Learning From SVB’s Failure: Key Takeaways and Concepts for Investors

What Happened at Silicon Valley Bank?

Banking is about confidence. A bank takes in deposits with a promise to return them to the client when requested. In between a deposit and a withdrawal the bank gets to use the money for other stuff (investments) and they use those deposits to make money. The key is understanding when money will be withdrawn so it’s available upon request but not too early. Banks generally use a lot of “safe” assets like bonds and loans to make money, with the assumption that they can, if needed, sell those assets to another company in short order. Normally that happens without much drama.

Silicon Valley Bank (SVB) made an error in calculating how much cash it needed to have on hand to fulfill withdrawals. And once one client couldn’t make a withdrawal the confidence in SVB failed and other clients showed up asking for a withdrawal too. It was all downhill from there. Now the question is what is it about SVB’s crisis that is contributing to the market’s movements? Why isn’t the SVB story just about mismanagement at one firm?

Why Are Regional Banks (and Banks in General) Under Pressure?

Banks use ratios to manage risk. For example, a bank with $100 billion in deposits may want to retain enough cash to fund 20% of withdrawals within the next ten days. This means they need liquid assets worth about $20 billion to fulfill withdrawals. The other $80 billion they may place in less liquid assets under the assumption that they’ll either (a) not need them anytime soon, or (b) be able to liquidate them in a reasonable period of time if needed (i.e., within 90 or 180 days).

We can imagine a structured system to both maximize the returns from the deposits and ensure we have the liquidity to fulfill withdrawal requests from our client depositors, like this:

Now, let’s imagine how we allocate those deposits into the different levels of liquidity.

So, we see that depending on the liquidity mandate we’ll be allocating money to different types of investments with a goal of maximizing the yield while complying with our mandates. Or to put it differently, we want to earn as much as possible with deposits while being able to fulfill the withdrawal requests of our clients.

Now let’s dig into a primary assumption, that the Bonds type of asset is relatively liquid and fulfills the "Immediate" and "Soon" mandates, as well as the "Near-term" and "Long-term" buckets. This assumption hinges on a key concept, that we could find a buyer for the bond to exit our position for cash before the bond matures…let’s focus on that for a minute.

Bonds generally are relatively easy to buy and sell because they are secured by something (e.g., the U.S. Government, Ford Motor Company, your local town, etc.) and they pay interest that’s valuable for the holder. This starts to change when the interest rate (the yield) of new bonds is greater than that of old bonds. When this happens the value of the old bond on the secondary market (the market to buy and sell bonds before their maturity date) declines because a buyer will demand compensation for the lower interest rate (yield) versus buying a new bond. Here’s a visualization of the value of three bonds and the difference in total value over the life of the bond, assuming a $1MM bond purchased with a 3% annual yield. We compare that to the value of a “new” bond at a 6% yield, and also for a bond at a 12% yield.

What we see is that in order to sell a bond yielding 3% when new bonds are paying 12%, we’re going to need to make up the difference by lowering our price so the buyer effectively gets the 12% yield. In this scenario we’d be forced to sell a $1 million bond for $674,000, or a 33% discount, to afford the buyer a 12% return profile. The net result would be a write-off of $326,000 on our balance sheet and we would only pocket $674,000 in cash to fund withdrawals.

This scenario plays out across all asset types, bonds, stocks, and alternatives. Banks are being forced to reassess their asset values based on lower potential sale prices of those assets. This changes their balance sheet ratios, and the banks may be forced to re-balance portfolios to get the ratios back within acceptable ranges. These re-balancing moves further upend the market so it becomes a cyclical math problem.

For example, let’s say we thought we had $20 billion in bond value, which we considered a supporting asset for our "Immediate" liquidity bucket. After reviewing the current prices of bonds we are forced to write down the value of our bond holding by 25% to $15 billion. That triggers a flag alerting us that we don’t have enough assets to fulfill our "Immediate" liquidity mandate. This forces us to move assets that were supporting "Near-term" and "Long-term" liquidity mandates, in other words, we would sell some stocks and alternative holdings and move the money into bonds or cash. This sell-off further drives down the value of stocks and alternatives, potentially triggering yet another issue as our "Soon" liquidity bucket relies on some stock holdings…and you get the picture.

TL:DR

Banks rely upon a variety of holdings of different types of assets to allow them to both fulfill client withdrawal requests and make money on deposits. When those investment asset values are in flux, as bonds are now, the banks must constantly re-balance their portfolios to maintain enough liquidity. Today’s markets are chaotic due to inflation and the associated interest rate hikes, the war in Ukraine, the escalating conflict with China, the end of the pandemic, etc. Interest rate hikes are the most immediate concern as banks rely heavily on bonds as an investment asset and bond prices on the secondary market are in turmoil as the rate hikes depress the value of older bonds.

We do not see a quick resolution to this challenge although we also recognize that the immediate problem is one of confidence. If a bank’s clients are NOT trying to make withdrawals, the bank can gradually correct any liquidity issues. The problem becomes a crisis when the bank is forced to make that correction too quickly and must sell assets at a massive discount.

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