Markets
Silicon Valley Bank failure highlights importance of portfolio diversification
By Jason Crumley 22 March 2023 7 min read
The rapid collapse of Silicon Valley Bank (SVB) facilitated fear in the US financial sector as people raced to banks across the US to withdraw both their personal and business deposits. On March 10, 2023, the Department of Financial Protection and Innovation in the State of California issued a press release indicating it had taken control of SVB due to inadequate liquidity and insolvency and the Federal Deposit Insurance Corporation (FDIC) was appointed as the receiver.
This marks the largest US bank failure since the collapse of Washington Mutual during the global financial crisis in 2008. While some have drawn comparisons to that event, we lend some insight on what makes the SVB collapse different. What both events highlight is how important diversification is. As an investor, a diversified portfolio should include different asset classes, geographies, and sector allocations to mitigate the risk associated with declines in one or more sectors. For example, while the financial sector was down considerably during the collapse of SVB, the information technology sector rallied and provided a positive offset to the losses experienced in the financial sector.
Background: 2008 financial crisis and the introduction of the Dodd-Frank
The collapse of the stock market during the global financial crisis in 2008 triggered subsequent events that devastated investors and consumers, and eroded trust in the banking system. US banking reforms ensued, leading to the creation of the Dodd-Frank Wall Street Reform and Consumer Protection Act that was signed into law by President Barack Obama in 2010. Both of these dramatically increased regulatory oversight on the banking system. An important component of Dodd-Frank was a Federal Reserve financial stress test regularly conducted on all banks with more than US$50 billion in assets. At the time Dodd-Frank was signed into law in 2010, SVB’s total assets were under US$20 billion and not subject to the additional regulatory stress testing, but its reputation was growing along with its technology clients. Fast forward to 2017, SVB had grown to over US$50 billion in total assets and had already started lobbying efforts to change Dodd-Frank’s “too big to fail'' threshold. SVB and others were successful in their efforts and in 2018, President Trump signed a bill changing the Dodd-Frank act. Arguably the most notable part was the stress testing total asset threshold increased from US$50 billion to US$250 billion paving the way for lighter regulations on SVB’s rapidly growing asset base.
Silicon Valley Bank total assets
Source: Bloomberg
Background: Silicon Valley Bank
SVB was headquartered in the technology hub of Santa Clara, Calif. and focused its business on the technology and health sciences sectors, providing commercial clients with general banking and venture capital funding, along with broader investment banking services. This involved helping entrepreneurs with seed capital and helping clients with banking and advisory services through the challenges of growing a business. Some successful business clients of SVB remained private and some needed wider access to growth capital and were taken through the initial public offering process, which added to the tremendous growth of SVB.
A timeline of events
In early March, the Department of Financial Protection and Innovation in the State of California and the Federal Deposit Insurance Corporation (FDIC) stepped in to help the failed bank return customer deposits.
March 8, 2023
SVB issued a press release and provided a mid-quarter updated presentation announcing it was taking, “strategic actions to strengthen our financial position.” To do this, the company attempted to raise US$2.25 billion through a secondary offering of shares along with selling “substantially all of our Available for Sale (AFS) securities portfolio.” This portfolio included an after-tax loss estimated to be US$1.8 billion on the sale of US$21 billion in bonds, with an average yield of 1.79%. These bond portfolios suffered steep losses as interest rates continued to climb in 2022.
Goldman Sachs was hired to find investors for the secondary offering and failed to do so, marking a pivotal moment for SVB.
March 9, 2023
With little interest from investors during Goldman’s efforts the prior evening, SVB explored the potential of selling the company. Meanwhile, commercial clients of the bank reacted by “initiating withdrawals of US$42 billion in deposits from the Bank on March 9, 2023, causing a run on the Bank” according to documents filed with the Department of Financial Protection and Innovation in the State of California. According to SVB Financial Group’s regulatory 10-K filing, the company had US$173 billion in deposits at year-end 2022 implying nearly a quarter of the bank's total deposits were withdrawn in a single day. This left SVB and government regulators with no choice.
March 10, 2023
The Department of Financial Protection and Innovation in the State of California issued a press release indicating it had taken control of SVB due to inadequate liquidity and insolvency and the Federal Deposit Insurance Corporation (FDIC) was appointed as the receiver. Concern started to grow as the $250,000 maximum protection under the FDIC only represented a fraction of what most businesses had deposited with SVB.
March 12, 2023
Fear continued throughout the weekend as New York-based Signature Bank experienced significant withdrawals prompting the FDIC and the US Treasury, Federal Reserve to announce that depositors of both SVB and Signature would have full access to their deposits. The challenges at Signature Bank increased fears that contagion was occurring in the financial sector.
March 13, 2023
Moody’s Investor Services downgrades the US financial sector from “stable” to “negative.”
March 14, 2023
Wells Fargo files a prospectus with the US Securities and Exchange Commision to raise up to US$9.5 billion to improve its capital position.
March 19, 2023
UBS acquires Credit Suisse in a deal facilitated by the Swiss government and banking authorities at a significant discount to its recent share price. In an unprecedented move, the deal is pushed through without shareholder approval.
Investors have a variety of questions
While reviewing SVB’s financial statements and regulatory filings, the company had an unusually large amount of investment securities relative to the size of an asset base that experienced significant growth over the last five years. These investments in yield-bearing instruments dramatically declined in value as interest rates rapidly ascended in 2022. This significant decline in the value of SVB’s investments raised concerns from ratings agencies such as Moody’s and S&P and prompted SVB to sell its AFS portfolio and look to raise additional capital through a secondary offering in an effort to keep its ratings. The unsuccessful capital raise followed by a loss of confidence and a run on deposits the following day contributed to SVB’s failure.
Another question is the lack of proper governance and oversight during a rapid rise in interest rates. According to SVB’s most recent proxy material, the company was without a chief risk officer (CRO) from April 29, 2022 to when its new CRO was appointed on Jan. 4, 2023. In that same time, interest rates on the US 2-year treasury increased 61% from 2.71% to 4.35% compared to an average yield of 1.79% on its recently sold AFS investment portfolio. SVB was without key oversight in what was the most volatile interest rate period in the last decade.
Contagion risk is also on the mind of investors as we assess the recent acquisition of Credit Suisse by UBS. While we can’t ignore the magnitude of such a transaction, it is important to understand the challenges faced by Credit Suisse over a number of years. Back in 2020, the bank was at the centre of the Archegos Capital downfall, which saddled Credit Suisse with a US$5.5 billion loss. Additionally, in its recent 2022 annual report published in March 2023, Credit Suisse identified “material weaknesses” over internal controls in financial reporting.
Investors are now asking how these cracks in the banking system could potentially influence the US Federal Reserve’s approach to interest rates and if these banking concerns will lead the Fed to change its interest-rate path.
Portfolio diversification mitigates risk
Risk comes in a variety of forms and unlike the global financial crisis of 2008, it wasn’t subprime lending or elaborately packaged mortgage-backed securities and complex derivatives that pushed SVB to fail. In the case of SVB, its downfall was arguably facilitated by a mismanaged balance sheet coupled with a rapid decline in its investment portfolio triggered by a rapid rise in interest rates. This led to a loss of confidence in the bank and a staggering 24% of total deposits withdrawn in one day. The collapse of Silicon Valley Banks, Credit Suisse and others will likely lead to regulatory changes in the banking system. In both these cases, the risks were widely unanticipated leaving investors wondering what the best course of action was.
While there is investor concern over the broader implications to the financial sector, it's important to remember that SVB was a unique bank in a niche market. It is also important to remember the benefits of diversification. Ensuring portfolios have broad sector and geographic diversification will serve to minimize volatile equity movements that are sometimes based on fear or speculation. Additionally, even sectors that are traditionally less volatile can experience “black swan” events highlighting the importance of a sufficiently diverse portfolio to limit the risk of over-concentration.
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