2nd Quarter 2023 Market Commentary
Financial Sector Update
The big news during the month of March was the failure of Silicon Valley Bank (SVB), which brought the financial stability of banks into sharp focus and resulted in a sharp sell-off in stocks throughout the sector.
How did this happen? Very briefly, the pandemic, with the ensuing monetary and fiscal policy response from the Federal Reserve and the government, respectively, led to a huge increase in money supply and liquidity. In respect to SVB, the bank had heavy loan exposure to tech startups and venture capital companies. Ready availability of credit to these sectors led to a massive surge in deposits at the bank. Deposits represents liabilities to banks, while bank assets include loans and securities, in the form of bonds usually, held to provide additional earnings for the bank and to meet liquidity and capital needs.
The Federal Reserve raised interest rates last year to combat inflation which reduced market participants willingness to accept as much investment risk. This resulted in extreme pressure for the technology and venture capital sectors. Higher interest rates resulted in capital losses on SVB’s bond portfolio, 55% of which unfortunately was invested in long term bonds. The bank sold its entire “Available for Sale” securities (liquidity reserves) at a $1.8B loss. SVB’s inadequate liquidity was in part facilitated by the 2018 rollback of some of the Dodd-Frank regulations, which removed the “stress test” requirement for banks under $250B. The stress test evaluates banks liquidity positions for readiness to withstand a
sharp spike in interest rates. When the announcement that SVB would need to raise more than $2B from equity holders to meet liquidity needs, there was a run on the bank deposits and the bank failed.
While SVB’s situation was unique in its heavy concentration to the tech start up and venture capital sectors and its untimely allocation of long-term maturity bonds in its securities portfolio, fear that the contagion could spread roiled markets. Especially hard hit were US regional banks that have heavy concentration of lending to the commercial real estate sector. Internationally, Credit Suisse was
rescued via its merger with Union Bank of Switzerland.
Federal Reserve/FDIC Action – In addition to a guarantee to cover all of the deposits of SVB (95% of which were over the $250k FDIC insurance limits), the Federal Reserve created a new short-term lending facility, the Bank Term Funding Program (BTFP), that will help banks meet liquidity needs for up to a year. These actions have demonstrated the path to financial stability for most banks. The charts on the next page demonstrate the level of lending that was provided to banks under the BTFP during the month as well as the impact on the Fed’s balance sheet.
Sector Outlook Near Future – Many banks that have been able to maintain liquidity reserves (or borrowed funds from the Fed) have reclassified “Available for Sale” bonds to “Held to Maturity” securities. Because these bonds will be held until they mature, the short term “paper loss” is not required to be expensed through the income statement per regulation. The bonds will be held until they mature and 100% of the face value of the security will be recovered at that time.
What this means is that because yields on banks’ purchase-value of bonds in their bond portfolio are undoubtedly low, bank profits will likely be somewhat lower versus historical average until the current portfolio matures and can be replaced with higher yielding securities. While Bank credit standards will be tighter in the short-to-intermediate time horizon, we anticipate most banks to weather this storm.
Conclusion – The Federal Reserve, primarily through the prompt establishment of the BTFP, provided over $300 billion in liquidity to banks in the month of March. This action signals strong support for the banking sector and successfully staved off a larger crisis at this time.
While we agree that tighter lending standards and higher interest rates raise the probability of recession later in the year, the dramatic sell off in stock prices for the financial sector, including high quality, well capitalized banks is viewed as an investment opportunity.
Please feel free to contact us with any questions that you may have, we are happy to discuss your concerns and/or
Rebecca Holden, CFA
Director of Domestic Research
Michael A Hart, CFA
April 3, 2023