On March 10, 2023, Silicon Valley Bank (SVB) crumpled after enduring a bank run. This has shaken markets. Failures amongst small US banks are not unusual. However, with over USD200bn in assets, SVB is one of the biggest banks to fail since the GFC. Following the collapse of SVB, the New York State banking regulator has decided to close the crypto-focused commercial bank, Signature Bank, further exacerbating the wavering confidence in the US banking sector.
In reply to these breakdowns, the US Federal Reserve (Fed) has implemented strict measures to restore confidence to the US banking sector and guarantee uninsured depositors in the failed banks. SVB customers will have access to their full deposits starting on 13 March 2023. No losses will be borne by the taxpayer. Signature Bank depositors have also been covered.
This week will be critical for the banking regulators and the Fed to compose markets. The immediate flow-on effect was an extensive rally for government bonds – in both US and Australia – and yields could well go even lower. For equity and credit markets, the outlook is more mixed. On the one hand, the Fed may need to pause rate hikes at the next meeting which will be good news for credit. However, if there are indeed contagion risks associated with these bank breakdowns, we could see a widening in credit spreads.
In relation to contagion risks, SVB did rely on a regulatory discount for smaller banks, meaning it did not have to hold capital for any mark-to-market (MTM) unrealised losses on fixed-rate securities held on its balance sheet. With yields moving higher, these MTM unrealised losses have mounted, therefore, when there was an initial fall in deposits (from growing financial problems with its major tech industry depositors), SVB was required to sell assets and realise losses. This shocked other uninsured depositors leading to a bank run.
What’s unknown is: how many other smaller US banks are sitting on big unrealised losses and are at a risk to a bank run? In our view, the Fed will manage the situation to ensure contagion risks are mitigated. However, there will no doubt be volatility in yields and credit spreads going forward. Currently, the Fed has put forward the following preventative measures to ensure it does not cause wide scale contagion.
- It will create a new lending program for banks – the Bank Term Funding Program (BTFP) – aimed at protecting institutions impacted by instability from these banking failures. This program will offer loans of up to one year to banks, credit unions, savings associations, and other institutions, which can take advantage and pledge high quality debt (such as treasuries) as collateral. This will enable banks to meet customer withdrawals without having to liquidate their fixed-rate securities at a realised loss – aimed at preventing further bank runs.
- Banks can borrow funds equal to the par value of the collateral they pledge. This should give more confidence to institutions and investors as this in turn supports confidence in the financial system, providing funding guarantees and liquidity that are considered essential during financial crises.
For now, this is one to wait and see. On the face of it, the problems appear to be more idiosyncratic than systemic. Looking ahead, it’s clear that Fed tightening has begun to bite, with more challenging credit events and volatility likely to unfold in the months ahead. In this environment, we stress that investment-grade credit (especially the higher quality/higher rated segments of the market, including A, AA, and AAA exposures) will still perform better relative to equities and high-yield credit. Therefore, it’s important investors ensure their portfolios are able to weather the various scenarios which could play out.
