Kambiz Kazemi, Chief Investment Officer
On March 6th SVB was proudly posting on Twitter that it made the Forbes list of America's Best Banks for the 5th consecutive year. Four days later, the bank was put in receivership by the FDIC.
Over the past days, much has been written as millions have become regional banking experts on Twitter, LinkedIn, and other outlets in the United States.
As of March 9th, 2023, only 4% of stock analysts had issued a "sell" rating on SVB (credit to Ramon Verastegui for this information). However, some savvy investors had identified this vulnerability and positioned themselves accordingly. Short interest on KRE ETF (regional bank) accounted for 78% of all outstanding shares, and some bearish option structures were acquired in recent weeks, resulting in significant gains for these investors last week.
This event came as a surprise to both the market at large and regulators. Undoubtedly, this will be a frantic week for many, as regulators, politicians and financial institutions continue to analyse the situation, while evaluating and preparing for the potential paths ahead.
The core issue, like in any other banking crisis, is that of contagion...
Even if the deposits of SVB (and others) are protected, the question remains: is this episode over, or are there short-term or long-term ramifications leading to potential contagion down the road? After all, to the initiated, the Global Financial Crisis of 2008 really started in summer of 2007 when cracks started to appear.
While each crisis is different, two decades of navigating them and a passion for history of markets has been helpful in providing a framework of analysis to define and weigh scenarios ahead.
Identify the risk at the core: Every crisis, whether financial, geopolitical or in one's daily life, is often the result of a forgotten, underestimated, or mismanaged risk. Most recently, the 2020 pandemic can be seen as a flagrant result of the mismanagement in containing the virus in the first few weeks, combined with underestimating the extent of the virus' effects in the first few months after it appeared. So what risk is at the core of the SVB saga? In short, the SVB episode is due to a combination of interest-rate risk and regulatory risk. This crisis is really a result of poor risk (asset/liability) management, facilitated by a loosening of regulatory requirements for banks of this size...
Bonds purchased by SVB - and many other financial institutions - during the period of very low interest rates in order to generate returns, suffered (unrealized) losses as rates rose to multi-decade highs in 2022. The regulatory framework, however, allows the banks to not account for these losses in the calculation of their "financial health" (called “capital ratios”). Given that they are unrealized, as long as they intend to hold them to maturity, at which time the losses dissipate through time as bond values get back to par.
As a result, a bank can be vulnerable to a massive draw in deposit as its capital ratio suggests an ability to meet such withdrawal, whereas in reality the unrealized losses are not cash at hand that it can access.
Is the core risk replicable and/or transmissible? To gauge what can be next, one needs to evaluate the identified risk along these two criteria.
If the risk is replicable, that means it can be easily present in other places. It can then either materialize or not depending on what actions are taken to deal with it when it first appears. In the case of SVB the same risk exists at other banks (replicable). Many banks resorted to the same strategy of buying longer maturity bond-type instruments in the low interest rate environment of 2020 and 2021. They also have had the ability to exclude any unrealized losses (by declaring their intention to hold the instrument to maturity) from the calculation of their capital ratio.
However, in the present case of SVB, the core risk itself is not necessarily highly transmissible. In 2008, the risk was extremely transmissible because major financial institutions were all counterparties to each other in an interconnected web of transactions. This meant that movements in one part of the system would directly affect the leverage at other institutions. While some financial institutions have risk exposure to SVB as counterparties, the size of the SVB balance sheet and the type of products involved in such transactions mean that transmission is likely, a priori, limited and/or can be contained.
What are the potential contagion vectors? Although the primary risk itself may not be contagious, it is important to consider its secondary effects, which can be transmissible. In this particular case, one significant factor in the transmission of risk was through the bank's depositors, who themselves had other obligations that they would have difficulty meeting. This was about to trigger a domino effect that is difficult to evaluate. However, it appears that at this time, the risk may be averted due to quick action by the authorities.
The other main vector of transmission which is common to all financial crisis is the psychological one. In a system where the transmissibility is low, but the risk is replicable - i.e. it exists at many other banks - a crisis of confidence can essentially result in the repeat of the same scenario at multiple institutions. By then, the crisis has morphed into a much bigger challenge.
Currently, most commentators do not appear to be concerned about this risk, but in our opinion, it is the one that requires close monitoring, not only when the markets open on Monday but also in the weeks and months ahead. Certain future developments in a hiking cycle could bring this risk back to the forefront, even if it does not materialize immediately.
What lessons can we draw from the past? There is a lot of discussion about contagion and containment, with many focusing on the Global Financial Crisis of 2008 as a comparative framework, which some argue (rightly) may not be the most relevant one.
The right question to ask and the right place to look for some indications about the risks we may encounter begins by inquiring: have we ever confronted a financial crisis that had interest rate risk at its center and initially impacted depositors? In our opinion, the answer is yes. The appropriate place to investigate is the Savings & Loan Crisis of the 1980-90s.
Savings & Loan (S&L) Crisis was mainly due to the risk emanating by the aggressive Federal Reserve rate hike cycle of late 1970s and interest rate mismatch in the books of these institutions. This was accompanied by financial deregulation and additional flexibility provided by authorities in both lending (liability) and investment side (asset) by S&L.
Ultimately 1,043 of the 3,234 Saving & Loan Association failed over a decade. Interestingly the first failure was not followed by an immediate wave (as we mentioned above things can take time), and it was resolved by the intervention of the Federal government and the Federal Reserve by setting-up successive federal entities to resolve and dissolve the S&L institutions over a decade long period.
It is important to note, however, that a lot has changed since then, and banks are much better capitalized. At the same time, the world is more interconnected (in commerce as well as in social media) and there is a lot more systemic risk.
What we know and should remember.
In this market things develop extremely quickly. Keep risk management as a top priority, take steps to mitigate your current and potential future exposures, and seek specialist advice where needed.
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