2023-03-12 06:56:24 ET
Summary
- The collapse of SVB had much to do with ineffective risk management.
- However, the Fed (and other regulators) had a large part to play in this as well.
- Contagion is likely unless regulators provide a backstop.
- The large U.S. banks are safe and I am buying the dips.
- Other regional banks may be targeted next week, so tread carefully.
Regulators shut Silicon Valley Bank ( SIVB ) on Friday and seized its deposits in the largest U.S. banking failure since the GFC and the second-largest ever.
In this article, I will not repeat the full background and reasons for the collapse of SIVB. These are well-covered in articles like this , where I agree with the main conclusions of the author including that large U.S. Banks are safe.
Suffice it to say, the key reason for the collapse of SIVB is the "supposedly" safe liquidity portfolio held by the bank where unrealized losses in this portfolio were larger than its capital base. Clearly, management focused on the credit risk of the portfolio but took their eye off the ball when it came to duration risk. This is effectively banking 101 and the sheer incompetence in this instance at the 16th largest bank in the U.S. is somewhat alarming.
However, the key reason for the liquidity vulnerability of the regional U.S. banks, in my view, is due to flawed regulations. And I will explain the details below.
Understanding The Accounting For Hold-To-Maturity Securities Portfolios
It is imperative to understand the accounting treatment of the banks' hold-to-maturity liquidity portfolio. Any unrealized losses (e.g. from rising interest rates) do not impact net income or flow through the profit and loss statement. Instead, it is recognized in the balance sheet as Accumulated Other Comprehensive Line ("AOCI") in the equity line. This avoids the inherent volatility in the profit and loss, which makes sense, as the institution should be holding these assets to maturity. Except of course, where the banks experience a bank run and are forced to sell these securities. In this instance, the unrealized losses are crystalized and flow through the profit and loss.
The key issue of course is the treatment of such unrealized losses in the banks' capital adequacy framework and this is where it gets interesting.
The Capital Treatment Of Unrealized Losses on HTM portfolio
For the large U.S. banks such as Citigroup ( C ), Bank of America ( BAC ), JPMorgan ( JPM ), and Wells Fargo ( WFC ), these losses (reflected in the AOCI balance) are included in their capital ratios.
Citigroup's current AOCI balance is shown below from its latest 10-K :
The total balance is ~$47 billion and includes net unrealized losses on securities (~$6 billion as of 31st December 2022). Importantly though, it is included in Citi's capital ratios in accordance with the applicable capital adequacy framework.
As Citi explains in its 10-K, to avoid volatility in its CET1 ratios, Citi hedges its interest rates exposure:
Citi also measures the potential impacts of changes in interest rates on the value of its AOCI, which can in turn impact Citi’s common equity and tangible common equity. This will impact Citi’s CET1 and other regulatory capital ratios. Citi seeks to manage its exposure to changes in the market level of interest rates, while limiting the potential impact on its AOCI and regulatory capital position.
SVB Is Exempted From Capital Rules Applied To Large U.S. Banks
For smaller banks, the Fed has provided an exemption from including unrealized gains in their capital ratios. This effectively allows smaller banks to operate with much lower levels of capital than large U.S. banks.
So in the SVB example, the bank excluded unrealized losses from its capital base. If they applied the same capital rules as the large banks, they would have been insolvent for many months. Instead, they have been rated as "well-capitalized" banking institutions with the explicit blessing of U.S. regulators. The latest bank run simply crystallized these losses. The Fed's exemption also allowed SVB not to hedge its interest rates exposure since it wasn't concerned about any impact on its capital ratios.
Excluding AOCI from the capital adequacy computation does not make any sense in my view, these are real losses and not imaginary ones as we just found out. Take for example a 10-year duration paper that was bought in 2020 and yielded 1%, the bank may now be funding it with a 4% or 5% funding cost for the next 8-9 years.
In recent months, some market participants identified this risk and started shorting the stock. Eventually, management yielded and crystallized the losses on Wednesday last week and attempted to raise capital. All of a sudden, the penny dropped to some of the more savvy tech funds that this bank is insolvent and the bank run resumed in earnest.
Final Thoughts
I believe that the SVB management was clearly incompetent in managing duration risk in the bank. I suspect they focused on credit risk and forgot about the basic rules in banking about matching assets and liabilities.
However, this would not have been possible without flawed regulations. The Fed's regulatory exemption allowing the exclusion of AOCI from SVB capital calculation is incredibly short-sighted. The regulators are just as culpable as the SVB management in what transpired. Regulators should have identified that this bank has been insolvent for months and taken proactive actions.
The consequences are dire in my view and contagion is certainly possible if not likely unless the cavalry arrives and quickly. This is rapidly evolving into financial instability concerns and the Fed and FDIC are clearly aware of the risks and as reported by Bloomberg are considering various options.
I would stay away now from most of the regional banks and any other banks that are vulnerable to a bank run. These would include banks where the unrealized losses (AOCI) are higher than 15% of their capital base and where the deposit base is predominantly not insured by FDIC (deposits greater than $250k).
The large U.S. banks are safe in my view and I continue to buy the dips.
For further details see:
SVB Financial: Incompetence Allowed By Flawed Regulations