Update on Recent Bank Failures

Clients & Colleagues -

Given the events in the banking system over the past few days, we wanted to reach out with some thoughts on the situation.

Most importantly, we want to provide some peace of mind.

While the failures of Silicone Valley Bank, Signature Bank, and Silvergate are troubling and worrisome, we want to stress that the assets held in your Charles Schwab accounts are largely immune from the banking system. As custodial clients of Charles Schwab, all investments in your accounts - including cash equivalents like money market funds and treasury bills - are held by the Broker Dealer directly in your name; these assets are not exposed to Charles Schwab’s affiliated banking entity. These assets are completely segregated and not commingled with any other client’s assets.

For clients who do have deposits with Charles Schwab’s banking entity, Wedmont has no client with Schwab bank deposits greater than the FDIC insurance limits.

Below, we have attempted to provide some context on the broader situation and what it means for the future. As always, if you have any questions or concerns please don’t hesitate to reach out to your advisor at any time.

-The Wedmont Team

Understanding the current banking crisis

While the situation is still evolving, there is plenty of speculation as to what might come next. The events of the past week have already created hardship for many companies and individuals as payrolls are disrupted and access to cash is halted. Yet, as always, when it comes to investing, it's more important than ever to stay levelheaded and focus on the big picture.
 
The collapse of Silicon Valley Bank (SVB) was the first FDIC-insured bank failure since 2020 and the second largest in history. This was followed two days later by the failure of Signature Bank, the third largest in history. Just a few weeks earlier, these two publicly traded companies had the 14^th and 18^th largest market capitalizations among U.S. banks, respectively. Silvergate, a smaller bank active in the crypto industry, also failed the same week, but through an orderly liquidation.

Bank stocks under immense pressure due to the recent failures

From a market and economic perspective, the main question is whether there is wider systemic risk to the financial system. This episode reveals that these particular banks grew too aggressively and with too little risk management as tech valuations rose and crypto prices rallied over the past several years. While this worked well in a bull market, rising interest rates created an imbalance that made these banks vulnerable to classic bank runs.
 
How do bank runs occur? A simplified description of the classic banking model is that customers – both businesses and individuals - deposit funds for safekeeping. Banks then use these deposits to make loans or to buy high quality investment securities which they hope can generate profits. This works well as long as these investment assets maintain or grow in value and customers trust that their deposits are safe. If either of these is not the case, a bank may not have the liquidity to meet its obligations. With this in mind, these recent failures were due to two related problems.

Banks accumulated unrealized losses on investment securities as rates spiked

First, rapidly rising interest rates and Fed rate hikes over the past year created financial stresses on bank balance sheets. As you’re well aware, bonds had their worst performance in history in 2022, driving unrealized losses on investment assets including U.S. Treasuries, as shown in the above chart. Whether banks need to book these losses depends on how these securities are accounted for, but this worsens as banks face pressure on deposits. Thus, SVB and others found themselves with assets that were worth far less as rates rose.
 
Second, SVB’s concentration of tech and startup customers made it vulnerable as conditions deteriorated for that sector, just as Silvergate and Signature Bank were exposed to the slowdown in the crypto industry. SVB tried to plug this gap by raising fresh capital, but this backfired since it highlighted the liquidity and solvency issues it faced. Like shouting "fire" in a crowded theater, once there is the perception of solvency problems, a classic bank run can occur swiftly, which can then become a self-fulfilling prophecy. To a large extent, this played out publicly as many in the startup and VC communities urged companies to move their funds.
 
While government actions are always controversial and subject to political debate, moves by Treasury, the Fed, and the FDIC to backstop customer deposits across these banks will likely help to prevent contagion effects across the system. At the same time, it does not directly address the underlying issue of impaired assets which depends on the quality of risk and asset/liability management at each bank. However, the risk that unrealized losses become a solvency issue is mitigated for larger, more diversified banks who are less reliant on deposits, have a stronger deposit base, and maintain higher amounts of capital.

These bank failures are the largest since 2008

*Note that the above data is taken from the FDIC which does not yet include Signature Bank

It’s understandable to be concerned given the there have been so few bank failures in recent history, especially since banking legislation such as the Dodd-Frank Act was put into place after the 2008 financial crisis. According to the FDIC, there were only 8 bank failures from 2019 to 2022, far below the 322 experienced around the global financial crisis or the hundreds that regularly occurred in the 80s and 90s. That said, SVB is an outlier in that it had total deposits of $175 billion while the 8 failures from 2019 to 2022 all consisted of very small banks that had a combined $628 million in deposits.

Naturally, there are parallels being drawn to 2008 when the last wave of bank failures threatened the global financial system. It's important to keep in mind that, back then, the problem was not just that all banks held significant amounts of mortgage-backed securities and other housing-sensitive assets that ended up being worth only pennies on the dollar. Rather, significant amounts of leverage coupled with new financial instruments such as collateralized debt obligations allowed a housing crisis to turn into a financial meltdown. While it's unclear exactly how this episode will play out, many banks today are much better capitalized and do not primarily rely on tech or crypto deposits. Additionally, any economic spillover has so far been concentrated in the technology and venture capital industries which were already struggling with layoffs and a slowdown in demand.
 
These developments impact the Fed's upcoming rate decisions since they underscore an unintended consequence of rapid rate hikes. It's likely that this creates a new sense of caution for the Fed as they continue to battle inflation. Based on market-based measures, investors no longer expect the Fed to raise rates again this year, but believe that there may be a rate cut by September. Interest rates have also fallen with the 2-year Treasury yield declining over one percentage point to around 4.1%. Ironically, this means that the very bonds with unrealized losses on bank balance sheets are now worth more. While these expectations can shift rapidly, they show how much sentiment has shifted in the past week.

The bottom line

While the events of the past several days are problematic to say the least, parallels to 2008 are premature. As of now, widespread contagion appears unlikely as the recent moves by regulators have essentially backstopped customer deposits, which should continue to ease the panic. As with most things, we believe investors are best served to focus on the big-picture and to allow the situation to stabilize before making any sudden moves.