BY GUY CARSON – INVESTMENT SPECIALIST
Global markets have been hit in the last week by bank failures and fears of contagion. The current fears started with the failure of Signature Bank and Silicon Valley Bank (SVB) in the US, and then spread across to Europe with fresh fears around Credit Suisse as they restated their financial statements from recent years.
In the wake of these events, we wanted to highlight our due diligence approach to the banks we work with and how we go about avoiding the above scenarios. First and foremost, we review banks financials. In recent years, we have had more than one bank come to us and want to partner with us but then have not been prepared to give us access to their financial statements. This is a huge red flag. With SVB, the risk that they were taking was on full display in their financial statements and we will touch on this below.
Secondly, we favour banks that have a custodial business model as opposed to traditional retail banks. Custodial banks make a majority of their profits via fees whilst traditional banks make their money via lending. Traditional banks don’t charge the same fees and instead make money via utilising their deposit base. What they do in effect, is borrow short (from depositors) and lend long. The issue for SVB came from this simple concept.
SVB was founded in 1983 but its growth in recent years has exploded, its recent 10K (comprehensive report filed annually about its financial performance) highlighted that its deposit growth in 2021 and 2022 was significant (c. $130 billion in total), and also stated that if that growth was to continue it would need further equity to support its capital ratios. This growth, however, did not continue. The deposits had largely come from the venture capital (VC) industry (it serviced half of the VC industry) and the bank couldn’t write loans fast enough to keep up. Therefore, in order to get a return on these funds, the bank started buying long term bonds. With the Federal Open Market Committee (FOMC) hiking aggressively, these bonds started falling in value (when rates go up, bond values fall). This would all be okay if the deposits matched the 30 year bonds they were buying, however deposits can leave at any time. So, with the duration mismatch, the risk was deposits leaving would leave the bank having to liquidate the bonds at losses and would make the bank insolvent. When SVB recently announced a large loss, depositors started to panic and pull their money.
The Federal Deposit Insurance Corporation (FDIC) was called in and the bank was quickly declared insolvent. Then the VC sector started to panic. 85% of the deposits at SVB were over $250k and therefore not covered by FDIC insurance. This led to fears of a larger run on regional banks. Major banks are deemed “too big to fail” but regional banks are not given the same luxury. The FDIC then announced that all deposits would be made whole to stop this contagion effect.
All banks borrow short and lend long. However, they all (except for SVB) manage their interest rate risk via derivatives and other risk management tools. SVB weren’t doing anything on the risk management front and as their deposit base was largely institutional, the deposits weren’t covered by FDIC insurance (the insurance covers deposits up to $250k). Hence, the risk of a bank run as all the institutional deposits headed for the exit at the same time. And they couldn’t cover those deposits because all their long dated assets had fallen in value due to higher interest rates.
Going back to the original point, the banks we use are largely custodial. This doesn’t mean they don’t conduct activities as above but it does mean in most cases they make a majority of their profits via fees from assets under their custody. They are less reliant on lending or investing in bonds, although they still do it. It means less of their capital is at risk and they don’t have to take the same risks that SVB did in order to make a return.
In addition, it is worth highlighting that SVB and other US regional banks did not have to follow Basel III liquidity requirements that other banks globally have to adhere to. This would have helped them avoid their downfall.
Finally, we come to Credit Suisse. Again, their business model differs from both the custodial banks and the traditional banks. They are a global investment bank and they have been in trouble for some time, as seen via their share price.
The fear this week news came about due to the restatement of cashflows in recent years. This news doesn’t appear to be material, however there are significant problems in their asset book and these problems have been known for some time. In order to stop any fears of contagion, the Swiss National Bank announced a liquidity facility for Credit Suisse to access. Ultimately the bank will either need to be broken up with a sale of good assets to cover the losses in the bad assets (not great for shareholders but good for stability), or alternatively absorbed by someone else, with UBS touted as the most likely partners.
The events of this week have reiterated to us the importance of the due diligence we undertake on banks. We are always looking for new options and new partners for our clients but we will never sacrifice the security of our clients funds.