Blueprint of a Banking Breakdown

In an increasingly complex financial landscape, understanding the factors that can lead to a bank collapse is critical. This article dives deep into the mechanics of a banking breakdown, shedding light on the various stages of a bank’s downfall and the domino effect that can result from mismanagement and external pressures.

When account holders become concerned about a bank’s ability to fulfil its deposit obligations, it can swiftly become logical to panic, withdraw deposits, and inquire later. The FDIC guarantees deposits under $250,000, so those below the limit need not worry.

However, for businesses with sizeable bank balances used for payroll or other operational expenses, it is crucial to have an understanding of their bank’s stability and reliability.

Last week, fuelled by discussions on Twitter, a bank run led to a liquidity crisis at Silicon Valley Bank (SVB).

SVB lacked sufficient liquid assets to meet withdrawal demands, so the FDIC intervened and assumed control last Friday.

For now, lets explain SVB’s failure and explore its broader implications for the banking industry.

SVB’s collapse highlighted the risks long-duration, held-to-maturity (“HTM”) securities present to banks. “Long duration” refers to bonds with ten, twenty, or thirty years until maturity, such as Treasury, corporate, and mortgage-backed bonds that fluctuate in price with interest rate changes.

SVB serves as an example of the dangers that arise when any investor (institutional or retail) purchases a significant amount of low-yielding, long-duration bonds right before a significant interest rate increase.

While these bonds are relatively safe to buy now, they were not in 2020 and 2021. They carried substantial interest rate risk due to their low yields at the time.

The Fed exacerbated this issue by excessively purchasing mortgage and Treasury bonds, mistakenly believing it was helping by suppressing long-term interest rates. In reality, it was storing up future problems.

Remember that bond yields and bond prices move inversely. 2020 and 2021 were historically poor years for buy-and-hold investors to purchase long-duration bonds. Concerns about rapid Fed rate hikes and inflation led to a surge in bond yields and a crash in bond prices. During 2020 and 2021, SVB’s internal treasury department heavily invested in long-duration securities, including various mortgage-backed securities.

These securities experienced price declines in the secondary market. SVB did not purchase derivatives to offset the risk that its securities portfolio might decrease in price and be insufficient to satisfy a significant bank run. Derivatives are widely available at large banks to hedge interest rate risk, and many bank securities managers utilise them for risk management. However, SVB did not.

Losses on long-duration securities generally are not problematic unless a bank must fund a liquidity requirement. During last week’s SVB bank run, management liquidated the long-duration securities portfolio to raise enough cash to meet withdrawal demands, crystallising a temporary loss for SVB shareholders.

Depositors ran on SVB for various reasons, including concerns about the quality of SVB’s assets, poor interest rate risk management by its treasury department, and simply because they witnessed other depositors running.

Some blame lies with the federal government and the Federal Reserve for their multi-trillion-dollar deficits and QE measures (QE involves buying bonds to push up prices and bring down long-term interest rates. In turn, that increases how much people spend overall which puts upward pressure on the prices of goods and services) following Covid. In other words, Congress and the Fed set the stage for SVB’s downfall.

Additionally, blame falls on regulators who should have recognised this risk. The Federal Reserve, SVB’s primary regulator, also holds responsibility.

Ultimately, most blame rests on SVB’s management team. They could have avoided failure if they understood the risks of heavily investing in long-duration securities with yields below 2%. Instead, they overindulged in these securities before the 2022 bond price collapse, leading to the current situation.

What does this mean for banks and bank stocks moving forward?

Investors may prioritise bank stocks with loyal deposit bases and devalue banks that rely on wholesale or brokered deposits.

Demand for interest rate hedges may also rise as banks seek to protect their securities portfolios from the extreme price fluctuations experienced by SVB’s portfolio. A secondary effect of last week’s SVB incident could be a shortened anticipated path to Fed rate cuts.

Other bank stocks declined, not due to exposure to SVB losses, but because of concerns that they may need to significantly increase the rates they offer on deposits. Over the past year, banks have been offering rates well below those on Treasury bills due to the abundance of deposits. They often used the cash from depositors to purchase Treasury bills and pocket the difference.

Last week may have hastened the rise in bank deposit rates until they approach Treasury bill rates. If so, the banking sector’s net interest margin will contract. A shrinking net interest margin means banks will have less income to cover future loan defaults.

If banks have less income to cover defaults, the Fed might consider a rate cut.

The sequence of events I outlined could take a year or more to unfold or may happen within weeks or months. Jim and I will watch for signs of the pace at which this process is occurring.

Regardless of how quickly it unfolds, the key point is that the Fed will not cut interest rates for reasons that favour the stock market.

Conditions are evolving rapidly. On Sunday night, the Fed announced a lending program similar to those implemented in 2008 and March 2020. This program allows banks like SVB with unrealised losses in their long-duration securities portfolio to borrow against them without a haircut or penalty rate.

Unlike in 2008, there is a clear, liquid market for agency-guaranteed (Fannie and Freddie) mortgage-backed securities. People are aware of these securities’ current market value. The question is who will bear the losses. With this lending facility, funded by extra FDIC insurance premiums, it appears that mostly responsible banks will bear the burden.

In short, Sunday night’s announcement significantly socialised risk within the commercial banking system, regrettably. This means that responsible banks—those prepared for interest rate risk—will begin to subsidise irresponsible banks.

This generous lending program will likely prevent bank runs for now. However, on Monday morning, smaller and medium-sized banks with unrealised securities portfolio losses saw significant selloffs.

The sell-off of bank stocks on Monday, despite the Fed’s new loan facility, indicates that investors are questioning the reputation of these banks and the stability of their deposit franchises.

Drawing conclusions now is premature, but we will continue to monitor this rapidly unfolding story.

Lastly, from a macro perspective, expectations for Fed rate hikes have shifted dramatically in recent days, and gold is gaining momentum. This could signal the start of a significant multi-month gold rally.

In conclusion, a bank collapse is a multifaceted event that can have severe repercussions on the economy and stakeholders involved. By understanding the intricacies of a bank’s failure, investors, regulators, and the public can better identify warning signs, make informed decisions, and potentially prevent similar crises in the future.