Banks, Fear, Risk and Runs

Last Friday we saw disturbing news regarding one of the largest banks in the country, Silicon Valley Bank. SVB did not have enough capital to meet withdrawals that were occurring. The banks lack of funds to meet these withdrawals forced the bank to halt all deposits. This causes the federal government to step in and take over operations.

What is a bank run?

Many depositors rush to withdraw funds from a bank because of the fear that a bank will essentially run out of money. This liquidity crunch and the spark that caused it was the fear that SVB had low levels of reserves on hand.

These large volume of withdrawals causes the bank to literally run out of short-term capital. This spiral of both fear and lack of liquidity causes the bank to halt withdrawals and technically shut its doors.

This is a textbook case.

Once the spark is lit, it can be a death spiral for the bank.

How did this happen?

From what we are seeing right now the cliff-notes summary is that the bank had a huge influx of deposits over the last few years. These funds came in from the large amount of COVID stimulus money that was injected into the economy. This five trillion dollars of new money had to go somewhere, and that somewhere was the banks.

In addition, the core business of SVB was to fund venture capital firms and funds have been freely flowing into these markets.

SVB serves a very distinct purpose in the financial world. They are one of the key players in the funding and the cash management of new companies. This serves as a vey important role in both economic and technological growth.

Their fatal mistake was that they invested these deposits, not in shorter term instruments, but instead invested in longer term Mortgage-Backed Securities (MBS). These bonds, just like all bonds, are adversely affected by rising interest rates. Essentially as rates went up, they lost a huge amount of money wiping out any equity that the bank had.

Contagion

The fear with all banking crisis is determining whether this is an isolated incident, or can this permeate into other institutions? The Federal government has stepped in and guaranteed that all deposits, regardless of the amount deposits are going to be insured. To me, this decision makes sense. Should a single institution’s mistake affect everybody? I don’t think so.

Currently, we are seeing lots of volatility in the financial markets right now, Charles Schwab included. However, this can change quickly.

Charles Schwab

Schwab acts as a bank to other institutions. Assurances have been given that they are not in the same position as other banking institutions, and that they have adequate liquidity to meet all its needs.

Schwab has 7.8 trillion dollars in assets under its umbrella. The vast majority of these assets are client accounts that hold securities separate from Schwab banking business. These assets are not Schwab’s, they are Schwab’s clients. For example, accounts with Rich Financial.

Accounts with Rich Financial are held with Schwab as custodian, which is Schwab’s core business. This essentially means Schwab holds the securities, insures them against loss of theft (not market fluctuations) and acts as a conduit for us to access the markets. Our positions are in individual stocks and bonds, Mutual Funds and ETF’s. Money market balances are backed by the holdings of the money market fund itself. MMF’s generally buy short-term instruments and are not an obligation of the brokerage firms.

In summary

We have seen banks fail in the past. This is no different. The mismanagement of their balance sheet was to blame, not a systemic issue like we saw in 2008.

This may affect the Federal Reserve’s ability to raise interest rates at this time. This will give banks some time to reassess their positions. I believe once this fear of widespread failure subsides, the FED will continue to raise rates in order to slow down the bigger economic problem: Inflation.