For most Americans, the last time anyone was worried about their bank was during the 2008-09 Great Financial Crisis. Since then, our country has had relatively remarkable stability within the banking industry. While some banks have failed since that time, none have matched the gravity or size of the Silicon Valley Bank (SVB) failure on March 10, 2023.
While there certainly has, and will likely be, continued fallout from the actions taken by the FDIC and the Federal Reserve since SVB’s failure, this post will focus on the basics of banking and why SVB and Signature Bank’s failures are more likely the result of poor management and less of a wider problem with banking as a whole.
The Important Relationship Between Bond Prices and Interest Rates
First, let’s talk about how bonds work. A bond is issued by the government or corporation with an interest rate attached to it. Investors can buy this bond and earn the interest rate for as long as they own this bond. Say a bond is issued for $100 and pays 2% interest every year. The owner of that bond will earn $2 each year, all else equal.
Now let’s assume a year later another bond is issued at $100 and pays 3%. Most investors would prefer that 3% bond to the 2% bond. The owner of the 2% bond would like to sell that bond and buy the bond paying 3% each year. In this scenario, investors would pay more for the 3% bond because it’s delivering more income for its owners than the 2% bond. Separately, because the 2% bond is less attractive, the value of the bond will likely fall because more attractive bonds are available.
This scenario describes exactly why when interest rates increase, bond prices fall. For people who don’t already own bonds, they may view rising interest rates with open arms because they are able to earn more by buying a new bond at the higher rate.
Unfortunately, the opposite is true if you already own bonds during a period when interest rates rise. The value of those bonds will decline as more attractive interest rates enter the market for new investors to purchase. Keep this relationship in mind while we move on to our next topic: Banking basics.
Understanding Banking Basics
Fundamentally speaking, a bank serves two purposes: Take in deposits and make loans. Taking in deposits is relatively straightforward. A new client comes to your bank with $100 in hand and they say, “Please keep my $100 safe so I can use it later for gas and groceries.” And you say, “Sure, will do!”
The second function of a bank is to make loans to people who don’t have enough cash to buy things outright like home improvement projects, new cars, etc. Banks, by and large, are generally good at determining the correct amount to lend to people based on their credit scores and can earn money by charging an interest rate on these loans.
However, if the bank has $100 in deposits it won’t often make $100 in loans. This is because the bank’s customers will want to withdraw some of their money occasionally to buy gas and groceries. Therefore, banks will often keep some of this cash on hand in the bank so the clients don’t become unhappy when they can’t access their money. In this example, let’s say that’s $20.
Over the past 15 years, interest rates on banking deposits have effectively been 0%. This is because the Federal Reserve has had an interest rate policy keeping rates at or near 0% this entire time. If you’re a bank CEO and you have $20 of cash sitting around you may think to yourself, “How can I earn a little bit of money on this cash while I wait for my customers to use it to buy gas and groceries?” Well, the most common answer to this question is that the bank takes most of that money, say $18 of it, and buys bonds that yield more than 0%! (Here’s where bond pricing comes into play.)
Running on a Bank
So, we have our bank that has $80 of loans outstanding, $18 in bonds, and $2 in cash to offset the $100 of deposits our customers gave us to keep safe. Over the last 12 months, the Federal Reserve has gone on an aggressive interest rate hiking campaign to stave off inflation. When interest rates go up, what does that mean for bonds? Bond prices go down! And when interest rates go up really fast as they have in the past 12 months, bond prices tend to go down really fast too. Now our bank’s $18 in bonds may look something like $15.
The problem now is our bank only has $97 to cover our customer’s $100 in deposits. If our customer notices this when our bank reports our financial results every quarter, they may get scared and say, “Hey Bank! I want my safe $100 back.” And you, as the bank CEO, may say, “Oh, umm, about that, we invested some of your money and we don’t have enough to give you your $100 back so we’re going to have to close, and let the FDIC take care of the rest.”
And that’s when you turn the sign on your front door from “Open” to “Closed” and hope the regulators and congress don’t claw back all of the bonuses you gave yourself over the last 15 years.
This is, in a very simple example, what happened to SVB and Signature Bank. The management teams at those banks bought too many bonds that fell too far in price and couldn’t successfully cover the massive customer deposit outflows over a very short period of time.
The reason we feel that this issue is isolated to a small percentage of banks as opposed to the banking industry as a whole is because, relative to other regional and national banks, SVB and Signature Bank took on a significantly larger proportion of risk with their bond investments and did little to manage that risk in the face of rising interest rates. Most other banks keep more cash on hand, manage their risk more conservatively, and are able to manage their deposit flow better than SVB and Signature.
If you would like to get a second opinion on how to structure your investments in these uncertain times, please call us at 866-832-1173 or schedule an appointment by clicking a link below.
Securities offered through LPL Financial, Member FINRA/SIPC. Investment advice offered through Great Valley Advisor Group, a registered investment advisor. Great Valley Advisor Group and Bernicke Wealth Management are separate entities from LPL Financial. Content in this material is for general information only and is not intended to provide specific financial or tax advice recommendations for any individual.
