Breaking Banks: Elements of a Modern-day Bank Run
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- financial stability
In the wake of the recent turmoil in the U.S. banking sector, we’ve taken time to explore what caused Silicon Valley Bank and others to fail. In this video, Peter Moirano, BMO’s Director of Liquidity Solutions, explains the key metrics and risk exposures business leaders should pay attention to in a banking partner to help protect themselves from the next crisis.
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Hi, I'm Peter Moirano, Liquidity Solutions Specialist here with BMO in the Commercial Bank. Given the recent market turmoil in the banking industry, we wanted to focus in on the failure of Silicon Valley Bank and take time to explore what caused the bank to break and to offer companies some guidance on what metrics they should be looking at to assess the counterparty risk of their financial institution.
Let's get into it. The first element we want to look at is liquidity. During the coronavirus pandemic in March of 2020, the world changed. Businesses were shut down, schools were shut down, and people were asked to shelter in place in their home and remain in their homes to avoid the spread of the global pandemic, the US government took two primary steps in responding to the shut down of the economy.
First, they dropped interest rates to the zero lower bound, effectively making access to money very cheap. And secondly, they created a bunch of stimulus, quite a bit of stimulus to put money into the economy to supplement the loss of business as a result of the shutdowns. $5.2 trillion were created and placed into the US economic system in order to support individuals and companies during this time of crisis.
Since then, as the pandemic has abated, the Federal Reserve has reversed course with their monetary policy and increased interest rates from 0 to 525 basis points. This is has had a tremendous impact on the economy and has a tremendous impact on the participants of that economy, specifically the banks that operate within that. And this was the first element and the first cause of the turmoil in the banking sector into 2023.
The next element we want to focus in on is how liquidity has impacted banks. And we take it back to the fundamentals and the fundamental balance sheet of how a bank works. On the right side of the balance sheet is where customer and client deposits sit for banks. These typically reside in three categories demand deposits. Think about your checking account, deposits that can be called immediately. Savings deposits, MMDA deposits, we call them on the corporate side. Or term deposits, certificates of deposits, deposits that mature over specific period of time.
When money comes in from the street, it typically lands into your bank account in one of these three types of deposits and are recorded on the liability side of the balance sheet. Banks then take this money and invest them into the asset side of their balance sheet. On the left hand side, we have loans, term loans, revolving loans, project finance loans, all kinds of loans that we turn around and place back out into the marketplace and put that cash from depositors to work. During the coronavirus pandemic, because there was so much stimulus pushed into the economy, the amount of loans that banks made shrank significantly.
There wasn't a lot of business to do. So what do banks do? Well, the next place they can put money is in their regulatory cash bucket. And we'll talk about this in a little bit. And the third place, they can place cash is in securities. These are equity government types of investments that mature over time that create income and create returns for banks.
So during the pandemic, it's important to remember the availability to make loans shrinks significantly because the government created stimulus. So primarily banks looked at taking customer deposits that $5.2 trillion and placing them into securities. This seems fine. However, we need to explore these securities to understand what went wrong specifically with Silicon Valley Bank. Now, typically banks invest in two types of securities. Government debt or equity securities and concentrate them in the most liquid securities, which are government securities.
Now, within those types of securities, there are two buckets. Available for sale securities, which are typically held for a long period of time and are earmarked to be put back into the marketplace and not held to maturity. The second type are held to maturity or HTM. This group of securities are intended to be held for the entire duration of their life and to be used as interest income for the bank. Available for sale
Securities typically are marked to market, which means their gains and losses are recorded on a quarterly basis. Held to maturity securities are typically not mark to market and this is where Silicon Valley Bank got in trouble. As we examine the securities portfolio of Silicon Valley Bank during 2022, we see a significant increase in the securities portfolio as a result of all that money being created and pushed into the system by the federal government.
Now, the way they manage their securities is what got them in trouble. As you can see, about 81% of Silicon Valley Bank’s securities portfolio were in held to market securities. So the intent was for them to hold on for the length and tenure of those securities and to receive the interest income. Only a small portion 9% were made up of available for sale securities.
Now, what happened with Silicon Valley Bank is that all of those deposits that they placed into securities, there was turmoil within the technology industry, which is a big industry for Silicon Valley Bank. And the customers, as interest rates rose, customers took money out and demanded that Silicon Valley bank return their deposits so they can go invest in their own securities, other types of investment vehicles. So they could take advantage of the rising interest rate environment.
But what happened was, at some point Silicon Valley Bank realized that they needed to dip into their securities portfolio, sell some of their securities in order to meet the demands of their customers. As they did that, this created a large loss for them at the end of February in 2023, which required them to go to the market and raise capital.
Once this happened, their customer base got nervous about the health and safety of their institutions and continued to draw down on their deposits. So more and more customers came back asking for their money, which required Silicon Valley Bank to sell more and more securities and incur more of a more of a loss. And they fell into a spiral.
So this is the real reason that was the demise of Silicon Valley Bank. Customers calling deposits, the need to unwind their security portfolio and which created losses for them, which they couldn't catch up on. Now, the next element and part of the problem with Silicon Valley Bank is concentration. Silicon Valley Bank was exposed to one specific industry, and that was the technology and biotech sector.
When they went to market to raise capital as a result of the losses from their securities, they put out information about the health and soundness of their organizations. The next couple of images we'll see are the specifics of what they put out during that period. They talked about their balance sheet and where their funds were, but we came to learned that 90% of their balance sheet was in securities and loans.
So not a lot of regulatory cash and a lot of securities that were underwater. The next element they put out was their loan portfolio. And on the surface, it looks like they have a well diversified loan portfolio. But when you dig into the specifics, you find out that 70% of their loans were to private equity and venture capital firms.
One type of customer. Their mortgage portfolio was primarily concentrated in the innovation economy and influencers or the technology sectors. 24% of their sensitive loan portfolio book was also to the tech and biotech industries. So when you unwrap the specifics of their loan portfolio, you see that they were primarily concentrated in one specific industry that revolved around their geographic location in Silicon Valley. If you look at their deposit portfolio, you see similar elements of concentration. Again, the image
likes to tell us that there are many different segments or industries that they were exposed to. However, when you dig into these things, you find it is all concentrated in one particular industry. Additionally, their deposit portfolio, the types of deposits that they held on the liability side of their balance sheet were also concentrated and most of them were uninsured.
So this means they were large corporate, they were all one industry and they were all market sensitive type funds. So this is the trigger that kicked off the run on deposits, which kicked off the need to sell securities, which kicked off the losses and put them into their spiral. Another element that Silicon Valley Bank had to deal with as a result of their concentration is that their customers were all connected on social media.
It took two days for Silicon Valley Bank to lose all of their deposits on their balance sheet, and that's because once one customer got spooked, they message out via social media that there was a problem with Silicon Valley Bank. That connected to thousands of other customers. And those customers turned around, turned on their computers and hit their withdraw buttons on their keyboards and deposits were sucked out of the bank
an extraordinary amount of speed. This has never happened before. It's something the regulators never planned on in the past. So the final element I want to talk about related to Silicon Valley Bank and what happened to them specifically has to do with regulations. In the United States, there are three primary buckets of regulatory supervision. The large and foreign banking organization group, which is banks have $100 billion in assets or more.
The regional banking organization, which regulates banks $10 billion to $100 billion, and the community banking organization, which regulates banks from $10 billion and below. Now Silicon Valley Bank, because of their exposure to the technology sector and because they were highly concentrated there, grew significantly during the boom years of technology. So Silicon Valley Bank from 2016 to 2019 grew from $90 billion in total assets and regulated by the regional bank organization, to over $200 billion in assets and becoming regulated by the large and foreign bank organization.
Now, with this shift over in supervision, the Federal Reserve admitted in their study on what happened to Silicon Valley Bank in May of 2023, that because of this transition, that some information wasn't passed and there was not a clean handoff between the organizations that in the supervision organizations that managed the regulations on this bank. So the Federal Reserve dropped the ball and they admit it and what happened shortly thereafter in 2020, less than a year after transferring to a new supervisor, the pandemic hit.
Supervisors were at home and it had a tremendous impact on the oversight of Silicon Valley Bank, resulting in the catastrophic failure in March. So this is where our story on Silicon Valley Bank ends. We've reviewed some of the elements that got them to the point of failure. As we know, during as a result of Silicon Valley Bank's failure, other banks started to feel a tremendous amount of pressure in the equity markets.
They felt a tremendous amount of pressure in their deposit portfolios. And, you know, we saw the failure of a couple more banks. First Republic Bank and Signature bank, all contagion as a result of contagion from the Silicon Valley Bank fallout. Now, this is where we also begin advising our clients and other companies about where to look for safety and soundness in the banking sector.
So we think about the banks that were under pressure during this time were banks that were under the $250 billion total asset threshold or Category Three banks. Now, why is that? This is because the types of steps from a regulatory perspective that banks greater than 250 billion need to take are extraordinarily restrictive. The rules were written post the financial crisis in order to prevent banks from becoming insolvent like they did back in 2008 & 2009.
So Dodd-Frank and global Basel-III regulations put new and strict regulatory requirements on the largest banks in the system in order to prevent a crisis like that from happening again. And what we saw during the market turmoil was that the banks that were subject to the strictest regulations were the ones that fared the best. So those regulations are working and were working during that time period, banks below 250 billion felt the stress and continue to feel the stress and see the deposit outflow for banks greater than 250 billion are not feeling the same.
The requirements underneath these regulations have to do with stress testing, leverage ratios, liquidity ratios, counterparty limits and capital ratios. And these are the elements where we ask our clients and prospects that we talk to, to look at, to assess the health and safety of their bank. And those banks that are heavily regulated are required to have stronger ratios than banks that are below. Another element
we advise our clients to look at are specifically the capital ratios. Now capital ratios and the CET1 or tier one common equity is the place where banks absorb their losses from first. So when there's trouble or there's issues, that component of capital is there to absorb those losses. It's really easy to find this information on any bank.
All you have to do is go to Google and type in “capital ratios investor relations”, and you'll be able to find the capital position of your financial institution. The FDIC states that a well capitalized bank is one that has a CET1 ratio of greater than 6%. And a question, we advise companies to ask their bank is in an adverse scenario
if you had to liquidate your securities portfolio, how does that impact your capital? The Federal Reserve stress test, which is another great place to look for information on your financial institution as a counterparty, has the results of a number of different adverse scenarios that the federal government puts banks under. To get to the answer of how this will impact capital, how it could impact revenue, how it could impact income, and what would be the results of banks taking severe loan losses.
So again, these stress tests were put in place as a result of the financial crisis in order to measure the health and safety of the largest banks in the system. All banks are not subject to stress tests. However, most banks do their own internal stress testing and do understand their capital position and will have this information readily available
if you ask for it. Another element that we advise customers to look at. Don't just take your bank's word for it. Ask a third party organization or a rating agency as to how they view a specific financial institution as a counterparty. So it's just as easy as going to Google typing in credit ratings on a specific bank, and you should be able to find independent ratings on a number of different elements from the four main rating agencies that are out there Moody's, S&P, Dun and Bradstreet and Fitch.
You can find ratings on financial institutions debt. You can find ratings on their portfolios, you can find ratings on their deposits as well. The final element, we ask our clients to look at when analyzing financial institutions is the portfolio. And again, going to Google and typing in loan portfolio for a specific financial institutions should yield easy and consumable results of how that bank goes to market and who they are exposed to in their loan portfolio.
So as we talked about, Silicon Valley Bank was heavily concentrated in one industry. That industry saw problems during the rising rate environment. That industry’s customers needed their cash, went to the bank and demanded it from Silicon Valley Bank. And because they were not well diversified and heavily concentrated, that caused the problem. You can go out and look at where is my bank, where is their customer base, where are their loans going to, where are their deposits?
I mean, are they exposed to a specific industry? You want to look for a well diversified multi industry portfolio on your financial institution in order to give yourself the comfort that if there should be a problem in a specific industry that your bank is not exposed and having knock-on effects from any trouble.
These are the primary elements that we've realized that caused the recent market turmoil and that can protect you from future market turmoil.
We appreciate your time spending with us today. Thank you very much.
Oscar Johnson
U.S. Head of Commercial Sales for Treasury and Payment Solutions
Oscar is the U.S. Head of Commercial Sales for Treasury and Payment Solutions for BMO Commercial Bank. His group is responsible for providing cash management, …(..)
View Full Profile >In the wake of the recent turmoil in the U.S. banking sector, we’ve taken time to explore what caused Silicon Valley Bank and others to fail. In this video, Peter Moirano, BMO’s Director of Liquidity Solutions, explains the key metrics and risk exposures business leaders should pay attention to in a banking partner to help protect themselves from the next crisis.
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