Last week, Silicon Valley Bank, a Santa Clara, California lender to technology companies across the globe was shut down and taken over by the Federal Deposit Insurance Corporation. Just two days later, Signature Bank, a New York-based bank that in 2018 began taking deposits of crypto assets, was closed by regulators to further mitigate risk in the broader banking sector. The two bank closures alone sent shockwaves in the markets and have left many wondering, what happened.
First, as banks take in money (deposits), they pay a small interest rate and then lend money to investors. Since these two banks focus on high-tech and crypto-type lending, and due to the difficulty within that space, many of those companies that they had lent money to went either into a recessionary-like environment or out of business. As a result, their book of business was at risk.
The second thing they did was go further out on the yield curve. What does that mean? Short-term bonds and short-term debt are usually over three, six, or even 12 months. The shorter the duration, the lower the risk factor is for the bondholder. So, a debt instrument like a bond has a certain interest rate attached to it. The shorter the length of time, the lower the interest rate. The longer the length of time, the higher the interest rate. Silicon Valley Bank went further out in duration or higher in the yield curve, which presented a higher degree of risk. All banks will face this, but a more aggressive investment approach on the part of the bank would expose that bank to higher levels of risk. How is that risk derived? There’s an inverse relationship between bond values and interest rates. Bonds are issued at par, or face value. For example, let’s use a $1,000 investment paying a 2.5% interest rate. If interest rates were to remain roughly where they were prior to the pandemic, then in a year’s time the recipient would receive 2.5% on an annual basis. However, when interest rates have gone up as they have in the last nine months, more sharply than ever before in history, this hurt the value of the bond. So, if a bond was issued at $1,000, and interest rates increased, the value of the bond on the open market might drop to $650-700 compared to the $1,000 it was issued at. The longer you go out on the yield curve, the greater the risk there is. Silicon Valley Bank went further out on the yield curve, exposing their bank to a higher degree of risk. Consequently, the bank suffered tremendous losses during this rapid escalation of interest rates during the last nine months.
Finally, once depositors became aware of the difficulty the bank was facing, fear set in, and they pulled their money out rapidly. This is called a “run on the bank.” As a result, the loss in confidence accelerated the collapse of the bank.
Another important point to consider is the stress tests performed by the Federal Reserve, determining how much a bank can withstand in adverse market conditions. There are two levels of stress tests.
Money-centered banks like Bank of America or JPMorgan Chase have a much more rigorous stress test than regional banks or community banks. This is more or less appropriate in how the economy operates. Last week, the money-centered banks were immune to the banking crisis because their stress tests would allow them to withstand this negative environment. Smaller banks like Silicon Valley Bank or Signature Bank suffered tremendous losses in their stock prices in the fear that this contagion would spread. The market recovered, but the risk still exists for those who endure a less rigorous stress test. Accordingly, they have greater latitude in who they lend to, including small and medium-sized businesses in their hometown or community, or in their area of expertise. As businesses face the challenges of reordering in the economy, some are going to fail, and some are going to thrive. And so, the bank is at risk as it’s associated with this. Silicon Valley Bank and Signature Bank lent to what now is considered high-risk tech and crypto-like companies. Regional and community banks are faced with a similar risk pattern. Also, depending on how the bank is managed, how they are on this yield curve issue also tells you where their risk factor is as it pertains to a marketplace with rapidly rising interest rates.
Another factor that would be a consideration for regional and community banks is the attractive rates they are paying to motivate depositors. However, the higher the yield, the greater the cost of money is for regional and community banks than it is for money-centered banks. Put all those things together in this turbulent economic environment and you get bank failures. In retrospect, as we look back at the banking crisis as it’s unfolding here, it makes perfect sense. But, two weeks ago, the market didn’t have any of this in view. The view of the market was inflation and interest rates going up to combat inflation. Now the market has shifted away from inflationary concerns and focused on the stability of the banking system.
Interest Rates, Inflation, and the Future
Prior to the fallout in the last few days, the Federal Reserve was expected to raise interest rates by 0.50% next week. To calm the waters, they may only raise it by 0.25%, or perhaps not at all until this crisis passes. This is one of the unintended consequences of the economic gyrations that the U.S. and the world have been through since the pandemic shutdowns and then the dramatic stimulus that came into the economy through monetary and fiscal stimulus.
A banking crisis by itself will prove disinflationary. In times of crisis like we are in right now, people will tend to pull in and not spend, dampening economic activity and reducing inflation. The banking crisis by itself will probably take a point or two out of inflation, as interest rate increases would in a normal environment. In the end, we will be getting the same effect, perhaps without interest rates climbing much further than they are at this stage.
We’ve been through several different banking crises in the modern era. Back in the 1980’s there was the savings and loan crisis, where many went out of business. Further was a collapse of the real estate market because those same savings and loan companies focused primarily on real estate. The great recession was also brought about by the banking and mortgage sector financing houses that had values well beyond what they should have been, finally collapsing. You didn’t really see banking failures per se, but rather a consolidation within the banking sector with bigger banks buying smaller banks. I think that’s probably what we will see here. In the end, I think this portends poorly for the emerging American economy. Small and medium-sized businesses in communities across America have normally looked to the smaller or regional banks for the credit and capital they need to grow and expand. This will become more difficult for that sector of the economy to grow if the community and regional banks suffer losses as they could in this environment.
What about my 401(k)?
The systemic risk that has surfaced in this last week with Silicon Valley Bank and Signature Bank and regional banks across America does not exist in the 401(k) sector, primarily because 401(k) plans are invested in mutual funds that are highly diversified. Generally, if there’s a bond fund, it’s in government treasury bonds, not individual small bank companies. The greatest risk associated with a 401(k) investor would be the volatility of the market in how it would respond to this crisis. Usually, the markets recover quickly. There was a JPMorgan study conducted from 2002-2022, that said if a person was invested 100% of the time over that 20-year period, they would have gotten a 9.5% return with the S&P 500. However, if they were out for just 10 days in that same period, their return would have been almost half at 5.4%; 30 days, 2%; 60 days, it’s barely a return at all. It’s almost impossible for an individual investor to catch the low or the high of the market, but rather to remain invested in good and bad times. Here’s the wonderful part of our economy. It has a wonderful resilience to withstand periods of crisis, adapt, and then recover. And those with a long view, even in the midst of a crisis, have benefitted very nicely over time. It’s important to note that the Y2K bubble burst, the tech bubble in 2001-02, the Iraq War, various wars in the middle east, the great recession of 2007-09, a global pandemic, and the collapse of the market on March 20, 2020, all occurred during the 20-year surveyed period. Yet at the same time, through all that calamity we saw a growing economy, record-low unemployment, and a great benefit to the long-term investor. What this demonstrates is that in the long term, the turbulence that could be in the economy or market will ultimately work itself out and the market will recover, many times in sudden jolts that are almost impossible to catch with any degree of precision.
The commentary and market insights provided by John Slavic are for informational purposes only and do not guarantee future results.