What has happened? Silicon Valley Bank (SVB) Financial announced yesterday that it was raising capital following losses from the sale of its AFS (available for sale) security portfolio to meet increased deposit outflows. Both deposit outflows and losses on securities, due to a sharp rise in interest rates, have been a worry for a while but the ‘shock’ of the announcement from what was a generally well-regarded bank provided the catalyst for broader worries, such as the failure of Silvergate Capital, a bank focused on a cryptocurrency client base.

Concerns are now focused on the following:

Deposit outflows: The key catalyst remains deposit outflows and although there is evidence of broader pressures (it is a usual US cyclical trend that depositors move their bank deposits to better- paying money market funds in periods of higher interest rates), SVB was very much an outlier on this issue because of its narrow focus on early-stage PE/VC backed companies. These are natural cash burners given limited profitability, with fresh capital raised finding its way into the coffers of SVB as deposits. Thanks to the impasse between seller and buyer expectations, VC funding has dried up as haircuts have not been sufficient to entice new funding; therefore, to meet deposit redemptions SVB has had to liquidate its AFS securities portfolio.

There is always the risk of broader systemic risk – although we suspect regulators would intervene before this happened, and do not forget FDIC (Federal Deposit Insurance Corporation) guarantees. US bank balance sheets are considerably more liquid given the plethora of new regulatory requirements, such as the liquidity coverage ratio (LCR), net stable funding ratios (NSFR) and annual stress tests that determine capital level. Worries are greatest for smaller banks since during a crisis large banks often see deposit inflows because of a ‘flight to safety’ mentality. Please also note that the banks saw arguably exceptional deposit inflows during Covid so this could be viewed as a period of normalisation.

Securities losses: Most of our time is spent worrying about loan-book quality but the securities book is currently in the spotlight. Rising rates have resulted in falls in the value of bond holdings which had increased during Covid since liquidity/deposits needed to be parked somewhere. To meet the deposit outflows, banks such as SVB are being forced to sell these at a loss and this is impacting profits/capital. Again, SVB was an outlier which saw its deposit base nearly triple from pre-pandemic levels, from $62bn at the end of 2019 to $173bn, which were mostly invested in the securities portfolio at a time when longer rates were significantly lower resulting in large losses on these bond holdings. It is also worth noting that accounting plays a role here, with only securities held in AFS subject to immediate losses, while HTM (held to maturity) securities do not need to be sold although we suspect investors will, in the short term, also look at these.

What about Europe and Asia?: Bank stocks globally have fallen today [10 March] but it is worth pointing out that elsewhere bank depositors tend to stay with major banks for reasons of safety (government-backed deposit guarantees) and a poor choice of alternatives (would you take out your deposits from Lloyds Bank and place them with a digital bank during a crisis?). Furthermore, following a sustained period of regulatory tightening following the global financial crisis, European banks have significantly strengthened their funding positions, reflected in a reduction in their loan/deposit ratios (90% now compared to 125% in 2007) and a liquidity coverage ratio of 162% (high-quality liquid assets versus net liquidity outflows during a 30-day stressed period), well above the minimum 100% and 136% sector figure reported in 2016. Given excess liquidity and limited levels of loan growth (2-3% year-on-year) we do not expect European banks to be forced sellers of bonds and consequently see a limited read-across from yesterday’s announcement by SVB. We suspect small banks everywhere might come under limited pressure but outside the US they tend to run their balance sheets more cautiously for this specific reason and the more limited access to bond funding. The ‘sympathy falls’ in European and Asian bank stocks today look excessive in the context that rate rises have been more subdued.

Implications for our portfolios: Our Polar Capital Global Financials Trust (PCFT) and Polar Capital Financial Opportunities Fund had already seen material falls in their US bank exposure since this time last year (-12% and -15% in PCFT and Financial Opportunities respectively), most of which was in US small and mid-cap banks on the expectation that their rise in margins from higher rates was reaching a peak. We have not made any adjustments to our larger US bank exposure (or banks in Asia and Europe) since systemic liquidity risk often provides them with an influx of new deposits. That is the space where we might add to holdings.

Update: Silicon Valley Bank was closed by the California regulator on 10 March after announcing it had failed to raise capital.