The failures of Silicon Valley Bank and Signature Bank over the weekend brought to life the notion that the Federal Reserve’s efforts to combat inflation would have knock-on effects for investment scenarios that had been dependent on a lower interest rate environment. But the Fed, along with the U.S. Treasury, took quick action to ensure that customer deposits of these banks would remain safe, even if the banks themselves cease to exist. Still, risks remain:

• Regardless the assurances of safety the Fed’s backstops might provide, depositors may still choose to flee other potentially vulnerable banks, maintaining pressure on banks to address those flows
• For its part, Charles Schwab emphasized its far-more conservative approach to balance sheet management in an effort to stem concerns that it, too, might face unforeseen demand for liquidity from depositors
• With investors heightening scrutiny of other potentially vulnerable sectors of the economy, markets likely will remain volatile in the interim—interest rates in particular—with the Federal Reserve likely to remain focused on taming inflation, even as it remains cognizant of the potential detrimental effects of still-tighter monetary policy

Regional Banks Succumb

Banks generally make money by taking in customer deposits, sometimes offering a yield in return, and investing those deposits in loans to other customers and a portfolio of securities seeking to generate an aggregate yield greater than the interest being paid on customer deposits. This model presents challenges when banks experience a demand for deposits in excess of the funds that can be provided from that pool of loans and other investments.

As the Federal Reserve has raised short-term interest rates, banks have been forced to pay higher rates on customer deposits lest those customers take their monies elsewhere. That trend had so limited Silicon Valley Bank’s (SVB) ability to meet customer withdrawals that it sought to raise additional capital last week. SVB’s ultimately failed attempt to shore up its balance sheet spooked enough of the bank’s clientele within the relatively small, club-like venture capital world that demand for funds surged beyond the bank’s threshold for viability. Further exacerbating the situation was the fact that many clients maintained balances far in excess of the Federal Deposit Insurance Corporate’s (FDIC) $250,000 limit for coverage of deposit funds in the event of a bank failure. Fear that deposits might be lost forever were the bank to fail compelled many depositors to shift monies elsewhere. This past weekend, then, SVB suffered fatally from the impact of that surge: customer demand for funds was immense and immediate, while capacity to provide those funds was constrained by an investment portfolio that had suffered a substantial decline on account of the shift higher in interest rates.

As far as comparisons with other banks, as hinted above SVB was a bit peculiar in that it maintained a host of relatively sizeable relationships with customers all in the same general space (large VCs and their funded companies). As one SVB executive told the Financial Times newspaper, “It turned out that one of the biggest risks to our business model was catering to a very tightly knit group of investors who exhibit herd-like mentalities.”

Signature Bank (no affiliation with SRCM) also failed over the weekend. We understand that Signature was exposed to the crypto currency space, and that crypto-market volatility may have led to similar imbalances. But the matters surrounding Signature’s closure by New York state regulators have been less covered, so we will leave any materially different issues worthy of a separate discussion for another day.

The Fed Intervenes

Seeing the potential for contagion of a much broader and more deleterious sort across the banking sector, in a fashion similar to actions during the GFC and the COVID-19 pandemic, the Federal Reserve on Sunday opened a credit facility that will provide short-term loans (up to a year) to banks that need it, with Treasuries, agency debt, mortgage-backed securities and other qualifying assets as collateral at par (i.e., face value, not their likely now reduced market value). This facility should ease the banks’ abilities to meet near-term liquidity needs while they seek to restructure their investment portfolios (where feasible). The Fed also is easing terms for lending made available via its discount window, where it no longer will apply that typical discount (collateral is valued at par). Meantime, the Fed has ensured that all depositors in SVB and Signature Bank will have full access to their deposits.

These actions were taken to 1) ensure bank customers that their monies were safe, such that 2) present runs on banks with business models that rhyme with SVBs would ease, and that 3) potentially additional runs would not commence, while 4) giving banks breathing room to meet heightened demand for deposits, and 5) quashing a potentially far-more broad-reaching financial crisis.

What About Schwab?

The swiftness with which the Fed and Treasury responded to this particular crisis is heartening, in that it shows they remain vigilant to the range of risks the current environment presents. But not all investors were convinced; stocks across the regional banking sector fell heavily again on Monday, though the group in the aggregate closed the trading day above intraday lows. The U.S. market, while volatile over the day, closed down by a comparatively modest amount.

Among the stocks facing greater scrutiny is that of Charles Schwab, SRCM’s primary custodian. In response to customer and investor concerns, Schwab provided a press release regarding its financial health. Schwab acknowledged that it was seeing bank cash balances decline, though it attributed that decline to brokerage clients choosing to shift those funds into securities with higher expected returns (presumably from yield or otherwise). That matters as, per the statement, “This activity reflects the collective behavior of our heterogenous client mix of individual retail investors and the advisors who serve them. More than 80% of our total bank deposits fall within the FDIC insurance limits, among the five highest ratios of the top 100 banks in the United States. As a reminder, our deposit base is primarily comprised of transactional cash balances swept to our banks from one of our 34 million brokerage accounts.”

The upshot is that Schwab’s design may not present the same sort of challenges that had been faced by SVB and Signature Bank. First, the custodial business provides a natural source of funds (last month Schwab saw its second-highest net-new-asset flow into the brokerage business, at $41.7 billion). And second, customers seeking higher yields on investible cash assets may be more likely to find such opportunities on the brokerage side of the business than they are by leaving Schwab altogether. Of additional note is the reminder that invested monies are retained on the custodial side of the business, which is entirely separate of the banking side of the business. Brokerage assets are protected up to certain limits and exclusions, depending on the client scenario, under a distinct system.

But even if demand for cash exceeded Schwab’s ability, on its own, to source funds to meet deposit demands, Schwab has stated that it maintains ample additional liquidity from other sources to meet near-term needs, with the Fed’s backstop ultimately providing an additional layer of comfort.

Meantime, Schwab highlighted its relatively more conservative approach to balance sheet management, which has been among the more pertinent reasons we continue to believe our maintaining a sole custodial relationship with them is in the best interests of our clients.

Which Dominoes are Next to Fall?

Recall when we noted earlier that banks take customer deposits and invest them in loans. Well, some banks specialized in lending to the commercial real estate sector. As they bear increased costs to service debt from higher interest rates, property managers have come under additional pressure on account of growing vacancies due to work-from-home trends limiting the need for expansive corporate office space. Banks heavily leveraged against those trends may find themselves facing further solvency issues. And despite the Fed’s intervention, it’s quite possible more regional banks will be confronted with liquidity challenges as customers shift deposits up the banking hierarchy. So, this moment may last for a bit, with the stock market perhaps not reacting so rather calmly as it did today to the ongoing distress.

The events of the past week are likely to make next week’s Federal Reserve meeting that much more interesting from a contextual standpoint. The GFC demonstrated how financial crises can have a long-term depressive effect on macroeconomic activity. But even as the potential for further bank closures remains high, we expect the Fed to maintain its vigilance against the ongoing inflation threat until the broader range of relevant data demand otherwise.

Thoughts on Portfolio Exposures

The weekend’s events found their way to our portfolios via an outsized negative impact on Value stocks, in particular of the smaller cohort. Not surprisingly, the Financial sector, in which our portfolios tend to maintain a moderate overweight, took it on the chin today. But such is the nature of investment risk and days like today are among the main reasons our strategies aren’t centered on single-factor investing (e.g., only Value stocks), highly concentrated portfolios, or market timing. Importantly, the events of the week leave us no less committed to the investment methodologies that power our investment portfolios on the equity side. Nor does the recent volatility across interest rates yet leave us wanting for an alternative set of exposures within the fixed income components of our portfolios.

As always, we welcome any further discussions clients wish to have in regard to the events discussed above and/or their observable impacts on portfolio risk and return.

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