Last Friday, an obscure regional bank failed. It was Silicon Valley Bank, headquartered just south of San Francisco in an area renowned as the Technology Center of the World.
Friday was a historic day for the little Bank. A classic bank run had begun. The New York Post reports that several notable Venture Capitalists appeared at the Bank’s Manhattan Branch early that morning, demanding to get their money out. Some of those present were rumored to be founders of the Bank.
By that afternoon, the Federal Deposit Insurance Corporation, State Bank Regulators, and representatives of the Federal Reserve closed the Bank. Doors were locked, with the promise that the FDIC would begin making deposit distributions on Monday.
Silicon Valley Bank, or just SVB for short, was the first FDIC Institution to fail in over two years. But making matters more difficult for the regulators, only about a third of their accounts were FDIC Insured. Those other accounts were in those high-yielding instruments, like Certificates of Deposit, that did not carry the insurance. This gave depositors higher yield but exposed them to potential loss. A loss that’s now likely to be realized with the Bank’s failure.
But before you write this off as just a tiny, remote bank failure, we need to take a second look at the impact of this failure. SVB had two distinguishing characteristics.
First, it was a commercial bank, as noted, the first such commercial Bank to fail in a couple of years. The reason few, if any, banks have failed is entirely due to the recent policy of the Federal Reserve. Beginning with the Financial Crisis of 2008, the Fed dropped the Bank’s cost of funds to near zero, and with free money, the banks flourished. It’s easy to be profitable when your costs are a 25 basis points.
However, all that changed last year as the Fed began its campaign against inflation. Like Captain Ahab and his battle with the “Great White Whale,” the Fed has focused on little else but their 2% target for inflation. At each FOMC meeting over the last year, its been one interest rate hike after another. The current Fed Funds target is 4.5–4.75%, with the Fed expected to raise that rate to 5% at their next meeting on March 22nd.
It has been one of the steepest rate hikes in history. And for banks like SVB, it has meant that their cost of funds has exploded from near zero to likely 5%. That will turn any Bank’s Income Statement upside down. And simply put, SVB couldn’t take it. Their income disappeared as they were forced to meet their steadily escalating financing costs.
We shouldn’t, for a moment, believe that SVB is alone. Every single Bank in the country has the same issue. Banks, which live on the spread between their cost of funds and their interest income, are being squeezed. Costs have sky-rocketed, while the interest received on their loans, for instance, has barely budged.
The result is that a marginally profitable bank, SVB, went out. And judging from their stock behavior on Friday, at least two or three other regional banks are facing similar troubles.
The second distinguishing factor for SVB is its clientele, Silicon Valley Capitalists. Throughout this growth cycle, it’s been Silicon Valley that has led the economy. A core of mega companies, Apple Computer, Alphabet/Google, and Facebook, have been central to the Valley’s success. Around them swirls a support group of subcontractors, Venture capitalists, and financiers of all kinds. It was this second group who were the clients of SVB.
Unfortunately, conditions have been slowing for those major Tech Companies. Earnings guidances have been lowered, staff layoffs have begun to appear, and international conflicts are beginning to upset their Supply Chain. China, in particular, is becoming increasingly difficult for the big Tech Companies.
And, as the saying goes, when those Big Guys catch a cold, the surrounding secondary companies catch pneumonia. Enough so that I’m sure we’ll find that some of their loans from SVB are not being serviced. And the combination of loan losses and higher capital costs likely took its toll on SVB.
So, here we have SVB, one of the strongest regional banks, serving the premier business community in the country, and yet it fails. It’s as vivid an indication as is possible that something is amiss in our financial system.
The Fed’s single-minded obsession with inflation, and its response in raising interest rates, just met a brick wall. The fact that these higher interest rates harm the entire banking sector ought to be evident to the Fed. The question is, will the Fed recognize these facts?
The answer isn’t apparent. This Federal Reserve has a hard time with course correction. Remember all those months that the Fed declared that inflation was just “transitory?”
SVB is the “canary in the coal mine,” a clear indicator that banks nationwide are struggling. Will the Fed see this and back off on their tightening? Or will they go on their merry way, cranking the interest rate knob, until the slow-down becomes unstoppable?
We’ll get the answer at that March 22nd FOMC Meeting.
Update: Sunday evening, the Treasury and the Federal Reserve created a special fund specifically to “bail out” the depositors of Silicon Valley Bank. Although Janet Yellen has gone out of her way to claim this is not a bailout, that’s just semantics. Take it to the bank. It’s a bailout.
Perhaps most significantly, analysts at Goldman Sachs now predict that there will be no more interest rate hikes. That is a complete reversal of the recent thinking on Wall Street and an indication of just how serious this crisis is. The Fed was bound to raise interest rates until “something broke.” Silicon Valley Bank just broke, and the scramble is now on to prop up the Banks.