What can the demise of Silicon Valley Bank teach investors?
Anthony Gormley’s impressive work ‘Another Place’ features one hundred naked men scattered along 1.5 miles of Crosby Beach in Liverpool. The work provides a useful twice-daily reminder about hidden risks in the financial world. As Warren Buffet once said:
‘You only find out who’s swimming naked when the tide goes out.’
The demise of Silicon Valley Bank (SVB) is one such case of being exposed by a falling tide. The bank focused on services for many early stage and start-up tech firms and venture capital firms, both in the US, and the UK. This was all well and good in an era of cheap money, but persistently high inflation has forced central banks in the developed world to increase interest rates and to cut down on their unprecedented quantitative easing programs.
Depositors began withdrawing their cash in early March due to concern about SVB’s ability to meet it’s obligations. The root cause of their concern lay in the exposed reality of the risks the bank had taken by investing large quantities of the money raised from deposits into longer-dated US Treasuries.
Government bonds are generally seen as safe investments. However, longer-term bond’s higher rates come at a cost of higher volatility, especially when interest rates are hiked more than expected. This is why personal investors, as well as banks like SVB, would do well to manage risk by ensuring lower-risk shorter term bonds form an important part in their portfolios.
SVB’s strategy worked just fine when short-term interest rates were near zero and longer-dated bonds paid higher yields. However, SVB’s skinny dip into the bond market was exposed by the rapid increase in bond yields in the second half of 2022. Yields on 10 Year Treasuries around doubled from late last year (bond prices move in the opposite direction to bond yields). This put a huge dent in SVB’s balance sheet, leading to a rapid loss of confidence that the bank could meet its liabilities, generating a self-fulfilling cycle.
What was the effect of SVB’s failure?
SVB UK was purchased by HSBC for £1. Its depositors’ money was secured. Young tech firms avoided a severe, even terminal, liquidity crunch. In the US, the Federal Reserve, the US Treasury and the FDIC, came up with a plan to protect all depositors, including those uninsured by the FDIC. The Fed also set up a borrowing facility for other banks to provide liquidity against US Treasuries (and some other assets) based on the bonds’ par (i.e. redemption) value at maturity. This has likely stopped any systemic risk to the banking sector.
The Financial Times have reported that many people in the US have taken their money out of smaller banks to put in larger institutions. This is perhaps unwise (see point 2 below) and may exacerbate the problem for smaller banks2. We may see some volatility in bank stocks until the full picture becomes clearer (i.e. is everyone else wearing swimming trunks and will the Fed’s towel cover the embarrassment of any who are not?).
What lessons can be learned?
Perhaps the most important aspect of this debacle is to identify what lessons we can learn. Here they are:
- A deposit is an unsecured loan to a financial institution. Your money moves onto their balance sheet and you only get your money back if the bank remains solvent.
- Government backed insurance schemes ensure you get your money back if banks and some other financial firms fail. There is a limit, for example, the UK’s FSCS guarantee on deposits is only up to £85,000. However, this limit is per person, per banking group3 so one person who holds £85,000 or less at two different banks would still get all their money back if both were to fail.
- Diversification is critical to managing risk. For those with cash, diversifying it between banks or via a money market fund should be an important consideration and advice should be sought where necessary. CFO’s of these tech start-ups, and those of the venture capital firms, should have known better.
- The other aspect of diversification is at the security level. SVB has a global market capitalisation of around 0.03%, which is an insignificant amount in a diversified, systematic portfolio.
- Never assume that all financial institutions are smart. The age old mistake of borrowing short and lending long has brought down many institutions over the ages, not least Northern Rock in the UK during the Credit Crisis of 2007-9. Many institutions regrettably pumped client money into Bernie Madoff’s multi-billion dollar Ponzi-scheme fraud through insufficient due diligence. More recently, many high-profile firms backed Sam Bankman-Fried’s now-collapsed FTX exchange in crypto-world (another area where a lack of swimming trunks is rapidly being revealed).
A systematic investment process can protect you from many risks, not least through broad diversification. Whilst the market’s tide will always ebb and flow, at least you know that you are swimming with your trunks on!
Risk Warnings:
This article is distributed for educational purposes for UK residents. It should not be considered investment advice, an offer of any security for sale nor a recommendation of any particular security, strategy, platform or investment product. This article contains the opinions of the author but not necessarily the Firm. Information contained herein has been obtained from sources believed to be reliable but is not guaranteed.
1 https://www.visitliverpool.com/things-to-do/another-place-by-antony-gormley-p160981
3 What we cover | Check your money is protected | FSCS
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