As we all digest the events that occurred in March, the consensus from the financial industry is that Silicon Valley Bank, the 16th largest bank in the U.S., failed because management purchased long-dated securities and didn't anticipate that the Federal Reserve would move interest rates as high and as fast as they did. They also had a concentration of large uninsured deposits controlled by a few key technology firms.
The story goes that the unrealized losses, and eventually realized losses on these bonds, caused deteriorating capital which, in turn, spooked depositors (controlled by a small group) and resulted in an old-fashioned "run on the bank." This story is not necessarily incorrect, but it is incomplete in some particularly important ways, resulting in shrapnel "damage" to our banking system. As a result, it now seems as if every financial institution in the country that has longer-dated securities and higher levels of uninsured deposits is under the microscope like never before.
In my first undergraduate finance class, we learned that as market interest rates move higher, bond prices move lower. In that same lesson, we learned that the principal and interest payments of U.S Treasuries and agency-backed securities have the full faith of the U.S. government or their agencies, have never defaulted and are described as "risk free" rates.
How is it then possible that the 16th largest bank in the nation failed in part from what experts are calling "interest rate risk" associated with these risk-free bonds? Are we concluding that at the time of purchase, key stakeholders did not understand or consider what would happen to the "theoretical" value of these bonds as rates rise?
Maybe memories of bank purchases of esoteric collateralized debt obligations from the Great Recession still haunt us, but that is not this story — these bonds were well-understood financial instruments. In reality, risk management is what seems to have failed. Unfortunately, this has put this country's more than 9,000 financial institutions — many of which are excellent risk managers — on the defensive. Experts seem laser-focused on determining what happened during the few months leading up to this failure.
However, there is far less attention focused on what happened in 2020-2021, when interest rates were at historical lows and deposits grew by $100 billion. This deposit surge helped fund more than $100 billion of long-term, "risk-free'' bond purchases. Was it really the investments that were not fully understood as rates moved higher, or was it the concentration risk in the deposit portfolio? Maybe the esoteric instrument in this crisis was not the long-term investments, but the deposits — specifically, the unique nature of these technology sector deposits.
Another Finance 101 lesson is that the value of growth companies, specifically technology companies, is tied to future earnings and, as interest rates rise, the value of those future earnings diminishes. In this crisis, an institution's primary funding source was dependent on the value of these growth companies. It should have come as no surprise that as rates started to rise in 2022, institutions that serve the technology sector would see deposit attrition putting strains on liquidity.
In fact, a lookback at the dot-com bubble may have provided some relevant risk management insights. In this event, 2021 was the critical risk management period, not March 2023. Questions remain, how were these
Economist Lacy Hunt recently pointed out in one of my firm's
But who are these depositors at your financial institution? How large are the total relationships and who controls them? How long have the balances been with you? And most importantly, how might these deposits behave as the system's liquidity is being sucked dry?
Unfortunately, most institutions may not be sufficiently quantifying how this proverbial vacuum cleaner may impact their liquidity and cost of funds moving forward. Industry pundits have already dubbed the current crisis as a "black swan event." Financial institutions cannot plan based on potential black swan events, but diligent risk management exercises today can minimize or eliminate tomorrow's most adverse consequences.
The positive impact from this black swan event is the paradigm shift occurring for all financial institutions to better understand the most important, yet esoteric instrument on banks' balance sheets — deposits.
