Over the last 24 hours I've heard a number of talking heads say how they don't believe collapse of SVB is likely to cause a contagion event due to the unique circumstances of SVB. But I fear those saying this are either lying to ease nerves, or fundamentally misunderstanding the cause of what happened at SVB, and human nature.

The real risk SVB exposed

SVB's exposure to silicon valley to startups was simply a catalyst, not the cause. The real cause of SVB's collapse was a textbook run on the bank, and this difference is important because what happened to SVB isn't unique, SVB was just more exposed to a risk all regional banks now face.

SVB being both a reasonably sized bank while at the same time not large enough to be deemed “too big to fail” is in my opinion what makes what's about to play out interesting…

If no action is taken and businesses banking with SVB are allowed to miss payroll and then fail as a result, then this should be taken as a warning to all US businesses with deposits at regional banks. Although most businesses may be able to afford losing a few percent on the value of their cash deposits, what most businesses simply can't afford is the liquidity risk of not being able to make payroll for weeks on end.

But in addition to this, if those banking with SVB who previously believed they were holding their cash almost entirely risk free only get back say 90 cents for every dollar they deposited, then everyone who banks with regional banks now also needs to consider the risk of capital loss as cash held by regional banks can no longer be considered in effect, “risk free”.

I'm already seeing signs of this 1920s-era thinking begin to take hold with a handful of business owners already saying they've decided to move all their accounts to one or more of the big four in light of the collapse of SVB to protect themselves from further contagion risk. Perhaps for now they're over reacting, but it's exactly this kind of panicked thinking that can cause a chain reaction of withdrawals and bank failures if not contained.

And truth is there probably is some reason to panic here…

Reasons to panic (?)

The FDIC posts a quarterly summary on the state of the US banking sector, and as of Q3 2022 they reported that US banks are collectively sitting on ~$700b of unrealised loses due to Fed rate hikes:

https://i.imgur.com/UG3N0Ij.png

And in addition to this deposits in 2022 were negative:

https://i.imgur.com/HcM3clZ.png

It was exactly this combination of a rapidly shrinking asset portfolio combined with net-withdrawals which caused SVB to fail.

If the Fed continues to raise rates we should assume that banks will be forced to sit on increasingly larger loses and customers will increasingly begin to withdraw their cash deposits and put that money to work in treasuries where they can get attractive risk-free returns.

This is why the situation at SVB is only unique in that it had a concentrated deposit base, but their exposure to long-dated treasuries and MBS is not a situation unique to SVB – instead I'd argue this more of a systemic risk currently facing the US banking sector. We saw a similar systemic risk come to light last year in the UK when pension funds were forced to liquidate government bonds to meet margin requirements. And as I pointed out at the time, when rates rise this quickly and this unexpectedly the default assumption shouldn't be that these are isolated events caused by a few excessive risk takers, but what's likely to be a wide spread failure of risk management given how unreasonable it would have been to model a tail risk as improbable as rates rising 500bps in a single year back in 2020 – 2021.

Human nature

In the aftermath of GFC to restore faith in the banking system the FDIC began insuring deposits of up to $250,000 held at banks. However given inflation this $250,000 promised in 2010 would have been worth much more than it is in today's dollars, and as we've seen from those banking with SVB in many cases it simply isn't enough of a guarantee for larger account holders, such as businesses. Interestingly instead of being a positive talking point and a way to restore trust, this seems to have become more of a negative catalyst in light of SVB's collapse – i.e., if you have more than $250,000 in a regional bank, you should probably get it out and put it somewhere safer. This $250,000 might be comforting to your average account holder, but for larger account holders its perhaps more of a threshold for when you should start to worry about your deposits.

I think something else that has been notable about the situation at SVB was just how fast word spread… Tweets, text messages and phone calls accelerated the pace of the bank run on SVB in a way that simply wouldn't have been possible historically. This in my opinion is now one of the primary risks for further contagion. Today it might not take much more than a few Russian bots on Twitter urging people to get their money out of their bank for a chain reaction to begin. And in the coming weeks as the media inevitability start to write reports titled, “Is [x] the next SVB?” we should probably expect more people to start questioning if their deposits are safe.

The market reaction so far…

In my opinion the stock market has started sniffing this risk out already. Those saying that the market is over reacting and that the fall we've seen in the stock prices of regional banks is not justified are probably underestimating the market's ability to price in these developing risks. In my experience the market rarely provides no brainer opportunities, and those who believe they have found them need to always consider whether they're simply not fully appreciating the risks.

But to be clear, I'm not saying this is a GFC-scale event. My guess is that if there are signs of contagion brewing the Fed will step in – perhaps even as soon as Monday morning. My personal opinion is that they will say something to calm markets, but it's going to be difficult to strike a balance between saying enough to restore confidence, while also not causing investors to question their commitment to further tightening. Again, just my opinion, but this situation is probably just the first warning sign should they continue to aggressively raise rates from here. This is exactly how things start to break.

Either way, be vigilant. Powell, et al, are not at liberty to tell you the truth about the systemic risks developing in the US economy. If they feel the need to take action next week while putting on a reassuring tone, you should not take that at face value.