Understanding what drives market value
The demise of Silicon Valley Bank (SVB) with its important systemic role in the rollout of US tech, happened quickly. In less than 24 hours it was all over for shareholders as regulators took over to prevent banking contagion by offering insurance not only on the deposits of all denominations at SVB but in effect on all deposits with US banks should it be needed.
This was not a run on the banking system per se — depositors were not lining up to cash out their deposits as they might have done in the primitive past. Ordinary clients acted online, transferring their funds as quickly as they could to banking behemoths such as JPMorgan, much as venture capitalists and their many subsidiaries had already done with their deposits with SVB.
It was clear what caused the panic withdrawal of deposits from SVB: a sudden loss in its market value. Most depositors will not have known what was going on, but they took fright because it is the market value of a company and its capitalraising potential that protects creditors, and this protection had fallen away. This had everything to do with decisions taken by SVB itself on poor advice, which investors in the bank recognised as destroying its market value.
The problem for SVB and other banks was that the fixed interest rate yield on their essentially sound assets had been rising steadily, causing their values to decline even as the interest rates paid on deposits were edging higher in response to the US Federal Reserve tightening monetary policy. Accordingly, the net interest income earned by the banks and their earnings per share were in decline, a trend clearly uncomfortable to earnings-conscious, and presumably earnings growth incentivised, managers at SVB.
The advice they received was to mark the portfolio to market values and to recognise the capital losses on the balance sheet. And to raise additional share capital in the market to restore the required capital-to asset ratios, and invest the capital in higher-yielding government and other securities. The goal was to improve net interest income, the earnings outlook and the share price.
There was no regulatory compulsion to recognise the losses on the SVB portfolio. The alternative was to have let the assets run off as they became due and to accept the consequent decline in earnings for the next three years or so — and the possibly negative reaction of the capital market to a well-understood and unavoidable economic reality. There would then have been no need to raise additional capital.
The capital market would surely have been capable of seeing beyond the decline in earnings and focus on the inherent quality of the SVB balance sheet and its potentially durable business model. The problem for SVB was that the capital market clearly did not think the proposed plans for the balance sheet made sense, or that $2bn of extra capital required could be raised on reasonable terms. These doubts put pressure on the share price and undermined the possibility of raising the additional capital.
The protection in the form of market value for depositors and shareholders in SVB and beyond fell away dramatically, and the bank went down. All because of a false belief in managing earnings per share, and a failure to recognise how companies are properly valued on the share market — concerns that extend well beyond the short-term prospects for accounting earnings.
Adjusting wisely to Covid-19 and its aftermath has proved difficult enough for companies with strong balance sheets. It is even more difficult for banks, with high degrees of leverage, to wisely adjust their balance sheets in such unpredictable circumstances. SVB failed on this score.