By: Reed C. Fraasa, CFP®, AIF®, RLP®
Everything Everywhere All at Once
Revelations around the collapse and government takeover of Silicon Valley Bank (SVB) dominated the news over the weekend. Except for the distractions provided by March Madness brackets and the Oscars, the word of failing financial institutions brought back bad feelings for everyone. Ironically, the film Everything Everywhere All at Once not only swept the Oscars but aptly describes the swiftness in which SVB collapsed.
Before providing a little background on SVB's collapse, I want to assure you that, at this point, the potential crisis is contained, and no one should panic.
The issues with SVB and Signature are specific to their business operations and not some more significant systemic problem with the US banking system.
The Federal Reserve (FED), Federal Depositors Insurance Corporation (FDIC), and the US Treasury have stepped in with a program to protect all depositor's funds above the FDIC limits.
Cash deposits at all large national banks and regional banks are fully guaranteed up to the FDIC limits, and the risk of funds above those limits at the large national banks is very safe.
FDIC protection is $250,000 per account registration (a married couple can have $1,000,000 in FDIC insured deposits - $250K each and $500K in joint title)
Flourish Cash deposits are all backed by FDIC up to $1,250,000 per account registration. They accomplish this with special agreements with five national banks.
Charles Schwab Corporation and TD Ameritrade (owned by Schwab) are very secure. In contrast to SVB having less than 10% of deposits insured by FDIC, Schwab Bank depositors have over 80% of their deposits fully insured by FDIC.
Clients' investments at Schwab are held in the investor's name at the broker-dealer and not commingled with Schwab Bank. Broker-Dealers are covered by SIPC, not FDIC.
SIPC provides up to $500,000 of protection for brokerage accounts held in each separate capacity (e.g., joint tenant or sole owner), with a limit of $250,000 for claims of uninvested cash balances.
Schwab has additional amounts of insurance from Lloyds of London insurers to provide protection of securities and cash up to an aggregate of $600 million and is limited to a combined return to any customer from a Trustee, SIPC, and London insurers of $150 million, including cash of up to $1,150,000.
Schwab has no business with SVB or Signature and has no direct credit risk exposure.
So then, what happened at SVB?
The story of SVB is one of fundamental risk management. As a Registered Investment Adviser with the Securities Exchange Commission, we understand risk management – both for our business and as fiduciaries for our client's assets. The term prudent procedures should come to mind when thinking about risk management.
Following the events related to the Great Recession, since 2010, US banks have been regulated by the Dodd-Frank Act. Banks doing international business are also subject to Basel III requirements. Designed to limit the possibility of another financial system collapse like the Great Recession, these regulations require banks with more than $50 Billion in assets to report their financial ratios to regulators to determine risk exposures. The term "too big to fail" describes banks with over $50 Billion in assets. Regulators reported on these "stress tests" periodically, and almost without exception, international banks since then have passed the tests.
During President Trump's first two years in office, with Republican control of the legislature, there was a big push to roll back government regulations, in general, to stimulate business across many industries. On May 24, 2018, a bill rolling back some of the Dodd-Frank Act regulations for regional banks was signed into law by President Trump. The bill raised the definition of "too big to fail" from a bank with over $50 Billion of assets to more than $250 Billion of assets. Seventeen Democrats, many in hotly contested mid-term election battles with Trump Republicans and some from states with powerful regional bank lobbyists, joined Republicans in voting for the bill. Although at the time, many other Democrats and economists expressed concern that two or three $100 Billion plus regional bank failures would constitute "too big to fail."
The rollback in regulations for banks between $50 Billion and $250 Billion is significant because they no longer were required to submit to the stress tests imposed by Dodd-Frank. That alone would not have prevented SVB's failure, but it would have raised some flags.
The assumption that banks with less than $250 Billion in assets would self-regulate and follow a prudent process to manage risk now seems naïve, if not careless. A closer look at SVB reveals a leadership team with a fundamental lack of prudent practices, perhaps mixed with greed and excessive growth.
Part One
SVB, perhaps to stay competitive with savings rates for their cash-rich startup clients flush with venture capital funds, bought long-term government securities. Although backed by the US government and not subject to credit risk, long-term bonds and mortgage-backed securities with more than ten-year duration carry significant interest rate risk. This is investment risk-return 101. As investment advisors, we use the discussion of bonds and interest rate risk to educate our clients on the relationship between risk and return.
SVB leadership could have mitigated the interest rate risk by hedging with commonly used tools like futures contracts, options, and interest rate swaps. However, the insurance cost of hedging would have impacted the gross yield they received. Interestingly, a quick review of SVB's website showed several articles for their clients on the benefits of hedging currency risk for their international business operations, but not followed by SVB's management for their portfolio.
Part Two
As the FED raised short-term rates to fight inflation, many people took advantage of government T-bills' security and higher rates. Businesses and individuals eventually started receiving annual yields between 4% and 5% on T-bills with maturities of less than six months. The rush for higher yields may have led to increased withdrawals at many banks, including SVB, as depositors sought higher returns. Remember that excess cash withdrawals are a risk consideration for large banks, and they mitigate that with excess reserves. SVB appeared to have too many long-term maturity assets to protect against increased cash withdrawals.
While the funds flowed in during the pandemic, the inflows were much more significant than the outflows. Still, once the post-pandemic economy began to slow down for many tech startups, the cash stopped flowing so liberally, and outflows became an issue. SVB, reporting their Q1 outlook, disclosed that they lost almost $2 Billion on security sales to free up cash for withdrawals.
Suddenly the advisors to the tech startups, many of which were the venture capital funds that recommended the startup firms to put their funds with SVB, advised their clients to quickly pull their funds from SVB – creating a run on the bank. When SVB needed a George Bailey from It's a Wonderful Life, convincing depositors only to withdraw what they needed and not what they wanted, there was no George Bailey advising clients of SVB that day. Word spread like wildfire, and the demands on the bank funds were unsustainable.
Part Three
The banking regulators stepped in and closed the bank on Friday, along with another bank mainly working with the cryptocurrency firms, Signature Bank, on Sunday. The government quickly devised a plan to provide loans (not bailouts) of up to $25 Billion collateralized against their illiquid assets for up to one year. The program guaranteed all the depositors above FDIC limits and contained the risk to these banks.
At the time of this writing, the markets have stabilized, and the crisis is over, but not the potential risk to regional banks. Some in the legislature have started talking about rolling back some of the rollbacks on Dodd-Frank to a level below $250 Billion in assets. Further putting SVB's management into question is that several top management at the firm sold a significant amount of stock in the months leading up to the crisis. Although the sales may have been within the legal framework for insider sales, the question will be what may not have been disclosed earlier to the public that may have led to the stock sales by insiders.
In Summary
As a fiduciary, I see three critical risks overlooked by management and advisors to startup firms—all of which are fundamental to what we do with clients all day long.
Diversification is vital to managing risk. Putting all your deposits with a bank whose clients are like you within narrow tech and healthcare industries increases financial risk.
Trying to achieve a higher yield on bonds without considering the tradeoff of assuming the risk for short-term liquidity is imprudent and irrational. We counsel clients about balancing their short-term liquidity and long-term capital needs. Mixing up long-term assets with short-term needs is a recipe for unnecessary risk.
Managing behavioral risk is a large part of what we do for our clients. Financial planning for both business and personal strategies is making better decisions. Emotionally charged decisions and impatience will almost always lead to regret. Risk is not a bad thing, but it should be managed and communicated.
Hopefully, this is a lesson well learned, and more prudent minds will prevail, including those of our government leaders with whom we trust to balance the need for some regulations in our free market system.
Reed C. Fraasa is a CERTIFIED FINANCIAL PLANNER™ and founder of HIGHLAND Financial Advisors, a Fee-Only financial planning firm that offers comprehensive financial planning, retirement planning, and investment management. Reed has 30 years of experience as a fiduciary advisor and is the author of The Person is the Plan®, a unique financial planning process. Reed was a frequent guest contributor on PBS Nightly Business Report and has been featured in the New York Times, Wall Street Journal, and Star Ledger newspapers.