The Root Cause of SVB Bank Failure

The 2008 Global Financial crisis was characterized by complex securities, too much leverage on bank balance sheets, and in many cases, excess risk-taking. There is also a strong argument that a well-meaning accounting rule, FAS 157, created unintended consequences in the banking sector as it forced many banks to take massive write-downs on hard-to-value assets (mortgage-backed securities, collateralized debt obligations, etc.), which crippled capital ratios and froze credit markets overnight. Many banks went from well-capitalized one day to insolvent the next, while also holding sizable portfolios of mortgage-backed securities that no buyer wanted.(1)

The current banking crisis – if we can call it a crisis – looks nothing like what I’ve just described above.

Instead of balance sheets riddled with subprime mortgages, derivatives, and near-worthless MBS portfolios (when marked-to-market), Silicon Valley Bank’s (SVB) problems were rooted in taking in too many uninsured deposits and investing them in arguably the most boring, safe securities available: U.S. Treasuries and federally-backed mortgage securities.(2)

The risk of default on U.S. Treasuries and federally-backed mortgage securities is essentially 0%, which hardly qualifies SVB as taking on too much risk. But the bank did appear to fail in another aspect of basic risk management: accounting for interest rate risk. As interest rates rise, the fair market value of fixed-rate securities falls, which means a bank may be forced to accept losses on these assets if they need to sell them to cover liabilities (deposits). That is, of course, what happened to SVB.

Mismanaging interest rate risk is not new ground for banking problems in the U.S., historically speaking. The savings and loan crisis of the 1980s was driven by a mismatch between long-term loans and short-term deposits, which crushed banks when interest rates rose sharply in the late 1970s in the Fed’s effort to fight inflation (sound familiar?).

In SVB’s case, supervisors at the Federal Reserve Bank of San Francisco had issued the bank six citations in the previous year, warning the bank that it was vulnerable to trouble and had “matters requiring immediate attention.” By July of last year, the SF Fed had put SVB in full supervisory review and rated the bank as deficient in governance and controls. In the fall, regulators met with the bank to discuss their exposure to losses as interest rates rose. SVB did essentially nothing in response.(3)

Perhaps the lesson to garner from SVB’s failure is that warnings and citations from regulators only matter if banks take steps to resolve issues, and/or if regulators take bold action like forcing the bank to turn away deposits or to raise capital, or both. SVB also had the glaring problem of 94% uninsured deposits from an undiversified set of customers, which made it extremely vulnerable to a bank run.

Fed supervisors in San Francisco may have held back from taking stronger action on SVB last year because of a mindset among Fed supervisors that uninsured deposits – versus brokered deposits or wholesale short-term funding – were a relatively stable and secure form of funding. That may very well still be the case, but as SVB showed, having those deposits concentrated in specific sectors (technology, life sciences) and with niche clientele (venture-capital funded companies) means the word can spread quickly that deposits are fleeing – which can trigger the psychological effect of a bank run.

Bottom Line for Investors

As I’ve written before, SVB was largely in a league of its own when it came to the level of uninsured deposits and unrealized losses on fixed-rate securities. The warnings the bank received from regulators in the year before its failure – and the lack of action taken in response – also pegs this as a crisis of mismanagement, in my view, not a symptom of systemic risk lurking elsewhere in the banking sector.

I think the biggest risk now is in how banks and legislators respond from here. I’ll be watching loan activity closely in the coming weeks and months, to gauge whether banks are ‘playing it safe’ and preferring to hold dollars versus lending them out. I’ll also be tracking proposals for new regulations or other legislative action that may be taken in response to SVB’s failure, the uncertainty of which may weigh on markets. The Fed, for instance, is now weighing higher capital and liquidity ratios for banks with over $100 billion in assets, lower than the current $250 billion threshold.

1 Wall Street Journal. March 21, 2023. https://www.wsj.com/articles/svb-fueled-turmoil-junks-lessons-of-the-global-financial-crisis-e3240816

2 Wall Street Journal. March 28, 2023. https://www.wsj.com/articles/top-bank-regulators-to-face-senate-questions-over-svb-signature-collapses-d50a50e0?mod=hp_lead_pos4

3 New York Times. 2023. https://www.nytimes.com/2023/03/19/business/economy/fed-silicon-valley-bank.html

DISCLOSURE

Past performance is no guarantee of future results. Inherent in any investment is the potential for loss.

Zacks Investment Management, Inc. is a wholly-owned subsidiary of Zacks Investment Research. Zacks Investment Management is an independent Registered Investment Advisory firm and acts as an investment manager for individuals and institutions. Zacks Investment Research is a provider of earnings data and other financial data to institutions and to individuals.

This material is being provided for informational purposes only and nothing herein constitutes investment, legal, accounting or tax advice, or a recommendation to buy, sell or hold a security. Do not act or rely upon the information and advice given in this publication without seeking the services of competent and professional legal, tax, or accounting counsel. Publication and distribution of this article is not intended to create, and the information contained herein does not constitute, an attorney-client relationship. No recommendation or advice is being given as to whether any investment or strategy is suitable for a particular investor. It should not be assumed that any investments in securities, companies, sectors or markets identified and described were or will be profitable. All information is current as of the date of herein and is subject to change without notice. Any views or opinions expressed may not reflect those of the firm as a whole.

Any projections, targets, or estimates in this report are forward looking statements and are based on the firm’s research, analysis, and assumptions. Due to rapidly changing market conditions and the complexity of investment decisions, supplemental information and other sources may be required to make informed investment decisions based on your individual investment objectives and suitability specifications. All expressions of opinions are subject to change without notice. Clients should seek financial advice regarding the appropriateness of investing in any security or investment strategy discussed in this presentation.

Certain economic and market information contained herein has been obtained from published sources prepared by other parties.?Zacks Investment Management does not assume any responsibility for the accuracy or completeness of such information. Further, no third party has assumed responsibility for independently verifying the information contained herein and accordingly no such persons make any representations with respect to the accuracy, completeness or reasonableness of the information provided herein. Unless otherwise indicated, market analysis and conclusions are based upon opinions or assumptions that Zacks Investment Management considers to be reasonable. Any investment inherently involves a high degree of risk, beyond any specific risks discussed herein.

The S&P 500 Index is a well-known, unmanaged index of the prices of 500 large-company common stocks, mainly blue-chip stocks, selected by Standard & Poor’s. The S&P 500 Index assumes reinvestment of dividends but does not reflect advisory fees. The volatility of the benchmark may be materially different from the individual performance obtained by a specific investor. An investor cannot invest directly in an index.?

The Russell 1000 Growth Index is a well-known, unmanaged index of the prices of 1000 large-company growth common stocks selected by Russell. The Russell 1000 Growth Index assumes reinvestment of dividends but does not reflect advisory fees. An investor cannot invest directly in an index. The volatility of the benchmark may be materially different from the individual performance obtained by a specific investor.

Nasdaq Composite Index is the market capitalization-weighted index of over 3,300 common equities listed on the Nasdaq stock exchange. The types of securities in the index include American depositary receipts, common stocks, real estate investment trusts (REITs) and tracking stocks, as well as limited partnership interests. The index includes all Nasdaq-listed stocks that are not derivatives, preferred shares, funds, exchange-traded funds (ETFs) or debenture securities. An investor cannot invest directly in an index. The volatility of the benchmark may be materially different from the individual performance obtained by a specific investor.

The Dow Jones Industrial Average measures the daily stock market movements of 30 U.S. publicly-traded companies listed on the NASDAQ or the New York Stock Exchange (NYSE). The 30 publicly-owned companies are considered leaders in the United States economy. An investor cannot directly invest in an index.?The volatility of the benchmark may be materially different from the individual performance obtained by a specific investor.

The Bloomberg Global Aggregate Index is a flagship measure of global investment grade debt from twenty-four local currency markets. This multi-currency benchmark includes treasury, government-related, corporate and securitized fixed-rate bonds from both developed and emerging markets issuers. An investor cannot invest directly in an index. The volatility of the benchmark may be materially different from the individual performance obtained by a specific investor.

The ICE Exchange-Listed Fixed & Adjustable Rate Preferred Securities Index is a modified market capitalization weighted index composed of preferred stock and securities that are functionally equivalent to preferred stock including, but not limited to, depositary preferred securities, perpetual subordinated debt and certain securities issued by banks and other financial institutions that are eligible for capital treatment with respect to such instruments akin to that received for issuance of straight preferred stock. An investor cannot invest directly in an index. The volatility of the benchmark may be materially different from the individual performance obtained by a specific investor.

The MSCI ACWI ex U.S. Index captures large and mid-cap representation across 22 of 23 Developed Markets (DM) countries (excluding the United States) and 24 Emerging Markets (EM) countries. The index covers approximately 85% of the global equity opportunity set outside the U.S. An investor cannot invest directly in an index. The volatility of the benchmark may be materially different from the individual performance obtained by a specific investor.