Unpacking the 2023 Banking Crisis: Causes, Risks, and the Future Outlook

The 2023 banking crisis brought to light significant vulnerabilities within the financial system, exemplified by the collapse of Silicon Valley Bank (SVB) and other financial institutions. To understand the underlying causes and potential ramifications, Alli Morse, Principal & Relationship Manager, conducted an insightful interview with Corporate Credit analyst, Charlie Sheehan. Here are the key points discussed regarding the failures of these banks, the systemic risks exposed, and the future outlook for the banking sector:

• SVB's collapse and the loss of confidence
• Velocity of money and technological advancements
• Risk management oversight
• Regulatory reforms 
• Future outlook for banking and investor considerations

Transcript

Alli Morse:

Hi everyone, and welcome to a Bird’s eye view of the Bond Market with Merganser Capital Management, where we invite members from our investment team to offer their analysis on the US investment grade bond markets and share insights into key economic developments. My name’s Alli Morse, and I’m a relationship manager here at Merganser, and I’ll be hosting today. I’m thrilled to be joined by Charlie Sheehan, analyst from our credit team who focuses on the financial sector. Today we’re going to be talking about the banking sector.

So, the implosion of the Silicon Valley Bank, also known as SVB, sent shockwaves through the financial system in March of 2023. Charlie, can you just remind our listeners exactly what went wrong with SVB specifically?

Charlie Sheehan:

So for a bank of its size (it was 16th largest at the time in the US), SVB was uniquely diversified in its business. For an investment grade bank with a specialized focus on startups. SVB’s loan book was nearly 80% in technology and VC funds, with the next highest of regional bank peers at just 4% of total loans. As the Fed began tightening monetary policy, those same borrowers who were the bank’s depositors began withdrawing funds to fund their own businesses. The bank eventually ran out of short-term assets to meet the cash needs of its clients, which led it to need to tap its longer duration securities portfolio value well below cost due to the rise in interest rates in 2022. SVB’s announcement of its plans to reposition assets to improve capital would have likely been sufficient to meet ongoing cash needs if the announcement had not been met with broad and swift calls to pull out all funds from the VC community. Within days, the regulators had to step in and close the bank. So in short, the downfall of SVB can be predominantly traced back to 1. lack of funding diversification, 2.  asset liability mismatches, and 3. the concentrated decision-making of the tech sector, the will of relatively few VC firms rather than the human behavior of millions of individual depositors.

Alli Morse:

SVB was not the only relatively large bank to fall into the crisis, most notably Credit Suisse, signature Bank and First Republic. Were those situations all the same?

Charlie Sheehan:

Well, each of those had their own wrinkles and specific stories, but particularly with Signature and First Republic, they shared in SVB’s lack of funding diversification, structurally low deposit, perceived stickiness, and a loan book that was concentrated in a sector falling out of favor. For CS or Credit Suisse, we could do a whole separate podcast on the saga Credit Suisse, but in short, a string of high profile credit events drove a surge in client withdrawals that were accelerated by the rapid fall of SVB, which illustrated a new paradigm in deposits/AUM velocity.

Alli Morse:

We can have folks look forward to your Credit Suisse dissertation in the future. So, what were some of the risk management failures that led to the challenges for the banks in the United States?

Charlie Sheehan:

Well, aside from major concentration issues, all three highlighted “ALM” issues. “ALM” is asset liability management. It’s a process that banks use to forecast the appropriate investment horizon to manage their assets and liabilities. ALM done well mitigates interest rate risk and ensures adequate liquidity. We can look at SVB as ALM done very poorly. Many banks took advantage of the historically cheap funding of deposits, which had grown dramatically during the pandemic and used them to invest in their own securities portfolios, generally in AAA or government backed papers. So very high quality securities, but with the rise in rates and increased options for higher returning safe asset classes, deposits proved shorter term than some banks had modeled, which transformed the rapid rise in interest rates from a profitability issue to a capital adequacy issue because those losses needed to be realized to meet withdrawals.

Alli Morse:

So, was the speed of this collapse different from prior bank failures? Has technology shifts had meaningful impacts?

Charlie Sheehan:

The speed was much more rapid compared to prior bank failures due to the shift toward online banking as well as social media. So to give it some historical context, Continental Illinois was around the eighth largest bank in 1984, making it the most high profile bank to experience a crisis between the Great Depression and the 2008 financial crisis. It saw a 30% drop in funding in 10 days. In 2008, Washington Mutual, the sixth largest at the time, saw a withdrawal of 10% of deposits over 16 days, which at the time was considered a massive deposit run. Now, by comparison, SVP lost 25% of its deposits in just one day. Signature lost 20% in a matter of hours. The ability to move funds at the touch of a button makes run on bank deposits so much easier now than in the past when you had to go into branches physically.

Alli Morse:

Wow, those are some remarkable facts. Why didn’t the analyst community, rating agencies, and regulators see this coming?

Charlie Sheehan:

Well, heading into 2023, the market saw the rise in rates as a net benefit to banks, and that the positive impact in net interest income would outweigh the rise in funding costs. With SVB, the issue was with clients taking out cash for business purposes as proceeds from equity funding that were deposited with SVB were used to fund operations for the bank’s predominantly startup client base. However, the ultimate failure of the bank sparked the banking crisis and led people to evaluate if the dollars were safe at banks. This led to regional banks in particular to raise rates to defend deposits, increasing funding costs beyond what had been initially expected at the beginning of the year. Because shifting assets across banks is as easy as a click of a button now, the historical precedence proved optimistic as to how long the sorting would take. Now add in a dose of viral social media posts from prominent talking heads, and the velocity was above and beyond what models had anticipated even in the tails.

Alli Morse:

What additional regulation has been put in place as a result of these events? How does this impact maybe the different bank categories?

Charlie Sheehan:

Final regulatory reforms still have not been released, but are expected to come in late 2024 and expected to phase in over two years. They’re expected to impact banks of all sizes, but with the most material impact on banks with assets between $100 billion and $700 billion. So those are category three and category four banks. This will include rising capital costs, reducing accounting flexibility on securities on the balance sheet, and  tighter liquidity controls of the banks most impacted. We expect those that are not currently programmatic issuers and those with large unrealized losses in security portfolios, those banks will be the ones that will bear the greatest burden.

Alli Morse:

What is Merganser’s view on the regional banking system. Is more consolidation needed?

Charlie Sheehan:

Our approach in banking, since our founding, has been to emphasize diversified institutions with strong cultures of risk management and the ability to adapt to a variety of market environments. Banking has always been a game of scale, and we see that as the long-term theme for retail banking. So with that being said, we feel comfortable with the largest, highest quality, most diversified regional banks. Banks that had the most breadth and client base. Banks that have demonstrated access to wholesale funding throughout a cycle. Where we remain cautious are in three areas – 1. Banks with a high degree of asset or liability concentrations, 2. banks growing at an unmanageable rate, and 3. those with weaker asset bases or risk management frameworks. Now, as far as M&A is concerned, it’s a hallmark of the regional space and we expect it to continue, particularly for category four and smaller institutions.

While most of these will be credit positives because of the increase in scale, we do remain cautious of banks pursuing transformative deals that carry heightened execution risk and the likelihood of regulatory challenges for geographic concentrations. We remain cautious on the regulatory side where we see fiercely competing priorities. The tightrope that regulators need to walk in maintaining room for smaller banks to succeed while allowing private transactions rather than FDIC receivership to clean up struggling banks looks exceedingly difficult to us. So as a result, we expect some wobbles along the way, reinforcing our preference for a conservative approach.

Alli Morse:

Anything else that you’re thinking about in the sector?

Charlie Sheehan:

CRE remains very topical in banking currently, so it’s important to note that CRE is heavily concentrated in the small regional banks. 80% of CRE held by banks is with banks below $100 billion assets. Smaller banks also tend to be more concentrated and have larger portions of CRE to total loans with the average being 13% compared to just 4% at the 25 largest US banks. With the focus on CRE, the most pain will be felt by the smaller banks. Now, all banks smaller than $100 billion in assets are not generally investment grade and or do not issue liquid bonds. We remain vigilant in analyzing the potential second order impacts on larger banks and in areas like CMBS and REITs.

Alli Morse:

Thank you, Charlie. This has been very informative and appreciate you joining us today. And thank you to our listeners for tuning into another episode of the Bird’s Eye view of the Bond market. We look forward to sharing another update with you soon and be well. Thank you.

Jeffrey Addis:

This presentation is for informational purposes only and should not be considered investment advice or a recommendation of any particular issuer, security, strategy, or investment product. Opinions and estimates offered constitute our judgment and are subject to change without notice as our statements of financial market trends, which are based on current market conditions. We believe the information provided is reliable, but do not guarantee its accuracy or completeness. This podcast contains or incorporates by reference certain forward-looking statements, which are based on various assumptions, some of which are beyond our control. Actual results may differ materially. Past performance is no guarantee of future results.