A crisis of confidence in the banking sector

Following a period of strong performance since October 2022, markets are back in volatile territory and have started retreating from January highs since the beginning of February.

The primary reason for the pull back in February was the market coming to terms with the ‘higher for longer’ narrative around interest rates. A tight labour market in the US and sticky inflation around the globe dashed hopes of a near-term peak in the interest rate cycle. Investors now have to evaluate the impact of ‘higher for longer’ interest rates on household spending, corporate earnings and balance sheets.

Concerns around the impact of higher interest rates on balance sheets have been at the forefront of the sell-off in markets during the month of March, specifically following the failure of Silicon Valley Bank (SVB), America’s 16^th largest bank, on 10 March and Signature Bank on 12 March. These bank failures sparked a flashback to the banking crisis in 2008 and has weighed significantly on markets.

This note gives some background around the recent bank failures and our views on the broader risks to the banking sector.

How does a bank function?

The basic function of a bank is to take deposits (which become the bank’s liabilities) from depositors and invest them in a variety of assets (which become the bank’s assets) with the aim of making a profit between the income generated on the assets versus the income distributed on the deposits.

The assets invested by the bank range from relatively safe and liquid instruments like cash and government bonds, but generate higher returns by investing in riskier instruments such as mortgage-backed securities (MBS) and loans (car loans, home loans, business loans, etc). This set up is best demonstrated below (these figures are for demonstration purposes only for a fictional bank with R1m in assets):

Banks don’t hold enough cash to pay out all deposits at once. This is because some of the bank’s assets are longer term in nature (think of a 20-year home loan for example). The bank always tries to match the liquidity of the assets they invest in to the expected withdrawals from depositors. Regulations also require banks to hold a certain percentage of their assets in safe and liquid instruments to be able to pay out the normal expected withdrawals from deposits.

A “run on the bank” happens when the bank doesn’t have enough liquid assets to fund the withdrawals. However, deposits are spread between millions of depositors and the chance of them all wanting to withdraw all their cash at the same time is quite low. Through the years the US government has also created additional support for the banking sector by insuring deposits up to US$250 000 in the case of a bank failure to further reduce the probability of a run on the bank.

Impact of higher interest rates on the bank’s balance sheet

Bond prices and interest rates are inversely related, so as interest rates increase bond prices fall. The risk that all banks currently face is that some of the assets they have invested in, even safer assets like government bonds, have lost value over last year as interest rates increased. This means that the value of the bank’s assets relative to its liabilities has fallen. We can demonstrate this below (this is only for demonstration purposes):

This doesn’t necessarily create a problem because bond prices might fluctuate in the interim, but they will still be repaid in full unless the debtor defaults. The risk of the US government defaulting is slim, while the rest of the assets are typically well diversified. These losses are therefore unrealised. This only becomes a problem when the bank has to sell the assets to fund withdrawals and the losses become realised.

Why did SVB fail?

SVB is a smaller, regional bank based in Silicon Valley that primarily services high-net-worth (HNW) individuals, venture capital and private equity firms in the tech industry. The bank has grown significantly in the past few years, taking on billions in new deposits. Banks typically take time to issue loans against deposits, so the new deposits were largely invested in riskier long-term government bonds and mortgage-backed securities.

The nature of SVB’s client base means they have fewer and larger depositors than other banks, the bulk of which didn’t qualify for the government’s insurance programme. Venture capital and private equity firms also make regular withdrawals from their deposits to fund their own investments, creating a mismatch between the bank’s long-term assets and short-term liabilities. This made some depositors nervous, which in turn led to more withdrawals. The bank eventually exhausted its most liquid assets and had to start selling other assets, realising the losses. This triggered even more withdrawals, culminating in a run on the bank. This is when the Californian government stepped in and took over the bank.

The combination of higher withdrawals, poor risk management by the bank, and a more concentrated client base, caused the bank to fail. This nervousness spread to other niche banks with similar characteristics to SVB, like Signature Bank.

What have authorities done to mitigate the fallout?

To prevent contagion to more banks, the government stepped in and effectively guaranteed all deposits at SVB and Signature Bank during this period, including deposits greater than US$250 000. They also created a facility whereby banks can transfer assets for cash to avoid selling the assets at a loss in the open market. This seems to have calmed depositors and slowed withdrawals from other banks.

Poor risk management at Credit Suisse, Switzerland’s second largest bank (considered to be systemically important to the global banking system) has been a concern with investors for some time. These concerns were exacerbated by the developments in the US and led the Swiss central bank to step in with a US$50 billion loan to shore up its balance sheet and ensure liquidity.

Why is this different from 2008?

Following regulatory and global banking best practice changes over the past decade, banks are in much better shape than they were in 2008. They have stronger balance sheets and less exposure to the riskier investments that caused the Global Financial Crisis. The larger, systemically important banks also have a diversified depositor base, with most depositors typically guaranteed by the government.

We are certainly faced with a crisis of confidence following a tumultuous three years. While these developments have caused equity markets to sell-off over the last week, the risk of a broader banking crises seems to be averted for now. We have flagged this as a risk and will continue to monitor the situation and its potential impact on client portfolios.