Reflections on the Ongoing Challenges for Banks and Bank Clients in the Wake of SVB's Failure
Banks and all those who do business with banks --essentially all of us-- have been shaken over events that have occurred over the last couple of weeks, certainly since the Government announcement that Silicon Valley Bank (SVB) was being taken over by the FDIC as receiver on March 10, 2023. Because of quick action so far by the Government and the banking industry, the failures of SVB and shortly thereafter Signature Bank (SB) have not led to a financial crisis at this point. There have been no other major bank "runs"; the stock and bond markets have stabilized; and the Fed and Congress have started to turn to the "lessons learned" portion of the event, with Congressional hearings already scheduled in both houses next week.
Nonetheless, before we shift our attention elsewhere, there is some work to be done for both banks and their customers before we can entirely turn the page on these concerns.
For banks, there should be a recognition that the bank runs experienced by both SVB and SB were the products of two separate phenomena, interacting in very dangerous ways.
Uninsured Bank Deposits
Both banks had far more than the normal amount of uninsured bank deposits, in each case over 90% of their total deposits. Bank deposits are insured by the FDIC up to $250,000 per bank, per customer. Customers who are over that limit in a particular bank are much more likely to pull their money quickly in the event of any clear threat to their bank's stability. Very few banks have this profile, but those that do (or anything close to it) must be aware of it and plan carefully to avoid the fates of SVB and SB.
Embedded Unrealized Losses
The second dangerous characteristic of SVB/SB is more widely shared. The Fed’s very fast run up in interest rates since March 2022 has meant that almost all bank portfolios of high-quality bonds, which are the main source of bank liquidity to meet customer withdrawals, are far underwater on paper. (Banks are holding many bonds that are paying 1%-3% interest while current market rates for the same maturity are running 3%-5% higher than that in the current market.) The official year-end 2022 number for these "embedded but unrealized losses" was officially $600 billion or so in U.S. banks as a whole, but unofficial current estimates are up to three times that amount. Banks that need to sell their current holdings of bonds en masse to meet customer withdrawals are at risk of recognizing huge losses upon sale. For example, SVB may have lost approximately $2 billion in one trading day, and thus the quick and lethal depletion of their capital in the event of a customer run.
What This Means for Banks
Banks have little they can do in the short term about their level of uninsured deposits, and banks with a high level of uninsured deposits should act urgently in taking other measures to address their risk. Each bank's Asset and Liability Committees should consider immediately turning to "de-risking" their bond portfolio to the extent possible, by gradually selling the lower yielding bonds and replacing them with higher yielding market-rate instruments of the same rating and credit quality. While this will cause small to moderate quarterly losses in the bond portfolio of most banks, --and publicly traded companies especially will not happily undertake this-- the risk management balance heavily weighs toward taking the smaller losses currently versus the potential for a catastrophe later. Banks that are already experiencing weakness owing to their levels of uninsured deposits will not have the time for this exercise, and thus may want to explore the potential for merging with a better-situated partner.
All banks and their boards should also assess the resources they possess to meet any rapid customer withdrawals without depleting capital, even if a bank run is unlikely in a bank's particular case. This means planning and projecting the use of available Federal Reserve borrowing (including the Fed's new facility for precisely this purpose), as well as existing programs like continuing Fed loan programs and facilities, Federal Home Loan Bank advances where available, and even raising quick and accessible new capital where it is realistic to do so.
What This Means for Bank Customers
If the current business media reporting and anecdotal evidence are accurate, bank customers have been recently moving their uninsured deposits to safer ground in bigger, more regulated banks and money market funds. While not typically insured like bank deposits, money market funds have market characteristics that make them appear (probably accurately) safer than bank deposits. This is the right approach for many. However, clients should check both their absolute level of uninsured deposits and the condition of the banks or funds where they are transferring uninsured deposits. In both cases, clients should obtain sophisticated data as well as judgements about what is and is not an insured deposit.
Time is of the essence for both banks and their customers in making these decisions. While congressional and executive branch discussions about helpful steps are taking place (e.g., insuring at least some bank deposits without limit as was done during the financial crisis of 2008-09 and the pandemic starting in March 2020), no private parties should count on government action as a solution. It is best to be proactive with immediate and thoughtful planning to steer through current challenges and remain on safe and dry land.
For further information, advice, and legal assistance as the banking industry course corrects, please contact your Quarles attorney or: