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Thoughts on the Silicon Valley Bank Failure

Recent problems in the banking industry have increased uncertainty in the financial markets. In this post, we summarize the circumstances at Silicon Valley Bank that led to its failure and provide comments on the broader investment implications.

Impact of the Silicon Valley Bank Failure

Silicon Valley Bank, the 16th largest bank in the U.S. and a leading institution in the tech startup space, failed on Friday after a run on deposits led the Federal Deposit Insurance Corporation (FDIC) to take control of the bank's assets, which include almost $175 billion in customer deposits. The failures sparked broader fears among other banks seen as having similarities to Silicon Valley Bank – notably First Republic Bank. Then, on Sunday, New York-based Signature Bank was also closed. Soon afterward, federal regulators, in an effort to restore confidence, announced Sunday night that all depositors of both banks will have access to all of their money on Monday, March 13.

In this update, we review what happened to SVB, address the investment implications including the potential for contagion to spread within the banking sector, review the ways in which this could impact clients, and provide a general review of how to keep your deposits safe.

How Silicon Valley Bank Went Bust

What happened to Silicon Valley Bank is that a boom in deposits in recent years amidst plentiful liquidity in the tech space left it with a challenge in earning an attractive return on those deposits. Lending opportunities among its tech customers were less than in other industries given that those customers had access to private capital and a tendency to be in an earlier stage of their lifecycle.

The bank chose to invest a large amount of the deposits in longer-maturity bonds with yields above what it was paying to depositors, including Treasury Bonds. While these investments had almost no credit risk, they had significant interest rate risk in that the market price of these bonds would drop in the event rates were to rise. And as we all know, rates rose sharply and swiftly last year, creating paper losses on those bonds.

Initially, deposits were affected because its customer base tended to have large balances and was attuned to maximizing the interest it received. With higher rates becoming increasingly available at other institutions, some Silicon Valley Bank clients moved their money. As its financial position gradually weakened, fear took hold and ignited a classic feedback loop culminating in last week's run on deposits that led to the bank's failure.

The Broader Impact of Silicon Valley Bank's Failure

The clear consensus among financial industry experts is that while shorter-term fears may roil some other regional banks, the Silicon Valley Bank failure is not a harbinger of another 2008-type financial crisis. There are some unique attributes of Silicon Valley Bank that are not common across the broader banking sector that contribute to this view, along with the generally healthy financial condition of most major banks.

While all banks are affected by rising rates, e.g. the need to pay more interest on deposits, Silicon Valley Bank was acutely exposed to rising rates. Rising rates decreased the value of the bonds it had purchased with depositor money while increasing the amount it had to pay to depositors – a double whammy. And SVB also apparently did not hedge its portfolio exposure to rising rates, unlike most other banks.

Its customer base is concentrated among tech-driven start-up firms, where higher rates and a general pullback in tech reduced the amount of capital flowing to the industry, reducing the supply of cheap deposits.

Finally, the demographics of Silicon Valley Bank's customer base contributed to its failure. Their generally much larger depositors were both quicker to move their money to get higher rates (while the smaller depositors more characteristic of retail banks tend to leave their deposits alone) and because many corporate deposits were far in excess of FDIC insurance (which covers up to $250,000 per deposit account) the first whiff of trouble quickly escalated into herd behavior, with almost $42 billion pulled in the 24 hours leading up to the FDIC takeover.

Charles Schwab & Company, which saw its stock price decline on Friday after the news broke on Silicon Valley Bank. Schwab is one of the largest custodians of client assets, but it's important to understand that Schwab's custody business is not affected by Schwab's banking operation. The investor reaction that pushed down Schwab's stock price seems more a function of the realization (and pricing in) of earnings pressure than contagion fear. The troubles at Silicon Valley Bank are shining a light on the impact of higher rates on bank profit margins and earnings, including Schwab – which last year saw nearly half its revenue come from net interest revenue (the difference in what it earns on invested deposits and what it pays on bank deposits). Earnings pressure aside, Schwab's liquidity and overall financial condition are solid and we don't have any concerns about their viability. Schwab issued a statement (see attached) that gives more detail on their financials and perspective on recent events.

Direct Impact on Our Clients Is Mostly Minimal

From an investment standpoint, as a member of the S&P 500 and other U.S. stock market indexes, Silicon Valley Bank was an extremely small position in a few ETFs and funds that we use in portfolios. In the case of the S&P 500, Silicon Valley Bank comprised just 0.04% of the index at the start of the year, which is about 4 cents per $100 invested in the S&P 500 (it's even smaller in other indexes). For comparison, the largest company in the S&P 500 is Apple at more than a 6.00% weight.

Logistically there is some impact. Financial regulators said Sunday night that all depositors will have access to all their money on Monday, March 13 (including amounts above the FDIC limit) and normal banking operations like clearing checks, etc. are expected to continue normally. So any disruption should be minimal.

But for any clients who would like to review their bank deposits and the FDIC limit, we encourage you to give us a call. We can help you assess your individual banking situation and provide ideas on how to ensure all your deposits are insured.

Summary and Next Steps

The situation involving Silicon Valley Bank is very new and still developing. We have worked hard to try and understand any potential ramifications that could impact our clients and will continue to do so in the days and weeks ahead.

Click here for the full statement from Charles Schwab.

Sources used in this commentary include The Bank Credit Analyst, JP Morgan, Goldman Sachs, and Litman Gregory.

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