The collapse of Silicon Valley Bank (SVB) in the US (along with two other smaller regional banks, Signature and Silvergate), and the forced sale of Credit Suisse to UBS in Europe, triggered a period of general banking stock volatility during March. Although tensions appear to have eased, it’s natural for investors to wonder whether there are any other shoes to drop.
We cover some of the key questions below:
Are Other Banks in Trouble? Firstly, we should be clear that banks are not remotely in a similar position to where we were just prior to the global financial crisis. Given what happened then, the banking system as a whole is now far more strictly regulated and much better capitalised (banks are required to hold far more capital/reserves as a buffer against any losses they might make). It is true that smaller US banks have been subject to lighter rules, but the heightened regulation has been strictly applied to bigger US banks and all banks in Europe.
To give a flavour of how strict bank regulation is now, UK banks undergo regular ‘stress tests’ to ensure they won’t fail in a crisis. And these are not mild stress tests either. 2022’s stress test results aren’t yet out, but the 2021 scenario analysis concluded that UK banks would comfortably survive: • House prices falling 33% (relevant given bank mortgage lending) • UK real GDP fell a further 9% after the COVID falls of 2020 (along with world real GDP falling another 9.6%) • UK unemployment peaking at just under 12% (for comparison the peak post the global financial crisis was below 9%)
What happened to SVB and Credit Suisse then? If banks are so safe, why did SVB and Credit Suisse fail? Well, both were pretty unique examples.
Firstly, SVB wasn’t as tightly regulated as the bigger US banks (and European banks) because in 2018 the US abolished some rules for banks with less than $250bn in assets.
It also turns out SVB was uniquely poorly managed, having problems with both its assets and liabilities. On the assets front, it invested far more of its assets than any other comparable bank in longer-dated US government and mortgage-backed bonds during 2021 (a classic case of not diversifying sufficiently). When interest rates went up in 2022, these bonds lost value. It might have survived if its depositors (its liabilities), mostly Silicon Valley tech and biotech firms, hadn’t started drawing down their deposits to fund their own needs as other funding dried up in 2022 and 2023. This forced SVB to start liquidating its bonds at a loss (reducing its equity buffer), which caused its depositors to panic and try to move more of their cash, causing SVB to sell even more bonds at a loss. This was really a classic bank run, albeit one sped up because of technology (digital cash transfers out and messaging apps spreading panic). Signature, a smaller bank which served a number of crypto clients and had its own specific issues, was next to suffer this loss of confidence from depositors following Silvergate, an even smaller bank catering to crypto investors.
Credit Suisse, on the other hand, was very well capitalised. It had, however, been involved in several scandals over the last few years and which had consequently seen long-term underperformance of its share price well before last month. What appears to have happened with Credit Suisse was a liquidity crisis triggered by the failure of SVB and the loss of confidence in Credit Suisse’s new management to turn the bank around. This was ultimately a failure of its business model, rather than bad debts or its assets falling short of its liabilities. It was bought by UBS and our initial read is that UBS looks to have got a good long-term deal in taking it over (albeit likely with some integration headaches along the way).
What Comes Next? In one sense, what happened was the failure of a bank which unleashed further nervousness about the entire banking system. In response, we are very likely to see the US implement stricter rules for its mid-sized regional banks.
However, whilst being badly managed dramatically increases the chance of the loss of confidence that leads to a bank run, the uncomfortable truth is that no bank, no matter how well managed, is completely immune from this risk. Banks, which borrow short (taking in deposits) but lend long (loans and mortgages), are inherently reliant on depositor confidence. Part of the solution to maintaining confidence is regulation (a combination of stress tests and, when necessary, quickly and cleanly winding up any failed institutions like SVB and Signature), but ultimately another backstop is also necessary. This backstop is provided by central banks and governments. The good news this time is that banks are much, much healthier than they were going into 2008. This in turn should mean that, whilst we may see further turbulence, less central bank and government intervention should be necessary and ultimately nerves will settle.
In a wider sense, what we are seeing is simply the usual effect of higher interest rates. Higher interest rates cause stress within the economy. Money (the ability to borrow), which previously had been cheap, suddenly costs more. And this additional monetary stress inevitably uncovers previously hidden weaknesses in economies. We saw it in the UK with the Liability Driven Investment (LDI) gilt sell-off late last year and we’ve just seen it again with SVB. The exact form of the weakness is often surprising, but there are incidents every time central banks raise rates. Very occasionally, the weaknesses uncovered are systemic and serious (like the housing issues during the global financial crisis), but more normally they are relatively minor and self-contained, like an increase in the number of company bankruptcies. Markets can still do well overall in these environments.
What should investors do? The correct response as a long-term investor is not to rush to cash every time we hit an inevitable bump in the road. This can lead to missing out on recoveries. The correct response is to continue to choose investments that are attractive based on their fundamentals, and to make sure that their portfolio remains very well diversified to handle these future “inevitable surprises”.
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