Capital Ideas^™ 
Investment insights from Capitals Express Investments

The sudden collapse of SVB Financial, a California-based bank focused on technology startups, has raised important questions about the health of the U.S. banking system and the government’s response to yet another crisis in the financial sector. Will additional small and regional banks face a similar fate? Are larger banks at risk? And will the U.S. Federal Reserve alter its expected rate-hiking path in response?

As these events are rapidly evolving, here are the current views of Capitals Express Investments analysts:

Over the weekend, U.S. regulators took action to protect all insured and uninsured depositors affected by the collapse of SVB (parent of Silicon Valley Bank) and Signature Bank (SBNY), a New York-based bank. Meanwhile, First Republic Bank (FRC) announced that that it has obtained additional liquidity from the U.S. Federal Reserve and JP Morgan.

Fed officials said they would also increase available liquidity to banks through a new facility — the Bank Term Funding Program. This facility will offer loans of up to one year to banks that pledge U.S. Treasury securities, mortgage-backed securities and other collateral at par. This means that banks can obtain liquidity without incurring the losses that come from selling Treasuries and agency mortgage-backed securities, which have declined in value as a result of rising interest rates. These actions were designed to limit the risk of further bank runs on small- and mid-sized banks.

That said, these actions essentially give affected banks a year to get their balance sheets in order. They do not remove the underlying loss created from rising interest rates; they just buy time for bank executives and regulators to manage it. The expectation is that the combination of deposit guarantees and the provision of liquidity will be enough to stem the contagion and avoid additional deposit runs.

As a consequence of these actions, the U.S. regulatory environment will likely tighten from here for small- and mid-tier banks. Regulators may require these banks to hold more capital, which in turn will structurally lower their profitability. Regulatory changes can be phased in over multiple years, similar to what we saw after the global financial crisis. 

The regional small- and mid-tier banks have generally traded at a premium to large money centre banks as they generated higher growth rates and are subject to lower capital requirements and less regulation. In addition to regulation, the events of the past week will likely lead corporate treasurers to rethink or possibly diversify their banking relationships. This dynamic could make it more challenging even for the best small banks to attract and retain deposits.

Big money centre banks are better diversified, well-capitalized, generally more liquid and subject to much more stringent regulations than small banks. The differences include much higher capital requirements, liquidity requirements, leverage limitations, frequency of stress testing and treatment of the mark-to-market securities portfolios — avoiding the kind of asset liability mismatch that brought down SVB.

The big banks, designated as Global Systemically Important Banks (GSIBs), do not present compelling valuation, in my view, and do not appear to be fully reflecting neither the risk of a recession in the U.S. nor the financial risks of a late cycle economy.

U.S. Treasury Secretary Janet Yellen, who is well-versed in crisis management, mobilized regulators over the weekend and on Sunday announced the Bank Term Funding Program (BTFP) as a backstop facility for depository institutions. This is consistent with the central bank playbook in times of emergency to err on the side of caution and go big.

In addition, the Fed statement said: "The Board is closely monitoring conditions across the financial system and is prepared to use its full range of tools to support households and businesses, and will take additional steps as appropriate." 

The failure of these sizable regional banks combined with the shock to the banking sector will likely accelerate the tightening of financial conditions, thus making an economic slowdown or an outright recession more likely.

In the near term, the Fed may take a 50-basis-point rate hike off the table. But if financial markets stabilize, I think the Fed will pivot back to inflation fighting. The central bank will want to separate liquidity operations from inflation progress. The recent strength in employment nonfarm payrolls shows that elevated inflation remains a significant risk.

The collapse of Silicon Valley Bank powered a rally in government bonds. The yield curve has steepened significantly with yields on shorter dated Treasuries falling more than those that are longer dated. The sharp decline in yields signals investors believe that financial stability concerns as well as the associated tightening of financial conditions may give the Fed the ability to end its aggressive hiking campaign to stem inflationary pressures.

The market, which had last week priced in a peak federal funds rate of 5.50%, has now priced in 4.75% as the peak — effectively saying we’ll have one more hike and then done. Credit spreads have widened as investors digest the potential impact of tighter financial conditions ahead and the greater chance of slower economic growth leading to a potential recession.

I agree that the Fed will likely delay rate hikes next week in the wake of these developments. When you’re looking at the prospect of more bank regulations resulting from this and other banks raising deposit rates to compete, it essentially translates to greater tightening of financial conditions.

This is a fluid situation, and credit spreads are widening given expectations of a weaker economy. We will closely watch developments over the coming weeks.

I don’t expect European banks to face the same crisis of confidence. Europe has a higher level of regulation that applies equally to small banks. Similar to the large U.S. banks, European banks generally have a more diversified deposit base and ample liquidity buffers.

From an operating standpoint the European banking sector is arguably in its strongest position since the global financial crisis. Capital ratios and profitability are at all-time highs. BNP, Barclays and UniCredit, for example, have all built up excess capital and have 15%-20% of their balance sheets in liquidity reserves.

In addition, most banks remain deposit-rich. The European Central Bank (ECB) regularly stress-tests banks to measure potential risk from higher rates on bank portfolios. European regulators have also signed off on dividend and share buyback plans. This suggests the ECB sees no major risks on the horizon.

SVB had a unique banking model, mainly serving customers in the venture capital community. Venture capital is less developed in Europe, and European banks generally have a well-diversified customer base. That said, in an environment of rising rates and quantitative tightening, unforeseen issues can emerge.

SVB’s failure will likely have a negative impact, at least in the near term, on startups and their venture capital sponsors. But I don’t see it as particularly disruptive to most public software firms and, broadly speaking, the large technology companies.

These companies do not bank primarily or at all with SVB, so there is limited or little direct exposure. Most graduate to bigger banks with scale and through relationships forged during capital markets events, including initial public offerings.

They sell primarily to large enterprise customers with startups being a small minority of their clients. As such, the indirect exposure through stretched receivables and reduced spending is minimal.

Most of the large tech companies are free cash flow positive and not reliant on potentially tied-up deposits, better enabling them to handle stretched out receivables from a minority of customers.