I have been following the recent collapse of several banks with great interest.
We had the largest US bank failure since the Global Financial Crisis (GFC) in the late 2000s.
Silicon Valley Bank (SVB), Signature Bank, and Credit Suisse have all experienced significant setbacks, leading to increased concern for the global banking industry.
In this article, we’ll break down the events leading to these failures.
Recent Bank Failures:
On March 10, SVB was closed by regulators, marking the second-largest bank failure in US history. Soon after, on March 12, state regulators in New York closed Signature Bank. And on March 19, the Swiss National Bank helped facilitate the purchase by UBS—Switzerland’s largest bank—of Credit Suisse.
Credit Suisse Troubles:
Credit Suisse, Switzerland’s then second-largest bank, had been showing worrisome signs for some time. A myriad of scandals and issues, including frequent management turnover, massive investment losses, regulatory changes, and an increasingly difficult environment for banks, brought Credit Suisse to the brink of failure.
The final straw came when their largest investor, the Saudi National Bank, declined to provide a much-needed capital infusion. This led to UBS purchasing Credit Suisse for $3.1 billion.
SVB and Signature Bank Collapses:
I was particularly interested in the collapses of SVB and Signature Bank, both of which catered to tech and venture capital clients. These banks offered relatively higher rates on deposits compared to larger rivals, which they funded by buying longer-term, higher-yielding bonds when they had excess cash.
However, when the Federal Reserve (Fed) began aggressively hiking rates and the venture capital market experienced turbulence, the value of these bonds decreased substantially, leading to large investment losses.
This situation was further compounded by lower deposit levels and looser lending standards.
SVB reported a staggering $1.8 billion loss in asset sales, leading to a rapid withdrawal of deposits by customers and ultimately the seizure of the bank by regulators. Signature Bank suffered a similar fate as panicked clients withdrew their funds following SVB’s failure.
How This Crisis Differs From 2008:
In the Great Financial Crisis of 2008, the main problem was poor credit quality due to sub-prime mortgages made to people who couldn’t afford to pay them back. However, the current crisis is different, and the root cause is rising interest rates, which is reducing the value of long-duration bonds.
It’s important to note that if banks hold these bonds to maturity, they will receive the full amount they initially invested. The reason these bonds are currently trading below their par value is because of the current high-interest rate environment.
Consider two bonds, Bond 1 and Bond 2, with the following characteristics:
Bond 1:
- Par value: $1,000
- Coupon rate: 3% (annual payment)
- Time to maturity: 5 years
Bond 2:
- Par value: $1,000
- Coupon rate: 5% (annual payment)
- Time to maturity: 5 years
As the central bank increases interest rates, new bonds are issued with a 6% coupon rate, causing the market prices of Bond 1 and Bond 2 to drop to $920 and $980, respectively.
As these bonds near maturity, their market prices gradually rise, eventually converging back to par value. For instance, with one year left to maturity, Bond 1’s price might be $980, and Bond 2’s price might be $998. At maturity, bondholders receive the full par value of $1,000.
The issue arises when depositors start to withdraw their funds from the bank, as banks may be forced to sell these long-duration bonds that are currently trading below par value. This means that banks would have to sell the bonds at a loss, which could put significant pressure on their balance sheets.
Therefore, it’s crucial for banks to maintain a high level of confidence among depositors to avoid a bank run. This is why it’s important for regulators to step in during times of crisis to help restore confidence and ensure the stability of the banking system.
As an investor, it’s essential to understand these dynamics and be aware of the risks involved. It’s crucial to keep an eye on interest rates and how they might impact the value of long-duration bonds. It’s also important to keep an eye on any potential signs of depositor withdrawals, as this could have a significant impact on a bank’s balance sheet.
Banks and the Confidence Game:
Confidence is a crucial element in the functioning of banks. Banks rely on the trust and confidence of their depositors and investors to keep their businesses afloat. Without this trust, a bank could suffer from a bank run, which is a situation where a large number of depositors simultaneously withdraw their funds from a bank, often due to concerns about the bank’s financial stability.
In the past, a bank run could take time to spread, as depositors would have to physically go to the bank to withdraw their money. However, with the advancement of technology, it is now easier than ever for depositors to transfer their funds in and out of bank accounts, making a bank run much easier to initiate and spread.
During a bank run, a bank’s liquidity can quickly become depleted, making it difficult for the bank to meet the withdrawal demands of its depositors. If the bank fails to satisfy these demands, it can lead to a complete collapse of the bank, as the trust and confidence of its depositors is irrevocably lost.
Therefore, it is crucial for banks to maintain their reputation and ensure that depositors and investors have confidence in their ability to weather economic storms. This can be achieved through various means, such as maintaining a strong balance sheet, having effective risk management strategies, and building relationships with key stakeholders.
Buffett on Investing in Banks
Investing in strong and well-capitalized banks is a key principle to keep in mind while investing in the banking sector.
Billionaire investor Warren Buffet has long emphasized the importance of investing in banks that have strong balance sheets, conservative underwriting standards, and a competitive advantage. Buffet is known to look for banks with strong deposit bases and that are located in markets with favorable demographics, economic conditions, and regulatory environments.
Buffett’s investment philosophy centers around seeking out high-quality businesses with a durable competitive advantage and a long-term growth potential. He seeks to invest in businesses with a strong management team, a history of consistent profitability, and a solid balance sheet. These principles can be applied when investing in banks as well.
Survival of Strong Banks in the 2008 Financial Crisis
During the 2008 financial crisis, banks with stronger balance sheets such as JPMorgan Chase and Wells Fargo were able to withstand the economic turbulence and even acquire weaker banks at a discounted price. For instance, JPMorgan Chase acquired Washington Mutual, which had faced severe losses due to the subprime mortgage crisis. Similarly, Wells Fargo acquired Wachovia, which was struggling with significant losses in its mortgage portfolio.
On the other hand, weaker banks such as IndyMac and Bear Stearns were unable to weather the financial crisis and were either forced to merge with stronger banks or go bankrupt. For instance, Bear Stearns was acquired by JPMorgan Chase, while IndyMac was seized by the Federal Deposit Insurance Corporation (FDIC).
As a result, the 2008 financial crisis led to the emergence of larger, stronger banks such as JPMorgan Chase and Wells Fargo, which were better equipped to handle future economic downturn
In the next article, we’ll take a closer look at Singapore banks and how they have weathered past economic crisis.
