Recent Bank Failures a Potential Game-Changer for The Fed

Regulators' prompt response and the creation of a new lending facility should limit broader market fallout from recent bank failures, notes Chief Investment Officer Larry Adam.

It is often said that the Federal Reserve (Fed) tightens until something breaks. In fact, history is peppered with examples of financial accidents caused by past Fed tightening cycles – Orange County’s default (1994), the collapse of Long Term Capital (1998), the bursting tech bubble (2000) and the housing crash (2008). That is why the market has been concerned about the Fed, particularly as the it has raised interest rates at the fastest pace in over 40 years and the full impact – which occurs with a lag – has yet to be seen. Last week’s sudden collapse of Silvergate Capital and Friday’s failure of Silicon Valley Bank sent shockwaves through the markets, driving the S&P 500 down -4.5%, sending US Treasury yields sharply lower, and wiping out nearly $300 billion market capitalization in the S&P 500 financial sector. The biggest question for investors: are the recent failures manageable events or is there a significant risk of financial contagion that could have downside economic implications?

Before we delve into these questions, let’s review what led to demise of Silvergate Capital and SVB Financial, the parent of Silicon Valley Bank. The two banks had a lot in common:

  • Niche banks | Both banks were niche players that benefited enormously from areas of the market that flourished during the pandemic tech boom. Silicon Valley Bank catered to venture capital firms and tech start-ups. Silvergate Capital was a major banking partner for the crypto industry.
  • Concentration risk | The lack of diverse deposit bases and their concentrated loan books left both banks in a vulnerable position. Once venture capital funds started to struggle to raise capital, liquidity tightened as new deposit flow slowed dramatically. In fact, the bank’s clientele started to draw down their deposits at an accelerating pace while they waited for the venture market to recover. The banks were unprepared for this. In addition, with so many companies having large deposits at the bank in excess of $250,000, the vast majority of the deposits were uninsured.
  • The pace of interest rate moves | The speed of the Fed’s rate hikes over the last year caught the banks by surprise. This exposed a huge mismatch between their assets (investments) and liabilities (deposits), and they were negatively impacted on both fronts. Deposits were getting more expensive to attract as short-term interest rates rose. Meanwhile, as their assets were invested in safe, liquid, high quality Treasurys and mortgages, these long duration bonds were sitting on huge mark- to-market losses due to the sharp rate increases over the last year. For reference, the 10-year Treasury yield increased 237 basis points over the last year alone. When the banks needed to raise cash to meet client deposit withdrawals, they were forced to sell these long duration securities at a loss that reduced their capital base. To be clear, this was not like the Great Financial Crisis where lax lending standards and leverage exacerbated losses. This was a mismatch of asset and liabilities where interest rate moves caught them off guard.
  • Social media mania | The proliferation of social media likely accelerated the failure of Silicon Valley Bank and Silvergate Capital. The speed at which they collapsed felt much like the meme stock mania of late, where investor psychology and rapid-response money flows drive the fate of the company. The hysteria-induced bank run caused clients to withdraw a staggering $42 billion of deposits from Silicon Valley last Thursday, sealing its fate the next morning.