While the collapse of Silicon Valley Bank (“SVB”, Ticker: SIVB) may not suggest major solvency concerns in the US or wider global financial system, it does illustrate the extent to which other vulnerabilities may be lurking in the financial sector and strengthens the case for central banks to exercise caution as the knock-on effects of the Fed’s recent hawkishness become apparent. As the old saying goes, “it’s only when the tide goes out that you see who’s been swimming naked.” Though the specific impacts of such an aggressive tightening cycle are difficult to predict, they’re not altogether surprising, either.
At a strategic level, the Quantitative Easing (“QE”) rolled out during the pandemic created space in financial markets for vulnerabilities like these to emerge, and the Fed’s reversal of these policies on the heels of rising inflation ultimately punished those who flew too close to the sun. Fundamentally, SVB succumbed to poor risk management in holding long term bonds funded with demand deposits. Fortunately for its customers, Treasury Secretary Yellen and the FDIC’s decision to guarantee all deposits at SVB and Signature bank will help spare those left vulnerable to the banks’ recklessness. On the other side of the coin, the Fed’s new lending facility (the Bank Term Lending Program (“BTLP”)) will assist banks that encounter similar liquidity problems, providing 12-month loans against assets that qualify based on their par (rather than marked to market) values, ensuring access for institutions sitting on unrealized losses in their held-to-maturity security portfolios.
Fortunately, it seems the direct contagion from SVB’s collapse will be relatively limited. The US banking system as a whole is better capitalized than in ’07-’09, and institutions should largely be better able to withstand losses on the asset side of their balance sheet, even without the insurance offered by the BTLP. Nevertheless, on the liability side, a collapse in counter-party confidence and a widespread deposit flight may cause interbank lending markets to freeze. Moreover, the collapse of SVB and Signature Bank have, on their own, placed countless small businesses and venture capital funds in jeopardy, and the consequences of this cannot be ignored altogether.
SVB held a unique position in the Silicon Valley Community. Chartered in California around twenty years ago, SVB was the bank for small tech startups and the venture capital funds that invested in them. When larger banks turned away, SVB provided these start-ups with lines of credit to grow their businesses, taking on pre-IPO equity shares as collateral. In return, SVB took a low rate and warrants on the founders’ shares. Unfortunately, this illiquid collateral and the concentration of risk in the tech space culminated in the bank’s recent collapse, as customers withdrew more than $45 billion in the last week alone.
At YE 2022, SVB reported $209B of assets and $175B of deposits. It had a strong loan-to-deposit ratio with a concentrated loan mix and strong capital position. SVB distinguished itself as the leading bank in servicing the venture capital industry, claiming 50% market share of venture-backed companies’ deposits, and probably banked a comparable share of venture capital funds. As of last Monday, March 6th, SVB had an equity market capitalization of $16B.
After the market closed on Wednesday, March 8th, SVB filed an 8-K that indicated it had sold $21B of its marketable securities, realizing a $1.8B loss, to create liquidity in response to the high volume of withdrawals. It also announced that it was bringing to market an offering for $2.25B of securities to support its regulatory capital. Further, it assured clients and investors that it had adequate capital on its balance sheet, as well as access to additional capital if needed. As SVB described it, while venture fund investing had slowed through 2022 and into 2023, venture-backed companies had continued to maintain their cash burn. As a result, SVB began seeing net cash outflows that peaked at $25B in Q3 of 2022, fell to $12B in Q4, and forecasted at $18B in Q1 of 2023.
Thursday, SVB issued a prospectus on its securities offerings, as well as several press releases that again assured of the adequacy of its capital reserves and spoke to its plans to respond to the recent events. However, through the day and into the evening, the messaging was taken poorly by clients and investors: SVB’s stock price opened at $176/share on Thursday and closed at $106. Through the day Thursday, folks in the venture community began to express concerns about solvency and continued withdrawing their funds as SVB’s stock price continued to fall after hours. By Friday morning, news that no financing would be provided to save the bank began to spread.
The longer-term implications for Silicon Valley and the US’s growth potential could be dramatic.
The situation also raises questions around whether higher-than-expected inflation may worsen securities losses at other banks, and how the Fed/FDIC plans to manage the situation if so. Additionally, as funding costs that exceed the returns on its treasury and MBS securities have left the Fed with negative carry on its own balance sheet, concerns around the additional risk the government has assumed by guaranteeing all deposits—and what new controls they might impose on the banking system to compensate for this—need to be considered as well.
Implications for the Broader Market
Because of SVB’s limited niche and the general soundness of the greater US banking system, we anticipate that the broader impact on US banks will be ultimately minimal. The Fed and the Treasury have a clear playbook for addressing bank issues after the GFC, are now actively assessing risk at other regional banks, and are prepared to take decisive action as necessary. Regulators in other countries are taking similar measures: the European Banking Authority is currently stress-testing 70 European banks (75% of EU banking assets), including nearly all banks with balance sheets in excess of €30 billion.
As the stability of the banking system is the Fed’s main remit, we think the ascension of rates will now slow, if not altogether stop, after the upcoming meeting. The rates hikes have been aggressive and fast, and it is widely believed the central bank should wait to better understand the actual impact of these actions before continuing if necessary. We believe politics will weigh in as well, and Chair Powell will be less free to determine the direction based solely on specific inflation measures. While we had expected the Fed to continuing hiking at 25 bps intervals until 5.5% was reached, we believe that the Fed’s ultimate target and the path toward it are now less clear.
Further, the hindrance or outright elimination of a key piece of venture architecture will have wide ranging implications, and we will monitor the situation carefully.
Specific exposure in our investments:
For a clear update, the venture funds we have invested with have all moved their monies to other banks or were already using Money Center banks themselves. One fund had a small cash balance at SVB of approximately $20 million out of $3.5 billion in AUM. Most of our funds have also already successfully helped their underlying firms/portfolio companies move their monies into safe custody. However, a handful of firms were unable to move their funds as quickly, and we are actively assessing the impact on the VC firms’ underlying companies and on fund NAV. We continue to assess each portfolio investment fund by fund and will circulate a summary later this week.
Risk to remaining banks deposits:
In 2022, we began moving our clients’ cash into an ETF that holds short-term (0-1 Year) treasuries, and generally try to keep minimal uninvested cash in all portfolios as holding a security is typically safer. As for our fund managers, the funds we invest with all use multiple banks to mitigate idiosyncratic risk and are also actively monitoring cash to minimize loss.
As a firm, we successfully navigated a similar situation during the GFC, and had moved all client cash into major US money centers by September of 2007, advising clients to do the same with any assets not under our firm’s remit. Today, global banking systems are closely monitored to ensure that the largest banks maintain high balances and ample reserves. As the 16th largest bank in the US, SVB should have been more carefully monitored, but its relatively small balance sheet and regional focus left it out of regulators’ view and more vulnerable to idiosyncratic risk. For these reasons, we are less concerned about the broader implications than we were at the start of the GFC, but we remain in the early days of this crisis, and much depends on the public’s confidence in the banking system. We are moving forward with a conservative cash playbook and a close eye on the situation as it continues to unfold.
For your further edification, we have attached a piece from Mike Cembalest, Chairman of the Market and Investment Strategy for J.P. Morgan, who thoughtfully assesses the overall risk to the broader banking system, as well as a helpful write-up from Evercore.
Please do not hesitate to reach out to anyone on the Appomattox team with any questions or concerns.
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