It was the crisis that virtually no one predicted would happen in 2023. Yet, back in March when the US lender Silicon Valley Bank (SVB) failed, traders sat up and listened. As we’ve progressed through the year, it’s clear the crisis is far from over and other banks in the US have been flagged as having similar vulnerabilities.
However, unusually, this crisis hasn’t caused market panic and stock markets haven’t crashed. Here’s a deep dive into what happened, why it happened, and what it means for the global banking sector.
This article isn’t personal advice. If you’re not sure whether a course of action is right for you, ask for financial advice. Past performance isn’t a guide to the future.
What’s caused this crisis?
There are two peculiarities about this banking crisis.
Firstly, it wasn’t a systemic event, with the bulk of the tension in the US regional, mid-sized banking sector. And secondly, it wasn’t caused by bad debt or obscure products that lost value, like in 2008.
Instead, the crisis was driven by unique factors including large amounts of uninsured deposits and losses on banks’ investments in government bonds relative to the size of their capital base.
Bank deposits in the US are insured to the tune of $250,000 per account in an insured bank. However, most account holders at SVB had much larger deposits than $250,000. It had a large market share of venture capital firms and start-ups on its books. That meant SVB had a large uninsured deposit base.
When confidence falls, many prefer to put their money in ‘systemically’ important banks, that are deemed ‘safer’ than some of the mid-tier banks in the US.
On the surface these smaller banks looked healthy. They had good capital provisions and strong liquidity positions. However, if you looked deeper at these banks, you could see where the problems lay.
The construction of their portfolios of liabilities were unlike larger banks and left them at risk, especially when the Federal Reserve (Fed) started to hike interest rates. Unlike larger banks, some of the mid-tier banks kept a large amount of their customer deposits in long-dated treasuries. For many years, this helped these banks make a return on their deposit base. However, things changed when the Fed embarked on an aggressive rate hiking cycle.
Since March 2022, the Fed has hiked interest rates on ten consecutive occasions, to combat inflation. US interest rates have gone from 0.25% to 5-5.25% and it’s one of the fastest monetary policy tightening cycles in 40 years.
The problem for banks like SVB is that when interest rates rise, the prices of bonds fall. So, although long-dated US government debt is considered one of the safest assets that you can own, the price of a treasury still moves inversely to its yield.
Once word got round that some US banks had suffered heavy losses on their treasury portfolios, this led some deposit holders to worry that their money wasn’t safe. More account holders pulled out their deposits, which in turn caused others to do the same. SVB lost nearly all of its deposit base in two days.
US 10-year treasury yield
Past performance isn’t a guide to the future. Source: Bloomberg, 09/05/2023.
These are the ingredients of a classic bank run, and a lesson in not putting all your eggs in one basket. It wasn’t caused directly by a bad investment – treasuries are usually as safe as houses. It also wasn’t caused by irresponsible lending or bad debts. Instead, it was a case of bad risk management, and not identifying rising interest rates as a key risk for the business.
What’s next for banks?
The most important question now is what will happen next and how this mini crisis in the banking sector will play out.
The good news is that unlike in 2008, this crisis appears to be easier to solve. The Fed has room to cut interest rates if the banks continue to struggle and if this impacts the real economy. However, at this stage, the real economy is proving resilient. For example, the US economy added 253,000 jobs in April, and wages also rose.
While lending standards have tightened in the US because of this crisis, it hasn’t induced outright panic, and there’s still liquidity in the economy.
We’ve seen some of the larger banks step in to rescue the troubled smaller banks. For example, JP Morgan has acquired most of First Republic’s assets in a deal announced at the start of May. However, this still hasn’t been enough to stem the crisis.
Since the start of March, the US regional and mid-sized banking index has lost more than 30% of its value, and it’s not yet in recovery mode. Banks might not recover until there’s an overhaul of regulation for the sector and/or the end of the Fed’s interest rate hiking cycle.
Interest rates are at the core of where US banks go next. If we get even higher rates, we could enter a more toxic phase of this crisis. Not only would it be an issue of deposit flight, but it could be driven by a fear of the underlying value of loans on the banks’ books.
Small and medium-sized banks in the US issue nearly 70% of all commercial real estate debt, which is sensitive to rising interest rates. If interest rates continue to move higher without a break, the commercial property market could be at risk from rising bad loan rates. Combined with losses on their treasury portfolios, this could leave banks in dangerous territory as we move through 2023.
This is a unique time. We have markets that are broadly stable around the world at the same time as the US banking sector is under stress. This stress, for now, seems manageable and not systemic. However, whether this crisis escalates and causes damage to the broader economy could depend on what the Fed does next.
Kathleen Brooks is Founder of Minerva Analysis, a market analysis company. Hargreaves Lansdown may not share the views of the author.
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