“People should be more concerned with the return of their principal than the return on the principal.” – Will Rogers
There is some news of a bank failure recently. How will this affect you?
The recent failure of three U.S. banks has raised concerns over the economy and financial system. The situation is still evolving and there is plenty of speculation as to what might come next. One recent development is that government officials from the Treasury, Federal Reserve, and FDIC have announced that depositors will be made whole to backstop the system and restore confidence. This crisis has created hardship for many companies and individuals as payrolls are disrupted and access to cash is halted. However, it’s more important to stay level headed and focus on the big picture when it comes to investing. What should long-term investors know about these bank failures, and what do they reveal about the financial system.
Bank stocks have struggled due to recent failures.
From a market and economic perspective, the main question is whether there is wider systemic risk to the financial system. This episode reveals that these banks grew too aggressively and with too little risk management as tech valuations rose and crypto prices rallied over the past several years. While this worked well in a bull market, the reversal of these trends in 2022 made these banks vulnerable to classic bank runs.
How do bank runs occur? A simplified description of the classic banking model is that customers – both businesses and individuals – deposit funds for safekeeping. Banks then use these deposits to make loans or to buy high quality investment securities which they hope can generate profits. This works well as long as these investment assets maintain or grow in value and customers trust that their deposits are safe. If either of these is not the case, a bank may not have the liquidity to meet its obligations. With this in mind, these recent failures were due to two related problems.
Banks accumulated unrealized losses on investment securities as rates spiked.
First, rapidly rising interest rates and Fed rate hikes over the past year created financial stresses on bank balance sheets. Bonds had their worst performance in history in 2022, driving unrealized losses on investment assets including U.S. Treasuries, as shown in the accompanying chart. Whether banks need to book these losses depends on how these securities are accounted for, but this worsens as banks face pressure on deposits. Thus, as rates rose, Silicon Valley Bank and others found themselves with assets worth far less.
Second, SVB’s concentration of tech and startup customers made it vulnerable as conditions deteriorated for that sector, just as Silvergate and Signature Bank were exposed to the slowdown in the crypto industry. SVB tried to plug this gap by raising fresh capital, but this backfired since it highlighted the liquidity and solvency issues it faced. Like shouting “fire” in a crowded theater, once there is the perception of solvency problems, a classic bank run can occur swiftly, which can then become a self-fulfilling prophecy. To a large extent, this played out publicly as many in the startup and VC communities urged companies to move their funds.
While government actions are always controversial and subject to political debate, moves by Treasury, the Fed, and the FDIC to backstop customer deposits across these banks will likely help to prevent contagion effects across the system. At the same time, it does not directly address the underlying issue of impaired assets which depends on the quality of risk and asset/liability management at each bank. However, the risk that unrealized losses become a solvency issue is mitigated for larger, more diversified banks that are less reliant on deposits, have a more substantial deposit base, and maintain higher amounts of capital.
These bank failures are the largest since 2008
*Note that this FDIC data does not yet include Signature Bank
One reason that investors may be concerned is that there have been few bank failures in recent history, especially since banking legislation such as the Dodd-Frank Act was put into place after the 2008 financial crisis. According to the FDIC, there were only 8 bank failures from 2019 to 2022, far below the 322 experienced around the global financial crisis or the hundreds that regularly occurred in the 80s and 90s.
Naturally, parallels are being drawn to 2008 when the last wave of bank failures threatened the global financial system. It’s important to remember that, back then, the problem was not just that all banks held significant amounts of mortgage-backed securities and other housing-sensitive assets that ended up being worth only pennies on the dollar. Rather, significant amounts of leverage coupled with new financial instruments such as collateralized debt obligations allowed a housing crisis to turn into a financial meltdown. While it’s unclear exactly how this episode will play out, many banks today are much better capitalized and do not primarily rely on tech or crypto deposits. Additionally, any economic spillover has so far been concentrated in the technology and venture capital industries which were already struggling with layoffs and a slowdown in demand.
These developments impact the Fed’s upcoming rate decisions since they underscore an unintended consequence of rapid rate hikes. This likely creates a new sense of caution for the Fed as they battle inflation.
The bottom line? While recent bank failures are problematic, parallels to 2008 are premature. Investors ought to stay diversified as the situation stabilizes, while focusing on the big picture rather than minute-by-minute speculation.
Let me know if you have any questions or concerns. Email me at Jeremy@Riverbendwm.com or CLICK HERE to setup a phone appointment.
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On the lighter side, Elliott came back from Disney World last week. First, he said, “next time I go to Disney, it will be with my own kids.” Guess he outgrew Disney World. Little context, they rode the bus all night to get there, and he shared a room with three other people. Guess it isn’t quite the same as having your own bed at home.
Finger Financial Five – 5 points in 5 minutes or less – is to provide you with a weekly shot of useful financial information. My intention is to share principles, so that you will have more clarity and peace, that help you make better financial decisions.
Investment advice offered through Stratos Wealth Advisors, LLC, a registered investment advisor. Stratos Wealth Advisors, LLC and Riverbend Wealth Management are separate entities.
This content is developed from sources believed to be providing accurate information and provided by Riverbend Wealth Management. The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. Stratos Wealth Partners and its affiliates do not provide tax, legal or accounting advice. This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, tax, legal or accounting advice. You should consult your own tax, legal and accounting advisors before engaging in any transaction.