A hot topic in the past few weeks has been the current banking crisis that started with the failure of Silicon Valley Bank and Signature Bank of NY. The crisis is now engulfing other major banks such as California-based First Republic Bank. It’s even spreading to European banking giants Credit Suisse and Deutsche Bank.
The two most common questions I’m receiving are:
- What caused this crisis?
- Is my bank safe?
Let’s review the culprits since there are always multiple factors that contribute to these issues.
Understandably, not everyone really knows how the banking system truly works. Most people have minimal knowledge about how their bank even interacts with the Federal Reserve or FDIC let alone how banks manage on a day-to-day basis regulatory capital ratios, demand deposits, asset-backed securities, interest rate swaps, and more.
I’ll try to stay out of the weeds and provide a higher-level summary that anyone can understand.
I am including a copy of Silicon Valley Banks’ balance sheet from the last Quarterly Report on their website which goes through September 2022. Highlighted are some key numbers that I’ll refer back to.
One of the biggest pieces, and the first one I’ll review, is people actually have to move their money out of a bank. Modern society allows us to transfer money straight from our smartphones. Long gone are the days of having to physically walk into a bank to get your cash when all it takes is a few swipes on your phone. Add in the traditional wire transfers which are same-day transactions and a bank can easily see billions of dollars move before 5 pm. Thus it’s actually quite easy for a run on the bank to overwhelm its capacity even if nothing is truly wrong.
Here is why.
Banks only have a fraction of the money on hand to pay you. In Silicon Valley Banks’ situation, they only had 7.9% of actual cash on hand versus their deposits. So if you have $100 in a bank account that means SVB bank only had $7.90 sitting around waiting for you. You can figure that out by looking at non-interest-bearing demand deposits(checking accounts) plus interest-bearing deposits(savings and money market accounts), and then dividing it by cash and equivalents. Here is what the formula looks like:
Every bank only has a small percentage of funds on hand to satisfy withdrawals. You can see from that information alone how it doesn’t take much after a few days of repeated heavy withdrawals for a bank to run out of money if they can’t sell other assets quickly enough.
That’s not the whole story. We know the bank only had 7.9% of depositors’ funds on hand. So where is the other 92.1%?
A big piece of that is in the next two buckets on the balance sheet:
Available For Sale Securities – Bonds with a mix of asset-backed securities the bank is ready to sell at any moment.
Held To Maturity Securities – Bonds with a mix of asset-backed securities that the bank doesn’t plan to sell.
To provide clarity securities in both buckets are a mix of US and foreign government-issued bonds, municipal bonds issued by states and cities, corporate bonds, and asset-backed securities such as mortgage loans or even securities issued by the Federal Home Loan Banks or even Freddie Mac. Banks will hold a variety of short(1 month to 5 years) and long-dated(5+ years to 30 years) maturities in each bucket based on their liquidity needs.
I’m about to explain a key piece so please refer back to the balance sheet for the numbers I pull. You’ll notice it says Available-For-Sale-securities is listed at $26,711, and Held-To-Maturity securities are listed at $93,286. But you’ll notice the line item also says in parentheses “cost of $29,502” and “fair value of $77,370” for each.
All that means is the assets are worth less than what was paid to buy them, aka LOSSES. Silicon Valley Bank specifically had $18.7 billion in losses on its balance sheet.
You might say ask yourself “Why would the bank sit on those losses?”
A simple answer is that the government requires banks by law to hold the assets I just mentioned above as part of their capital reserves. In other words, they have no choice but to buy and hold these assets since the law dictates certain asset types must be held as collateral.
The laws are written that way because generally these assets are considered to have a low CREDIT RISK. What that means is it’s very likely you’ll get the money back if you need it.
However, these securities can still rise and fall in value. Bonds also have INTEREST RATE RISK. When interest rates rise or fall then the value of your bonds can rise or fall depending on the rate they currently pay. That means you might not necessarily get all the money back.
This will be easy to explain with an example thanks to the past year few years.
In this example let’s go back to February 2020. You decide to invest $100 in a US Government bond paying 1% interest. The bond will pay you interest once a year($1) and at the end of ten years, you get the $100 back. You earned $10 throughout that time as interest for a grand total of $110.
Now it’s February 2023 and you have another $100 to invest and you see that a US Government bond is paying you 4%. The bond will pay you interest once a year($4) and at the end of ten years, you get the $100 back. You earned $40 throughout that time as interest for a grand total of $140.
It’s immediately apparent that the 1% bond you purchased in February 2020 is not earning you as much interest as the money you could invest today.
Suddenly you have a few unexpected bills to pay. You start asking a few friends if they would be willing to buy the 1% interest bond from you as you’d like the money back to help pay your bills. Each of your friends offers you $60-$70 because they could go out and get a 4% bond themselves so why would they accept a 1% return? Since you really need to pay the bills you decide there is no other choice and sell it for a loss to the highest bidder.
Circling back to Silicon Valley Bank they already told you their bond investments have lost $18.7 billion in value. Now they have to sell these assets at a loss to give your money back. For the record, banks can choose to pledge these securities as collateral with their Federal Reserve branch to raise funds instead of selling, but that might not necessarily solve all their short-term liquidity needs.
Dealing with falling portfolio values is not isolated to Silicon Valley Bank or Signature Bank of NY. In fact, virtually every US institution is grappling in some way shape, or form with a portfolio that is worth significantly less due to the rapid interest rate increases.
Here is data directly from the FDIC showing the total value of losses sitting on bank balance sheets spread across Available For Sale and Held To Maturity assets.
Since interest rates were held near historically record low rates for the past 15 years you can see that meant there was very little fluctuation in bank portfolios. The past year sticks out like a sore thumb as losses have increased exponentially due to the Federal Reserve increasing interest rates to fight inflation that coincidentally has been caused by the government. Think back to my example to put this into perspective.
Banks have ways to hedge against the risk their portfolio will rise or fall in value. This is where the term credit default swaps, interest rate swaps, and more come into play. I won’t elaborate on those strategies for brevity’s sake but know that’s where this would normally go next. It does not look like Silicon Valley Bank did the best job possible utilizing these tools. How well any bank manages its hedges can vary.
The final piece is that Silicon Valley Bank, like many other banks, invests funds to earn a return. This is highlighted under “Non-marketable and other equity securities” which they valued at $2.595 billion dollars. Digging a little deeper into their balance sheet it’s not hard to find that number is misleading.
The bank had been sustaining losses in the value of these assets despite the fact they showed an overall increase, albeit small, in value the past year.
That’s possible to show an increase if they committed more money toward investments, But the investments overall were losing money. Everyone knows many asset prices in every category have declined this year so it’s not a total shocker.
What made it worse for Silicon Valley Bank is their specific tech and “green” investments had not paid off. When I dug into the numbers some individual investments had lost more than 50%!
The timing of all these events at once helped create an environment that made the bank susceptible to a collapse.
It would not be out of the ordinary for a few more banks to collapse considering the general economic uncertainty, and the rapid portfolio declines this past year. So far I think regulators and other major banks have done a decent job at containing the issues.
How To Protect Yourself
The first thing you can do is make sure you do not keep more than $250,000 in a bank account. Even though the FDIC has come out to back up full account values it’s unknown if they will do it for every bank indefinitely. For the average person, this won’t be a huge concern, but for some middle to upper-middle-class Americans, this is a reality. An easy solution is to split up your funds between a mix of banks and credit unions.
An alternative is to utilize a strategy I refer to as creating your own bank.
In essence, what you do is take the money from your bank and directly invest in bonds or asset-backed securities. Coincidentally this will not do your bank any favors, and in fact, will contribute to the bank run problem. Nonetheless, you need to do what’s best for you.
Buying these securities directly will take some leg work on your part if you choose this path. Then you have to know which security types to buy, and how much. Layered within that question is how you allocate funds between government-issued, agency-issued, and corporate bonds depending on your specific needs. The next question is what account types to use. You have a choice of purchasing these securities directly from the issuers, using taxable accounts, and even retirement accounts. All these steps and more are already handled for Valor clients, when appropriate for their needs, internally through standard processes.
You can also check your bank’s balance sheet to see how much they have in losses within their portfolios. It would be wise to see if they are investing in riskier assets too which varies by bank.
It also can be helpful to keep some cash on hand ready for an emergency. Determine what an appropriate amount is for your situation and go from there.
If you have specific questions please reach out through the contact page or send an email.
