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***Special*** Market Update - 15 March 2023
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"History," it has been said, "does not repeat itself. The historians repeat one another."
~ Max Beerbohm
Making headlines the last few days have been two bank seizures by regulators in the United States. Over the weekend authorities in California and New York with help from the FDIC have closed both Silicon Valley Bank (Friday) and Signature Bank (Sunday), with a third bank, First Republic under shareholder scrutiny. Anytime regulators or bankers work the weekend it is serious, so we thought an update was in order.
First and foremost Australia’s banking sector is both well regulated, well capitalised and typically asset backed by property or businesses with 3yrs of profitable trading. Over the years local regulators have pushed to increase minimum capital requirements, provided better backstops through higher capital to non-risked assets ratios, and increased liquidity requirements to stave off short term periods of funding stress. These safeguards are in addition to the rules enacted in the wake of the GFC. Further to beefed up regulation stands the implicit support of the Australian government if there was an event that could affect trust in the sector as a whole (e.g.: pandemic).
We can see that Australian banks are some of the most well capitalised in the world (CET1 ratios in below chart are led by Australia’s big 4).
The Collapse
With that background we move to the US, where we are witnessing the treasury departments of two banks asleep at the wheel. The GFC was a credit crisis that became a liquidity issue when banks stopped trusting other banks. The aftermath of which could only be put back together again by federal bailouts. The current issue at Silicon Valley Bank, Signature Bank and possibly First Republic has more to do with how banks measure their assets and fund their liabilities.
A quick refresher, for most of us the loans we take out are liabilities and cash we hold on deposit is consider an asset. For a bank this relationship is flipped, deposits are a liability as they pay interest on the funds, and loans are an asset that generate revenue. For CBA they have $108 in loans covering every $100 in deposits, their treasury then uses diverse short-term and long-term funding options to assure that the bank is able to fund withdrawal requests.
At Silicon Valley Bank, you saw a situation where $43 of loans covered $100 of deposits, which is fine by itself as deposits are a cheap source of funding. The issue that began to arise was threefold, first unlike CBA that has a diversity of depositors, Silicon Valley Bank targeted customers in technology and life sciences/healthcare with nearly half of the US venture backed companies calling their bank home. With Venture Capital reining in spending this past year, instead of adding to deposits, these depositors were making withdrawals to fund operations. Investors noticed that deposit growth had slowed during 2022.
The second issue that arose as Silicon Valley funded their deposit interest obligations with US Treasuries and Mortgage-Backed-Securities, they were exposed to interest rate risk. When central bank rates rose, values of those assets decreased 5%-15%. They were able to hide these paper losses as the assets were not being marked to market as they believe the securities would be held to maturity. With higher withdrawals than deposits, they were forced to sell these securities and realise the losses.
Finally the third issue was when during the investor call last week they revealed a shocking $1.8bn (USD) shortfall to their investors generated by the forced sale of underwater assets. The CEO had a plan though that would see the shortfall covered with new capital from an equity and debt issue that was already 1/3rd covered. After the investor call Venture Capital funds notified their portfolio companies to pull deposits from the bank, and the bank run was on. Word spread quickly and within 48hrs $42bn in deposits were taken from the bank, and they no longer had sufficient capital to fund their account deposits. The bank was seized on Friday in the US to protect depositors’ capital (Saturday in Australia) with the bank’s loan book and operations going to auction.
A similar pattern of lack of funding diversity and treasury prudence struck Signature Bank on Sunday and it was seized to protect depositors. Other small banks with concentrated client bases will fall under scrutiny as diversified banks appear less exposed to interest rate risk and bank runs (shown in chart below).
Small Changes Can Build to Big Problems
A lot of questions are being asked around how these banks were able to manage their balance sheets in this fashion. In 2018 key legislation was passed by the Trump administration that loosened the rules set forth by the 2010 Dodd-Frank Act for banks under $250bn in assets. These smaller institutions were considered “non-core” to the world financial system and successfully lobbied to become immune to certain stress tests as well as capital and liquidity requirements. At the time experts warned that banks between $100bn and $250bn in assets would be at higher risk of failure. Australian regulators have not gone down this same path, instead strengthening regulation and capital requirements.
In the US and in Australia there is a $250k deposit limit in place for federally guaranteed deposits. Accounts that exceed this threshold will find the excess uninsured. Estimates are that Silicon Valley Bank has 95% of its accounts over the insurance threshold. On Monday federal regulators stepped in to make special arrangements to cover all deposits at the two failed banks and stop contagion within the sector that could dry up liquidity.
Impact of the Collapse
We reiterate that the current issue in the US banking sector is unlike the GFC in that it is not a credit issue, leverage is not involved, and regulators have acted quickly to stop the spread. Our funds have less than 1% exposure to regional banks in the US. Our exposure to Australian bank equity is low at this point in the cycle as mortgage growth is expected to be muted so we remained underweight the equity. We do carry exposure to bank hybrids in our portfolios, but these notes are short duration and majority issued by the large diversified banks.
For the share market, we do expect further volatility in the banking sector as investors sell the rumour and a spotlight is shone on the industry, but we do not expect contagion to severely cascade through the equity market. Central Bank’s are not tone deaf and these bank failures could trigger a slowing of rate rises, like last year’s currency volatility providing a reality check.
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Gareth Jakeman
Chief Investment Officer
Territory Funds Management
Kyle Schlachter
Sr. Analyst
Territory Funds Management
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