Bank Failures? Financial Crisis part Deux? Probably Not…
A lot of clients touched base to talk about the failure of Silicon Valley Bank. They had smart questions about what this means for their banks and for the financial system in general. I thought we could share some things from those discussions. You might have the same questions.
SVB has some factors in common with other banks, (system issues) and it also had specific risks your bank will likely not face. From our reading SVB failed because of a few major factors:
- The nature of their clients. SVB clients tend to make risker deals. They’re tech entrepreneurs or perhaps crypto investors. When money is cheap, that clientele is more likely to have windfalls from pre-IPO shares of stock, or if crypto is appreciating, perhaps they’re flush. Now that interest rates are rising, the air is coming out of crypto and higher risk tech stocks. That’s not likely to be a problem at your local bank.
- There’s more competition for deposits. A year ago, banks could hold onto your money and pay you less than 1% interest. There wasn’t much reason to go shopping for better rates; everyone was in the same boat, and most of us had gotten used getting almost no interest on our bank deposits. Now? We can get around 4% interest rates on money markets. The 1 year treasury note pays a bit over 5%. The *difference in rates might be over 3% now. So, banks are having to compete for deposits, and if they don’t compete by paying higher interest, they stand to lose some of the capital that anchored lending. Expect to see higher CD rates now and in the future. Money isn’t free, and banks shouldn’t get to use your money for free.
- SVB invested deposits into longer term treasuries. Did your portfolio go down in value last year? Most people had some loss of value last year—a little or a lot depending on what you owned. Bonds were no exception. Bonds often provide diversification from stocks, but not last year, when rates rose to 4%. The typical bond index was down about 13% (high credit quality, a range of maturities). However, long term treasuries were down over 30%. So, if the bank structured a lot of its deposit base in 10-30 year treasuries, they could have had a significant loss of book value. And this seems to be the story with SVB.
Some Guidance about the Environment
This is a funny and somewhat riskier financial environment than we’ve had in recent years. Forecasting is very difficult now, but the economy is not in crisis. This sets up a paradox:
- Forecasting is about impossible
- Knowing what you should do is pretty simple
Take a typical client of ours. Let’s say I posed a hypothetical: Ok Mr. Client, how would you feel if we had a positive 5% return on your accounts in 2023? Three years ago, that investor might have said, “I’d be ok with it, but I’m shooting for higher returns.” But after last year? I think a lot of people think positive returns sound pretty good, and a 5% return would be pretty good. Guess what. You can almost get that on cash.
Or to put it another way, let’s say a balanced investor in 2019 had 70% stocks, 20% bonds and 10% cash. Suppose that person’s risk tolerance hasn’t changed. But the environment has. You used to get less than 1% on cash and bonds weren’t much better. Now you can earn 5% with very low risk. Relatively speaking, don’t you want more cash and fixed income than you did in 2019? So, think about how the market will rebalance. Perhaps even people that want faster growth will want 30-40% of their money in cash equivalents, treasuries and longer term bonds.
It’s not that complicated. There are good alternatives to risk, so risk is relatively less attractive, probably to you personally and then to the system at large.
This is one reason we may experience “multiple compression,” i.e. the market just paying a bit less for growth assets. Stocks trade at forward PE’s of about 18. What if that’s too expensive? Ok your perfectly good growth stocks might trade at 15x in the near term instead of 18x. Or, if economic growth is good enough, perhaps prices will split the difference in their adjustment: some multiple compression, but not too much if there’s still earnings growth.
Why isn’t this another financial crisis?
People do learn from past experience. Following the 2008-2009 meltdown in financial assets, big banks came under greater regulations. The thinking was: if these are systemically important businesses, we can’t allow them to take all kinds of risk with federally insured deposits. Four banks hold almost 50% of the country’s deposits. The top 10 banks hold about 63% of the total deposits.
JP Morgan Chase, Citigroup, Bank of America and Wells Fargo are systemically important banks. They have to ask permission to raise dividends, raise executive compensation, buy back shares etc. They and all the country’s largest banks get stress tested regularly. The regulators are more focused on whether they have adequate capital.
Here’s a list of the country’s largest banks from the Federal Reserve at year end. You can see that SVB is significant: it was the 16th largest at year end.
If you’re worried about financial conditions, the largest banks have the most oversight and the tightest controls. We can hold your cash in those institutions by buying CD’s or layering deposits. Money market funds are also insured- up to the limits per registration, per bank.
How does Federal Deposit Insurance work?
Here’s a link to the FDIC website.
One of the main things to understand is that a bank can “fail,” but that customer deposits that are insured will still be safe.
In other words, the bank may lack adequate capital. The people that owned the bank may lose the investment they made in the bank stock. Those same people may also have deposits in the bank that failed and still be able to withdraw their savings.
That’s the point of FDIC insurance. It protects deposits, not at-risk market investments. It’s designed to give Americans confidence in the financial system.
So how does a bank failure work? The FDIC becomes aware the bank is at risk. Bank capital levels may fall below acceptable levels. Effectively, the FDIC can say: we’re shutting you down. The business you’re running can’t protect customer deposits. You’re out of business on Friday, and we’ll try to find someone to buy you and keep operations going on Monday.
The FDIC may have to provide certain assistance to the buyer. Perhaps the buyer gets a look at the books of the bank that failed. They say: we don’t want to buy all that debt. Some of these assets are good, some of them are the reason the bank failed. The FDIC will often backstop the purchase to an extent, mitigating the risk to the purchaser.
And that’s how insurance works: it spreads specific risk over a larger group that can handle it. Effectively we all pay for that insurance. Hypothetically, we’d receive slightly higher interest if we didn’t pay for FDIC insurance. However, it’s a small price to pay to keep the system functioning when individual businesses fail.
How can we help you?
We are helping a lot of clients with cash:
- Money markets pay close to 4%.
- 1 year treasury notes pay a bit over 5%
- We can help you organize your funds so they’re not scattered in many different financial institutions.
- This way you can know which of your funds is covered by FDIC insurance versus those that have market risk.
- Please note that the FDIC insures deposits of up to $250,000 per registration, per bank.
- Investors want to know their low risk holdings are properly structured to receive FDIC coverage on deposits. A lot of financial institutions “waterfall” this coverage by layering customer deposits into different banks when they exceed the coverage limits. If you have funds in multiple institutions, it will be more difficult to see if you have redundant deposits because they’ve been layered into some of the same banks.
In short, we can help you get organized. We can help you know the difference between what is safe and what is at risk in markets. We can help you improve your interest rates on cash. We can help you establish the right balance between very safe money and longer term investments that might have higher growth potential but more price volatility.
You don’t have to predict the future to do smart things with your money. And you can have a must less stressful experience of money if you answer those basic questions.
At the end of the day, what’s the point of having a bunch of money if it stresses you out? The point of having money is enjoying it, sharing it, having less concern, anticipating the future opportunistically. But sometimes wealth is a burden. Reframing your relationship to it and getting the basics right can help you relax and can set up future opportunities. It’s times of trouble that create the best investment opportunities.
Your balance of risk can be the difference between feeling eager, curious, excited or stressed out and reactive. Give us a call.
Jeremy L. Strickler, CFP®
*This material is provided as a courtesy and for educational purposes only. Please consult your investment professional, legal or tax advisor for specific information pertaining to your situation.
This article may contain links to articles or other information that may be on a third-party website. Advisory Services Network, LLC is not responsible for and does not control, adopt, or endorse any content contained on any third-party website.