Market Commentary

Banking fears, Silvergate, and SVB Financial

By Rob Sigler, MBA

March 10, 2023

As many of you might have seen, the market fell sharply during the day over fears in the banking system.  The behavior that we witnessed today speaks to irrational fear, as opposed to rational reaction to any news or systemic problem.  Investors have misunderstood the issue and behaved in a shoot, ready, aim fashion.  Let’s take a look at what is really happening.  There have been two bank failures in the last two days.  First, Silvergate announced that they would be winding down operations.  What did Silvergate do?  Silvergate operated a digital currency network exchange and also extended loans to individuals so that they could use their existing crypto holdings as collateral to gain more leverage.  When FTX collapsed and cryptocurrencies fell 70+% over the past 12 months, many depositors suffered enormous loses, causing a collapse in the collateral that they posted.  Other depositors, fearing that they wouldn’t get their deposits back, rapidly moved money out of the institution.  As such, Silvergate’s capital dwindled and they were forced to liquidate.

Separately, SVB Financial failed today and was seized by the FDIC. Why did that happen?  SVB specializes in banking solutions for Venture and Private Equity.  As you can imagine, most venture capital companies are early stage with negative profits and cash flow.  They need a steady stream of capital infusions to fund their operations as they get started.  With interest rates rising, it’s getting much more expensive to finance themselves.  As such, the companies and their Venture backers started to pull down cash from their accounts to satisfy those financing needs.  Deposits at SVB fell.  Let me show you how that can become problematic in an hypothetical example.  Let’s say SVB receives $10mm in deposits.  Banking authorities allow banks to make loans, but they require that banks keep reserves to satisfy liquidity events.  So in our hypothetic example, let’s say SVB made loans of $8mm and retained $2mm of regulatory capital.  They invest those reserves in Treasury securities.  If depositors rapidly come in to the bank and request $2mm of deposits back, SVB needs to sell Treasuries to satisfy those withdrawal demands.  Given how fast rates have moved, SVB was selling those securities at a loss.  The other problem is that the cash withdrawal erodes their regulatory capital.  SVB now needs to post more capital.  The problem is the loans that SVB extended are typically longer term in nature.  SVB can’t immediately call them in.  As such, SVB is left in a situation where they don’t have adequate regulatory capital to satisfy federal requirements.  As the panic cascaded, depositors continued to pull money at an increasing clip and eventually SVB became functionally insolvent.  The reality is that SVB’s loans haven’t necessarily soured, they are simply unable to post adequate capital.  That is what happened here.  In this case, the FDIC steps in to run the bank.  As depositors realize that the FDIC is backstopping the bank and they don’t need to worry about their deposits, the run on the bank will come to a conclusion.  In theory, the FDIC only is required to guarantee deposits under $250k, however, they have never seized a bank and not backed all deposits.  I would expect nothing different in this situation.

As for all other banking institutions, the honest reality is that banking institutions rely on public trust to be in operation.  Banks take in deposits that can be withdrawn at any time and use those proceeds to lend in longer duration.  There is always going to be a mismatch in duration (meaning they borrow short and lend long).  As such, if everyone decided tomorrow that they wanted to withdraw all funds and place everything in the mattress, every single bank would fail.  They could not call in the loans fast enough to service the withdrawals.  However, the Federal Reserve and other banking regulators understand this perfectly.  They know that the orderly operation of our financial system is the cornerstone of our economy.  Without it, capital extension and formation couldn’t occur.  As such, there is no way they will allow an unwind.  They will make a concerted effort to assure depositors that funds are adequately protected and that they don’t need to worry.  They have emergency funding vehicles in place to retain solvency and they will use them.  I am certain that you will see announcements over the weekend speaking to this very point.  I want to emphasize something very important.  The Global Financial Crisis (GFC) was categorically different than what we are experiencing today.  Today is a crisis of confidence and panic instilled by fear of the unknown.  There is no systemic problem.  By contrast, there was a systemic problem in the GFC.  The problem during that crisis was that banks regulatory capital was falling like a stone.  The Treasuries they held were fine, but the mortgage bank securities that they held were coming under enormous pressure and there was a huge question mark as to what the capital was even worth.  In other words, that crisis was a real concern.  This time around, we know that the value of Treasuries has gone down slightly as interest rates have climbed, but we are talking a minor adjustment, not something like the GFC where mortgage back securities were falling 50%.  Believe me, this is going to end up to be a tempest in a teapot similar to the event last year when people panicked over the British banks who were having to sell Gilts to satisfy regulatory capital.  That ended up being nothing, as will this event.

Finally, moving on to Schwab where we custodian your funds.  Schwab does has a bank, but the place where hold all of our client funds is within the brokerage arm.  It enjoys a complete Chinese wall from the bank.  They cannot commingle funds and your assets may not be used to satisfy any other obligations.  Importantly, Schwab brokerage doesn’t extend loans to companies.  The only lending they do is to individuals that have margin debt in their specific account.  That margin debt is collateralized with securities that are held by the individual.  If the margin debt isn’t satisfied, they simply sell that individual’s holdings.  In other words, the duration mismatch that banks have is not at all similar on the brokerage side of the business.  Additionally, Schwab doesn’t trade proprietary capital or take risk on behalf of their brokerage firm.  The reason Lehman brothers failed is that they held obligations that spiraled downward and they didn’t have the regulatory capital to satisfy claims when the value of their mortgage back securities fell.  There is no such analogous situation here.  There will not be any contagion to Schwab brokerage.  The selloff in that security is odd and speaks to fear rather than reality.

I’m happy to answer any additional questions that you may have.

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