I was supposed to be in Hawaii this week speaking at the ICBA Live event. However, I was hit with my second round of COVID on Thursday requiring a last minute cancellation. Never been to Hawaii. It was so disappointing not to be there and meet with so many bankers.
As a preamble today, all banks are currently seeing a draw down on deposits. This has been happening since April 13, 2022 and has picked up steam since October 2022. I have been warning my clients and those in my classes that you need to look for alternative sources of funding for loans as deposits are going to continue to fall. Part of the deposit issue is inflation, it is eating into both consumer and commercial accounts as more is being spent. We have astute bank customers looking for the best rate of return, often this is outside the bank. Hence, deposit drain.
This brings us to SVB. The Silicon Valley Bank failure has dramatically restructured the economy and the future outlook. The interest over inflation and other economic indicators are now being viewed through the prism of how will further actions by the Fed impact the banking industry.
Silicon Valley Bank, as of December 31, 2022, was not a troubled bank! As the 16th largest bank in the nation its earnings were strong, over $2 Billion last year. The net interest margin was slightly under peer levels but still good. The credit portfolio was strong, its delinquency rate was .19%. This was actually better than its peers. The Tier 1 Capital Ratio was over 15% ranking it well above the industry average and considered strong.
Certain politicians rushed to the microphones to blame the bank failure on the 2018 bank deregulation act that was signed by President Trump after being passed with bipartisan support. That bill did allow banks to begin investing again in mortgage backed securities. The mortgage industry had changed dramatically from the dawn of Dodd Frank in 2010 which prohibited banks from investing in mortgage backed securities. The type of mortgages that caused the Great Recession no longer existed. The deregulation allowed banks under $250 Billion the flexibility of not having to do the full stress testing of larger, too big to fail, banks. This does not mean SVB did not do any stress tests, but rather the ability to perform less rigorous tests. To be clear, there was nothing in the waived stress tests that would have caught the risk of what happened, that is not part of the measurements.
In 2018 before the deregulation, Silicon Valley Bank had a Tier 1 Capital of 11.76%, its net income was less than $2 Billion and its credit portfolio was considered strong. The delinquency rate was .48%. It is easy to say that SVB was actually stronger in 2022 than 2018. The only dent in the armor was the insured deposit level. In both 2018 and 2022 the bank had an extremely low insured deposit ratio. The average in the industry ranges from 40% to 60%. Many independent community banks are at 70% or more. SVB was 11% in 2018 and a horrendous 5% in 2022. This was a ratio that did not get a lot of attention prior to last week. Further, it was a ratio that was not touched or discussed in the 2018 bill.
So, what happened? The fiscal policy of the United States since March of 2022 has pumped record, unsustainable liquidity into the economy. This of course has led to the highest inflation levels that our country has experienced in a generation. The Federal Reserves interest rate movements, as limited as they have been, have pushed bond rates higher.
Banks use their excess liquidity to invest in select securities. In their investment portfolio they have two baskets. The first is readily for sale. These securities can be sold at any time to meet liquidity needs if they arise. This part of the portfolio is required to be priced at mark to market. This is a cool way of saying, as the market changes you need to reflect the true market value of the portfolio on your balance sheet. Adjustments of course show up on the income statement. The Hold To Maturity portion of the portfolio is held constant, avoiding the gyrations of the market.
For SVB and other banks, recent deposit bleed offs have stressed the liquidity of the bank. Last week SVB hit the point where the readily for sale portfolio was sold off and they had to sell the Hold to Maturity portion. As interest rates rise in the market, fixed rate bonds drop in value. Who will pay more for a 2% bond when a 4% one will yield more? By selling the Hold to Maturity bonds, SVB locked in huge losses as they held low interest rate bonds. The losses quickly wiped out the equity of the bank.
As we see continued deposit bleed offs, more banks will have to address liquidity issues. Whether this is cured by selling off investments or becoming much more selective in making loans, the nation is in for a period of disintermediation. This is where banks are illiquid so they stop making loans which slows business leading to a recession.
While this sounds ugly and it is, it might be that back door way of slowing inflation without higher interest rates.
Have a great week.
