Silicon Valley silliness
he weekend’s news was dominated by reports of the second-largest banking failure in US history. Those are not the headlines that anyone in financial services wants to see, as there are inevitably jitters throughout the investor community whenever an event occurs that sucks liquidity out of the market.
The Federal Reserve has been acting as a sponge for months now, mopping up excess liquidity and moving profits from the hands of equity investors into those of debt investors. With the dollar as the world’s reserve currency, the interest rate cycle in the US drives rates across the world. South African investors certainly haven’t been immune to the impact of higher rates not just on valuations but also on net profits as floating-rate debt becomes more expensive.
Various US reports suggest that Silicon Valley Bank (SVB) was among the top 20 American commercial banks, playing an important role in the venture capital ecosystem. The flood of liquidity into tech start-ups during the pandemic (and resultant low interest rate environment) was a bonanza for the bank, helping it quickly grow its client and deposit base.
Founders raised money when tech was hot and stashed it away for an inevitable
Trainy day. As evidence of how accustomed the developed world is to relatively low interest rates, the bank had positioned itself for rates to stay lower for longer by investing in long-dated US government bonds.
Now, if you are happy to just collect the yield at which you bought the bonds until maturity, then the fair value of the bond won’t matter to you. For a bank that needs to be able to honour the deposits of its customers, the fair value is absolutely critical.
Based on recent US data and the continuing hawkish tone of the Fed, a decrease in interest rates simply isn’t going to happen any time soon. As the value of its longdated bonds plummeted, the bank had to sell assets to meet the demands of its startup clients, which specialise in incinerating cash in their businesses. It didn’t work, as the fears about the bank spread and more depositors tried to withdraw their cash. This only makes the problem bigger, as more assets then need to be liquidated to meet the cash demands.
If you know anything about banking, you’ll know that a “run on the bank” means the end of the road. The bank doesn’t actually have all deposits available at any given time, so it cannot meet the liquidity demands of its customer base all at once. It’s great to have marketable securities like
Where did this go wrong? On the one hand, we have a bank with a highly concentrated depositor base that is collectively burning cash and finding it increasingly difficult to raise more. The start-up community is likely to panic simultaneously, creating the risk of a run on the bank. On the other, we have the catalyst for the panic in terms of a truly poor risk management approach at SVB. Managing interest rate risk is core to running a bank, which is why banks have teams of very smart people who think about things like asset duration and interest rate hedging strategies.
Sitting on more cash than it probably ever imagined possible, SVB needed to invest in assets to achieve a net interest margin and generate a return. Most banks (like commercial banks in South Africa) lend to individuals and businesses who have demand for credit and can afford to repay it. Risk is managed through lending to a wide variety of clients across sectors.
SVB had more cash than it could lend out, so it bought long-dated bonds instead. It’s quite obvious that no scenario analysis was ever run that contemplated an increase in rates to these levels, as the bank essentially blew itself up through losing a fortune on its investments.
It’s more than a little awkward for numerous equity research houses (like JPMorgan) that they were carrying buy recommendations on the stock. Equity investors have probably lost everything here and there were other brokers who also had buy recommendations on the business.
The bigger focus will be on the depositors and access to their funds, with regulators needing to step in to restore trust in the banking system.
It’s also another blow to Silicon Valley itself, where start-ups are already buckling under the pressure of a higher interest rate environment.
At the time of writing, things are moving quickly. HSBC is rescuing the UK arm of SVB, which doesn’t do much to help the tech fraternity in the US. US regulators are trying to put together a deal to safeguard deposits at a time when major tech companies are carrying huge exposure here, like Roku which has 26% of its cash at the bank. Trust in the banking system is now a developing story.