By Brian Reilly, CFA – Senior Municipal Advisor | Managing Director
and Tami Olszewski, CPFIM – Senior Investment Adviser
Understanding the SVB Failure and Protecting Public Deposits
Imagine it’s 1946 and you’re on the set of “It’s a Wonderful Life” …Depositors confront George Bailey outside the Bailey Building & Loan, demanding their money be returned. Mr. Bailey responds with a brief tutorial on the basic operating structure of banks, stating “You’re thinking of this place all wrong! As if I had the money back in a safe. The money’s not here. Your money’s in Joe’s house…right next to yours. And in the Kennedy’s house, and Mrs. Macklin’s house, and a hundred others.”
Fast forward to 2023 and you know that banks still fund themselves using deposits (liabilities) to buy assets (loans and securities) that yield more than they pay on their liabilities, earning the difference between the two. It’s essentially a borrow “short” and lend “long” strategy.
There is inherent risk in that model, which relies largely on a positive spread between long- and short-term rates, and perhaps more importantly the confidence of those lending the bank their money – namely its depositors. Just like Bailey Building & Loan, if all the depositors were to show up one day and demand to withdraw their money, there is no bank that keeps those funds “back in the safe.” Instead, the bank would need to liquidate assets to raise the cash needed to meet depositor demand. The key takeaway here is that the number one job of bank executives is to manage balance sheet risk, a critical factor that’s also monitored by a panoply of state and federal regulators.
What Happened with Silicon Valley Bank?
The added wrinkle to meeting depositor and regulatory mandates is that the assets of any bank fluctuate in value over time relative to prevailing market rates. This is where the executives of Silicon Valley Bank (SVB) of Santa Clara, California made fatal errors in managing the bank’s balance sheet. When SVB was flush with cash and rates were at all-time lows, the bank searched for yield, which required buying longer-dated securities that returned only nominally more than the near-zero short-term rates at that time. Further, SVB’s deposits nearly quadrupled from almost $50 billion in 2018 to just under $190 billion in 2021. SVB was the beneficiary of a cash bonanza in Silicon Valley, as money poured into venture-backed startups throughout the region.
However, SVB was not immune to simple math: when rates go up, the value of existing bonds (and fixed-rate loans for that matter) goes down, and in this case…way down. In November 2022, JP Morgan analysts noted a $16 billion unrealized loss in SVB’s securities holdings (primarily U.S. Treasuries and agency mortgage securities) that could pose a material risk to the bank’s ability to continue operating as a going concern. On top of that, the “tech boom” that had resulted in cash pouring into SVB’s coffers had “gone bust” in 2022, resulting in the demise of companies and dents in the fortunes of founders and financiers (i.e., SVB customers). To further compound the crisis, the Federal Reserve had embarked on its most aggressive series of increases to short-term rates in history, greatly increasing any bank’s cost of capital. Ultimately, on March 10, 2023, SVB became the second largest bank failure in U.S. history. The looming question immediately became “What would be the broader impact of SVB’s failure to the banking system at large?”.
Federal authorities quickly stepped in, with the Federal Deposit Insurance Corporation (FDIC), the Federal Reserve, and the U.S. Treasury making a joint statement on March 12. That statement made clear the FDIC was committed to protecting all depositors of SVB, even those with deposits in excess of FDIC coverage. The release also announced that the Federal Reserve would provide a lending facility to its member banks to ensure their liquidity needs could be met, since what transpired with SVB was more of a timing issue, rather than one of credit quality. The securities the bank owned would have been paid in full at maturity but were currently worth less than face value because of increases to interest rates. For the time being, it seems that further contagion within the banking system should be mitigated by these swift actions, providing a needed sense of calm among the nation’s depositors.
What Does This Mean for Public Funds Depositors?
For public funds depositors, this is indeed, a cautionary tale. Regardless of size, every governmental entity has a depository banking relationship. One of the most alarming aspects of the SVB failure was the speed at which it progressed. Early during the week of March 6th, SVB announced that it had liquidated a large portion of its securities portfolio – at a loss – to raise cash and that it would be additionally seeking a share offering to shore up its capital. On Friday, March 10th, the FDIC took over the bank, and by Saturday, it had established a receivership entity to sell the bank’s assets. As of Sunday, Federal officials had ensured depositors would be made whole.
The FDIC (and the National Credit Union Association) provides specific insurance limits to depositors, but many individuals and entities regularly carry balances beyond FDIC coverage. If you hold larger deposits in excess of what is covered by FDIC limits, it’s important to consider collateral. Collateral requirements vary by state, with some requiring over-collateralization and others requiring none at all. Even if your depository institution provides collateral coverage for amounts above insured balances, consider these questions:
- Are you certain that collateral has been sufficiently “perfected” for your benefit?
- Are you fully aware of what your bank has provided as collateral?
- Is the collateral provided an eligible investment under statute?
- When was the last time the collateral was valued, and that value presented to you?
- Who holds that collateral?
And perhaps the most seminal question is this: What would you do with pledged securities specifically, if you had to take possession of the collateral? Ultimately, you want cash. You can’t spend securities.
If the collateral pledged to you has not been properly perfected and you haven’t been regularly monitoring it, it’s unrealistic that you would be able to take the necessary actions to protect yourself in the course of a single business week. It’s also highly unlikely you would to be able to communicate with anyone at that depository institution if it were on the cusp of failure.
Governmental entities are meant to be perpetual; the funds you have entrusted to depository institutions have accumulated since your organization was established, and you are the stewards of those resources. You can and should exert control and influence over the protection of your depository assets. If this is something you may have neglected in the past, there’s no time like the present to reinvigorate your treasury management practices, and, perhaps, consult with your banker. In the meantime, please know that Ehlers’ Investment and Treasury Management professionals would be privileged to assist you if this is an area where you feel a practiced hand is now needed.
Please note: Our June E-Quarterly Newsletter will include a detailed article on the topic of perfecting and managing deposit collateral.
Resources: FDIC Insurance for Governmental Deposits https://www.fdic.gov/deposit/deposits/factsheet.html
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