Our Views on the Collapse of Silicon Valley Bank

Summary

The failure of Silicon Valley Bank Financial Group (SVB) in early March has hit equities globally, especially banks. In this note, we assess how this situation unfolded, its current and potential future effects on markets, and what this means for our portfolios.

Whilst it appears that SVB faced a particular set of circumstances that led to a run on the bank, the fact that a significant US regional bank has failed has hit the sector and created some panic more broadly in financial markets. Whilst the global banking system is far more secure and better regulated than it was in the Global Financial Crisis of 2007/8, the significant increases in interest rates and higher inflation that we have seen in many economies over the last year have inevitably caused some strain in the system, and SVB were particularly exposed.

Investors have understandably been rattled by what is the second-largest bank failure ever in the US, with the inevitable question of whether there are other banks which could also be vulnerable. Thankfully, governments and Central Banks around the world have stepped in to find a buyer for SVB and to seek to manage the wider fallout from the bank’s collapse; actions that have been well-received by markets this week.

Our portfolios invest in a range of different funds, which in turn are well-diversified across many different companies. We expect both positive and negative impacts from different drivers related to the SVB situation, which we explain later in this update.

The story so far

Background. Silicon Valley Bank Financial Group (SVB) – which was the 16^th largest bank in the US – was a popular choice for tech companies and startups. While companies across the world have been adjusting to higher interest rates and higher inflation, there have also been concerns about a slowdown in the growth of tech companies, following the boom of recent years. As well as an increased level of bank withdrawals driven by higher cash needs in these companies, concerns around the tech sector have in turn led to worries about banks that are heavily exposed to it, like SVB. These factors combined to increase the rate at which SVB’s depositors were withdrawing their cash.

Closer to home the share price of Credit Suisse, Switzerland’s second largest bank and arguably more important than SVB fell sharply as its largest shareholder declined to support a planned capital raising in response to another scandal following a succession of scandals in recent years. This has catalysed a broader decline in bank share prices.

Why bank capital rules are important to this story. To ensure that banks hold sufficient capital, banking regulation requires them to hold high-quality assets like government bonds, which as we know have substantially fallen in value over the last year due to rising interest rates. US accounting rules allow these high-quality assets to be valued as if they will be held to maturity (which in many cases they will be); gains/losses are only realised if they are crystalised in a sale.

How the market lost confidence in SVB. The bank held some high-quality assets, but due to the heightened demand for customer withdrawals, it had to quickly sell these. The bank then attempted to raise more capital to repair its balance sheet, through a share sale on Wednesday 8^th March. Whilst this is not an uncommon thing for a bank to do, the process of doing it brought attention to the scale of the recent withdrawal of deposits, the bank’s financial position, and the significant losses that were being crystalised in the sale of high-quality assets (owing to the accounting rules we mentioned above). These realisations spooked investors as they signalled that SVB’s profitability and capital base were significantly poorer than had been expected. Their risk management has been called into question, too; to fulfil their obligations in holding high-quality assets, SVB decided to buy long-dated government bonds and mortgage-backed securities whose values are highly exposed to rising interest rates, instead of shorter-dated investments. Later that day, the rating agency Moody’s downgraded SVB’s credit rating, and the bank’s share price fell by around one-third in overnight trading.

Bank run. The US government has a scheme in place to guarantee bank deposits of up to $250k, but 96% of SVBs deposits were over $250k and therefore were not completely covered by the scheme (a particularly high proportion compared to other banks). This made concerns over SVB’s position particularly acute. Realising that they were not covered, and fearing that they would not get their money back, on Thursday 9^th March many of SVB’s customers panicked and started a run on the bank. On Friday 10^th March the US banking regulator closed the bank. A few other smaller US banks have faced difficulties since, driven by similar fears, with at least one shut.

Government response. In a step to limit wider contagion, over the weekend the US government promised that depositors would be protected even above the $250k level, paid for by a special deposit insurance fund. They also announced new funding support for all US banks. In the UK, the government and regulators worked over the weekend to find a buyer for SVB’s UK arm, in order to protect its many customers in the UK tech sector; HSBC agreed to the purchase.

Additionally, the Swiss central bank has provided a liquidity backstop to Credit Suisse which will enable it to meet customer withdrawals. It also important to note that Credit Suisse is deemed a systemically important bank and its balance sheet is subject to much higher scrutiny and monitoring than SVB.

Market impact. The collapse of SVB has had an impact on financial markets in a number of ways:

• Interest rate expectations. Many investors now expect that US interest rates could rise more slowly/fall sooner than was expected, should the Federal Reserve look to create a more supportive environment following the SVB issue. This could be a factor in their policy if the market impact of the SVB collapse was to be protracted, but they would need to weigh it up against their mandate to reduce inflation, which remains at an elevated level.
• Bank concerns. Small/regional banks in the US have seen significant share price falls, as the failure of SVB has raised concerns over other small banks, which tend to have less diversified lending and/or assets held. Despite the US government’s guarantee, anecdotal evidence suggests that many depositors are this week moving from smaller banks to larger ones, too, which has not helped. We have also seen the share prices of larger banks and non-US banks affected, partly based on concerns about the impact that static or falling interest rates could have on their profitability (banks are typically more profitable when interest rates are higher).
• Wider markets. Financial markets do not respond well in the short term to shock events such as this; investors have become fearful and this has negatively impacted a number of different investment markets. Government bonds have actually risen, likely driven by changing expectations over the future direction of interest rates (as explained above), and from a ‘flight-to-quality’ that we often see in any sort of crisis.

How this might affect our portfolios

• Bonds vs equities. Changing expectations over the future of interest rates and a flight-to-quality have sent bond yields down (ie prices have risen), and equity markets have struggled. Our purchase of Government bonds following the mini budget last year will have helped portfolios.
• Short duration. This has been particularly pronounced in shorter-dated debt; within bonds, we have an overweight exposure to these assets.
• Value equities. Our value managers are overweight banks relative to the wider market and to peers, so this will put some pressure on performance in the short term. We are comfortable that our value managers have spotted good-value opportunities and have done their homework on the risks that they are exposed to.

Our outlook

The full extent of the wider impact of the collapse of SVB and the news regarding Credit Suisse is still to be understood. At the time of writing, the most significant impact has been on the share prices of US regional and European banks. Authorities have taken swift action to try to limit the fallout from the collapse of SVB and to re-establish confidence in Credit Suisse and so reduce depositor’s concerns.

These events are complex, and second-guessing how impactful they might be is very difficult. What we can say is that the collapse of SVB does draw attention to a number of risks that we see building, given the stage in the market cycle. There have been some areas of speculative tech investment following the boom the sector has experienced in recent years, some of which will come under pressure as growth slows. Furthermore, the significant interest rate rises over the last year bring financing pressures not felt in economies for over a decade.

Whilst the initial bond market reaction suggests that some investors now anticipate central banks will stop raising/reduce interest rates later in the year, we don’t think such predictions are useful. The job of most central banks is to control inflation, and with inflation still at elevated levels, further rate rises may be needed to achieve this goal. Ultimately, such events are a reminder of how difficult it is to make short-term predictions about financial markets and how important it is to take a long-term, well-diversified approach.

Prepared in conjunction with Fundhouse, our Investment Partner