March 12, 2023 | ModernFi Insights
Periods like this are a stark reminder of the vital role banks play in the U.S. economy. The failure of Silicon Valley Bank (SVB) has the potential to hamstring entire industries, thousands of companies, and hundreds of thousands of jobs.
The ModernFi team is working around the clock to help our bank partners:
Sweep unanticipated, large inflows off balance sheet as needed
Provide sweep accounts with extended FDIC insurance to depositors in order to retain funds
Source insured deposits to shore up liquidity and diversify funding
If anyone on this thread knows an institution that needs the above, feel free to send them our way, and we will get them spun up in a couple of days. You can reach out to our leadership directly at firstname.lastname@example.org. Our goal at ModernFi is to ensure the stability and health of banks of all sizes.
This off-cycle letter is longer than our usual notes. Our aim is to provide clarity into the events of previous days and provide guidance for what folks can expect moving forward.
Table of Contents
The background on SVB
SVB’s bank run and the increased volatility of deposits
Game theory and the Depositor’s Dilemma
Liquidity seesaw creates a perfect storm
The risk of contagion and crisis moving forward
Flight to oligopoly and the impact on community banks
Regulators’ response and the steps that banks can take
1. The background on SVB
SVB, the nation’s 16th largest bank, provided banking services to roughly 50% of US venture-backed companies. SVB’s deposit base grew rapidly in recent years driven by increased activity in tech and venture. In 2021, the bank used excess funds to purchase a large amount of long-dated MBS — a conservative investment, but one that locked them in to earning low yields. As interest rates rose rapidly over the past year, deposits began running off from SVB, and SVB’s tech clients continued to burn through their deposits.
As interest rates rose, the value of their MBS portfolio fell (fixed income prices fall as yields rise). The bank did not want to sell the securities and realize the loss. On Wednesday evening, the bank announced that it had sold a portion of its securities portfolio (essentially all of its available-for-sale securities), likely to free up liquidity to cover withdrawals. In doing so, it booked a $1.8bn loss. SVB’s stock fell ~30% after hours following the news.
Going in to Thursday, the main concern was that a bank run would force SVB to sell its remaining securities to cover additional withdrawals. As of their Q4 2022 call report, SVB held $91bn in held-to-maturity MBS, which, if sold, would realize a $15bn loss. The loss would be roughly equivalent to SVB's capital cushion, which was $15.4bn. If losses exceeded capital, then the bank would be insolvent (liabilities > assets).
SVB, like most banks, would be fine if only a few folks pulled funds but would be in deep trouble if everyone pulled. Unfortunately, SVB had three distinct characteristics that made large outflows more likely:
SVB's deposit base is highly concentrated in businesses (startup, venture, and corporate) that hold balances far in excess of the $250,000 FDIC insurance limit.
SVB's deposit base of venture-backed companies and investors all talk with one another, which can spark coordinated outflows.
Given SVB’s asset portfolio, there was a non-zero chance it would be insolvent if it had to sell its securities.
2. SVB’s bank run and the increased volatility of deposits
On Thursday, SVB was subject to a bank run. $42bn of deposits were pulled from the bank throughout the day. At the close of business, the bank had a negative cash balance of $958 million and did not meet its cash letter with the Federal Reserve (source). Regulators determined the bank was insolvent and moved to take over. The FDIC announced that it had put the bank into receivership on Friday around noon.
SVB woke up on Thursday as a relatively healthy institution and went to bed insolvent.
As one friend aptly put it, “gone are the days when you had to go in person for a bank run.” Companies rushed to open new business bank accounts online, spinning up accounts in minutes / hours and initiating wires. We’ve talked about it before, but technology has made deposits – whether they are core, brokered, insured, or uninsured – less sticky. It is simply the new reality.
3. Game theory and the Depositor’s Dilemma
The point above
SVB, like most banks, would be fine if only a few folks pulled funds but would be in deep trouble if everyone pulled.
is a game theory problem.
In game theory’s simplest example, the Prisoner’s Dilemma, two prisoners have to decide whether to confess or stay silent. If both stay silent, they will serve short sentences. If one confesses and the other stays silent, the confessor will be set free and the silent one will serve a very long sentence. If both confess, they both will serve long sentences.
The prisoners would be best off if they cooperate and both stay silent. However, the Nash equilibrium of the problem, the solution where neither prisoner can improve their outcome by changing their strategy, occurs when both confess. Essentially, the stable outcome occurs when both prisoners confess and condemn each other.
Bank runs, unfortunately, look a lot like the Prisoner’s Dilemma. Should a depositor keep their funds at the bank or pull? All depositors would be better off if no one pulled funds, but pulling funds is the Nash equilibrium.
4. Liquidity seesaw creates a perfect storm
The economic history of SVB’s collapse will read pretty simply.
During the pandemic, deposits in the banking sector grew by a remarkable 35% from ~$15tn to ~$20tn, driven by fiscal and monetary stimulus. Deposits grew much faster than loan demand, and banks simply did not have a good place to keep the funds. Without enough loan demand and not wanting to keep the funds in cash earning ~0%, banks purchased large amounts of securities. These securities, which mostly included fixed income investments like MBS and Treasurys, were conservative investments but were subject to market and duration risk.
The Fed then increased rates extremely quickly. Rising rates result in 1) deposit runoff as deposits move to higher yielding assets, and 2) falling fixed income prices. So now banks with large securities portfolios are in a liquidity crunch and cannot sell their securities without taking a substantial loss.
This seesaw of liquidity put SVB in a dire situation.
5. The risk of contagion and crisis moving forward
The concern moving forward is that the balance sheet issues outlined above apply to a large number of banks, not just SVB.
However, the three points mentioned in the first section increase confidence that any panic will be contained to SVB. SVB was unique in its combination of 1) almost completely uninsured deposit base, 2) clients that are well connected to one another, and 3) potentially insolvent balance sheet.
Unfortunately, SVB is not unique in number 3). There are a decent number of banks that would be insolvent if they had to sell their securities portfolios. Some of these banks are already seeing their share prices come under pressure as investors start to worry.
Financial crises are caused by panic more than by fundamentals. If people panic and pull funds from otherwise stable institutions, the economy is in trouble. If people remain calm, we’ll be fine.
6. Flight to oligopoly and the impact on community banks
The main concern we have at ModernFi is that depositors will lose trust in their banking partners and move funds to the largest four banks in the country, which are often considered “too big to fail.” To put it bluntly, this would be terrible for the U.S. economy.
Oligopolies leave consumers worse off. Depositors get near zero yields from the largest banks, and the banks often overlook certain areas and populations, leaving entire communities and sectors underbanked or unbanked. Community, regional, and midsize banks play a fundamental role in our economy by serving their neighborhoods with attentiveness, reliability, and care.
Consolidation of power in the hands of fewer, larger banks and the diminished number and importance of community banks would reduce options for depositors and restrict credit to borrowers, negatively impact our communities and our economy.
7. Regulators’ response and the steps that banks can take
Regulators need to more quickly and decisively to return depositor funds and suppress fears of contagion. The FDIC is fortunately brutally efficient when it comes to insured deposits, and insured depositors will have access to their funds no later than Monday morning. Uninsured depositors will receive a partial advance dividend this coming week, and regulators will likely provide additional clarity on uninsured deposits in the coming hours / days.
We expect uninsured depositors will ultimately get back a large amount, if not all of their funds; the FDIC and other agencies will either find a buyer for the claims or will move to sell assets and return funds. However, the timing is key. Weeks might be too long for companies that need to meet payroll, vendor bills, and other expenses.
The Fed, which is tasked with financial stability, will also be heavily involved moving forward. Any sign of contagion across the banking sector, which would spread between banks with underwater securities portfolios, would prompt the Fed to take action. The Fed could simply cut interest rates, which would immediately increase the value of banks’ fixed income portfolios. However, given the pace of inflation, rate cuts remain very unlikely unless signs of a true crisis emerge.
Moving forward, banks should
Increase liquidity and funding diversification as needed, either through traditional or wholesale channels
Sweep excess funds off balance sheet as needed instead of taking on more duration risk
Move to reassure depositors and offer deposit accounts with extended FDIC insurance through a sweep program
Reanalyze their deposit base to understand stability and diversification of funding
Raise more capital as needed in case of unrealized losses
The ModernFi team is working to help banks across the country with their balance sheet management. ModernFi’s deposit marketplace was built to help banks navigate volatile periods with speed and accuracy, and can directly assist with the first four points above by
Sourcing insured deposits for banks through the marketplace to diversify funding and provide liquidity on tap
Sweep excess deposits off balance sheet through the marketplace instead of purchasing securities that directly increase interest rate risk
Offer accounts with extended FDIC insurance to depositors where deposits are allocated to multiple receiving banks through the marketplace
Utilize ModernFi’s deposit analytics to understand stability and runoff risk at the account level
Quick, calm, and decisive action from regulators and institutions will contain this situation. The fearmongering and finger pointing on Twitter and other venues is childish. Emotions caused this problem, and now it's time for unemotional people to step up and solve it.