The return of the bank run
And what this means for the markets
Pre-1933, bank runs were a common occurrence in the United States. A third of all banks failed, and the Great Depression resulted in the failure of 9000 banks alone. The Banking Act of 1933 creating FDIC Insurance, which today ensures $250k of each person’s deposit from loss in the event of a bank failure. The creation of FDIC Insurance ushered in renewed confidence in the US banking system and reduced the amount of bank runs that led to failed banks. Nevertheless, FDIC Insurance wasn’t enough to prevent the Savings and Loan crisis of 1980 and the Great Financial Crisis of 2008.
Over the past week, two high profile banks have entered troubled waters. Silvergate Bank catered mostly to crypto businesses, and with the demise of the crypto bull market, the bank lost $8B in deposits in Q4 2022. The first sign of trouble was on Jan 5, when they revealed they sold $5.2B worth of debt securities (short to medium duration investment grade and government debt) at a $718m loss. On Mar 2, the bank said it was unable to file its annual report with the SEC and was reviewing its ability to continue as a going concern. Upon that announcement, Coinbase, Circle, and Paxos publicly ended their relationship with Silvergate, sealing the bank’s fate.
That brings us to Silicon Valley Bank (a top 20 bank in the US), whose shares dropped 60% yesterday after they announced that they realized a loss of $1.8B upon selling a $21B portfolio of debt securities. To shore up their balance sheet, they announced a $2.25B share sale, which would massively dilute current shareholders. The KBW Bank Index was also down 7% as worries spread across the banking sector. VC heavyweights Founders Fund (led by Peter Thiel), Union Square Ventures, and Coatue Management have come out and warned investors to pull their money out from SVB.
What went wrong here? Banks are in the simple business of borrowing short (from depositors) and lending long (via bank loans and owning debt securities). This simple business suddenly becomes complicated when:
1) Your customer base is concentrated in one industry (crypto or tech startups) and that industry experiences a severe downturn, resulting in a drastic reduction in deposits and deterioration in the quality of your loan book. Suddenly your portfolio of debt securities is too large relative to your deposit base, and you are forced to sell the securities at a loss.
2) The Fed hikes interest rates at an unprecedented pace, resulting in the value of your debt portfolio dropping precipitously. Meanwhile you’re under pressure to increase the amount of interest you pay to depositors, squeezing the margin on the yield of your debt portfolio which you bought when interest rates were 0%.
Does the downfall of Silvergate and Silicon Valley Bank signal more contagion to come across the banking sector? I don’t believe so, as Silvergate and SVB happen to be unique cases where their depositor bases were concentrated in industries that were extremely sensitive to interest rates. Throw in large debt portfolios also highly sensitive to interest rates, and you get a perfect storm. That said, their troubles are symptomatic of challenges most US banks face right now, which is the squeeze of profit margins from multiple angles. Banks have been reluctant to raise their deposit rates because so much of their loan book and debt portfolios were locked in at low rates.
This has resulted in depositors fleeing to money market funds (which get their yield from the reverse repo facility) and Treasury Bills. If banks want to keep their depositors, they need to raise the interest on deposits, eroding their interest margin.
The heavily inverted interest rate curve also makes it difficult to borrow short and lend long. When you factor in the fear of recession, there’s very little incentive for banks to do much lending at all. The pullback in bank credit will be one of the factors that eventually bring inflation down and possibly send the economy into recession.
Source: Piper Sandler
Despite how scary this all sounds I don’t think this is all bad for risk assets in the medium term. In fact, there’s a scenario where this may be GOOD. Hear me out.
The Fed’s campaign against inflation can only be sustained if financial stability can be maintained. Trouble in the banking sector raises the bar for Jerome Powell to be aggressive on inflation. The incoming data from employment today and CPI on Mar 14 will need to be extremely inflationary for Powell to raise the pace of hikes to 50 bp per meeting. Depending on how non-farm payrolls data comes in today, we may see the Fed slow down the pace of hikes and put a temporary end to the stagflationary market regime that started on Feb 2. Even if a recession is inevitable, the path to recession from a stagflation regime passes through a disinflation regime, which is supportive of equities and negative of USD.
Since concerns over SVB hit the market, the Fed Funds implied probability of a 50 bp hike has dropped to 50% from 75%, while market pricing of the terminal rate is now back to 5.48% from a high of 5.69% yesterday. The Treasury market experienced a violent squeeze, with 2 yr yields pulling back 30 bp from the highs. Data from Vanda Research suggests speculators, hedge funds, and trend following CTAs are heavily positioned short in Treasury and SOFR futures.
If the market suspects that vulnerabilities in the banking sector will prevent the Fed from hiking too aggressively, the unwind of these positions in the rates market would ease financial conditions and be a tailwind for equities and a headwind to USD.
For this reason, I have unwound my short GBP/USD position (which I entered on Mar 8) at 1.1920.
I also got stopped out of my short Mar 23 euribor position at 96.25. While I still believe that escalating inflation will force the ECB to continue hiking more than expected, we may be entering a pullback or choppy period for euribors.
At the moment my portfolio is very light, with a long-term allocation to gold as my only position. We may be in the midst of a regime change from stagflation (yields and USD up, risky assets lower) to a disinflation regime (yields and USD down, risky assets supported). I’d prefer to see incoming data such as employment today to confirm this thesis. When I do enter a new position, I will highlight it in posts for paid subscribers.
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My closing thoughts - crises induce reactions by central banks, and reactions by central banks turn markets. Remember the UK Gilt crisis last October, when overleveraged pension funds faced margin calls due to their gilt LDI positions? That marked the bottom for equities, the top for the USD index, and preceded the high for 5 year Treasury yields (at least for the next three months). In my post on Oct 14, I turned decisively bullish the market. We will see in coming days whether trouble in the banking sector induces a reaction from Chairman Powell.
From top to bottom - UK 10 yr yields, S&P 500 index, USD DXY index, 5 yr Treasury yields
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