Last weekend, the FDIC put the failing Silicon Valley Bank (and, lesser known, Signature Bank) into receivership. This marked the largest commercial bank failure since the 2008 Great Recession and the second-largest bank failure in U.S. history. Investors were understandably concerned with the potential of contagion spreading to other U.S. banks, particularly regional banks, which could cripple the entire financial system.
To calm the markets and stabilize the system, the Federal Reserve intervened with emergency actions to alleviate fears that bank depositors could not access their money. Additionally, it sought to prevent contagion by providing a new avenue for banks to ensure they could meet accelerating depositor redemptions without incurring losses. While the intervention calmed fears in the short run, its ultimate success and any unintended consequences are still yet to be determined.
What Happened to Silicon Valley Bank?
On Thursday, March 9th, the stock of Silicon Valley Bank (SIVB) fell over 60% following an announcement that customer withdrawals were significantly faster than anticipated. Due to a mismatch in duration management, the bank owned too many long-duration treasuries and mortgage-backed securities relative to its liquidity needs based on the size of the withdrawal requests it was receiving. The bank was forced to raise liquidity by selling a significant portion of its long-duration assets at a $2 billion loss to meet these withdrawals. Upon this news, other Silicon Valley Bank customers quickly began liquidating their accounts, fearing the bank may be insolvent. This resulted in a classic run on the bank where the value of withdrawals exceeded the bank's cash on hand.
Unable to meet customer withdrawals, the FDIC took over the bank. All deposits in accounts up to $250,000 were fully protected and available per FDIC insurance. However, since tech-related start-up companies primarily used the bank, over 90% of SIVB's deposits exceeded the FDIC insurance coverage, well above the national average at other banks. The prospect that such a large amount of uninsured deposits could be lost increased the risk of contagion and that other banks could face a similar run on deposits.
In response, the Federal Reserve declared the failing banks a systemic risk to the financial system and enacted emergency measures that provided safeguards for all depositors and backstopped uninsured deposits at both Silicon Valley Bank and Signature Bank.
Additionally, the Fed introduced the Bank Term Funding Program (BTFP), which allowed banks to access the funds necessary to meet the short-term liquidity demands of their depositors. Rather than having to sell assets at depressed prices to cover their deposit withdrawal shortfall, the BTFP allows banks to use the full par value of U.S. treasuries and other asset-backed securities (which are currently trading at lower prices due to the rise in interest rates) as collateral for a loan of up to one year.
Moral Hazard and Other Costs
Any bank facing a short-term liquidity crisis can use this program to avoid locking in losses by selling at current, beat-down prices. In theory, since the assets being pledged as collateral are considered high quality (i.e., ultimately have a low risk of default), the prices of these securities are eventually expected to increase as they near maturity. This would allow the banks to sell at better prices when the one-year loan comes due.
However, since most of the assets that are likely to be pledged as collateral have a duration of longer than one year, it is unlikely that their prices will have fully recovered within this time. While this is not the program's intention, if this is the case, rather than forcing banks to take back their depreciated assets (and potentially still sell them at a loss), the Fed may be forced to hold the assets for a longer time or until maturity.
While these actions have been presented as not a bail-out for the banking industry and taxpayers would bear no costs, that is misleading. The equity and bondholders of SIVB and Signature Bank will indeed suffer losses. However, these interventions effectively help out the equity and bondholders of any other bank that may have been under similar distress without these backstops. Further, the increased regulatory burden on the banking system will likely result in costs being passed onto customers through higher fees or lower yields. Though the costs may not be directly levied on the taxpayer, they certainly exist.
The intervention also increases moral hazard. By protecting 100% of the deposits at the failed banks, there is an implicit guarantee that deposits at all banks will be fully protected. This reduces the incentive that both banks and customers have to be cautious with the deposits and increases the likelihood of a similar problem in the future.
The Fed's actions prevented a widespread run on the banks. However, market volatility will ensue as investors weigh the quickly changing landscape in the U.S. and abroad. In addition, with the Fed scheduled to meet next week, it will be tasked with the seemingly impossible decision of balancing stubbornly high (yet, falling) inflation data and a teetering financial system when determining the best course of action for interest rates. With such market uncertainty, ensuring that the risks within your portfolio are aligned with your financial goals is paramount.
Finally, it is important to note that the current events are very different than the banking crisis of 2008. In 2008 banks invested in risky mortgages that were likely to default. The concern then was that the banks' assets might be worthless or significantly compromised. This stands in stark contrast with today, where the assets at the heart of the two banks in receivership are government-backed bonds. Ultimately, the risk of default on these bonds is low. Instead, the risk was that banks would be forced to sell these bonds before maturity, thus turning a temporary impairment into a permanent loss.
Schedule a Consultation
We have helped our clients answer these questions and more. If you want a clear understanding of your financial future, and need help making changes to reach your goals, schedule a consultation and we can get started.
The material has been gathered from sources believed to be reliable, however Bedel Financial Consulting, Inc. cannot guarantee the accuracy or completeness of such information, and certain information presented here may have been condensed or summarized from its original source. To determine which investments or planning strategies may be appropriate for you, consult your financial advisor or other industry professional prior to investing or implementing a planning strategy. This article is not intended to provide legal advice, and nothing contained in these materials should be taken as such. Investment Advisory services are offered through Bedel Financial Consulting, Inc. Advisory services are only offered where Bedel Financial Consulting, Inc. and its representatives are properly licensed or exempt from licensure. No advice may be rendered unless a client agreement is in place.