losses will be borne by US taxpayers, but instead by existing banks in the system through their insurance premiums.
Additionally, the US Federal Reserve (Fed) announced that it would make funding available to eligible depository institutions through a new Bank Term Funding Program (BTFP). This program allows banks to place US Treasuries, agency mortgage-backed securities, and other eligible collateral (which have declined sharply in value over the past year) at the Fed. In exchange, the banks will receive face value back in the form of a one-year loan. The BTFP can serve as an additional source of liquidity against high-quality securities, eliminating an institution's need to quickly sell those securities in times of stress. The Treasury will make US$25 billion available from its Exchange Stabilization Fund to prop up the BTFP.
The situation remains highly fluid. Early in the week following SVB’s failure, bank stocks came under pressure, credit spreads moved wider, and Treasury yields sharply declined, reflecting both a flight to quality and a repricing of future Fed policy rates. Most currencies rallied versus the US dollar, led by higher-beta ones. At the time of writing, some of these moves have partially retraced, as markets perceive that forceful US policy action has been able to contain the fallout for now.
At the time of writing, the US regulatory response to these bank failures has greatly increased available liquidity in the banking system. In the near term, deposit outflows are likely to continue because the interest rates paid to depositors remain well below the yields of short-term US government debt. Banks will be forced to raise the interest rates paid to depositors in order to retain deposits, which will cause banks' net interest income and profits to decline. Longer-term impacts could include tighter regulations on capital, liquidity, and resolution.
It’s possible that some regional banks may need to raise additional capital, but we expect different banks to take different approaches to adapt. We believe that many big, well-capitalized money-center banks are positioned to withstand these challenges and may even ultimately benefit from potential market share gains.
We believe that volatility in the banking sector will likely prompt banks to make lending standards stricter. This will probably put additional financing pressure on smaller companies that are more reliant on bank lending. Banking sector volatility is also likely to contribute to the Fed’s overall agenda of tightening financial conditions, which began in 2022.
As mentioned, as part of the BTFP and Treasury backstop, the Fed is offering loans against eligible collateral valued at par, the goal of which is to eliminate the need to crystallize unrealized losses on banks’ security holdings. In response, we expect market participants to focus on whether this temporary measure may become permanent. They may also wonder whether it extends to other notable US-based fixed income security holders, such as insurance companies or pension funds.
The key takeaway is that this banking sector shake-up is ongoing, with the outcome still very uncertain. While it’s reasonable to question the risk of contagion, at this point, US policymakers appear to have managed the turmoil appropriately. In any case, there will likely be both short- and long-term impacts on the US banking sector.
We believe there is significant dispersion and differentiation among individual banks in their approaches to asset/liability management (e.g., deposit beta, loan book profile, investment portfolio composition). Certain banks are well-positioned to withstand these challenges and even benefit from potential market share gains. We believe that the large, systemically important banks and select regional banks are likely to fare better in the current environment because they have more diverse businesses and deposit bases that have already had to adhere to stricter regulatory capital requirements than smaller, regional banks such as SI and SVB. For smaller banks, we think those that hedged their balance sheets more effectively against the risks of rising short-term interest rates are likely to weather these challenges better. We’ll be watching the situation closely as it continues to evolve.
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