US regional bank collapses have been front and centre in the news cycle over the last few months. The first reported bank to collapse was Silicon Valley Bank, the second largest bank failure in US history. This was shortly followed by more trouble cropping up at other regional lenders. With a deeper dive into the causes of the collapses, we can see how a focus on risk management could have reduced and likely prevented the disaster.
WHY IS THERE A REGIONAL BANKING CRISIS IN THE US AND WHAT HAS CAUSED THESE FAILURES?
Warren Buffett once famously said, “You don’t find out who’s been swimming naked until the tide goes out”. It’s a straightforward example that implies that only when the prevailing environment changes does the full picture get revealed. In the current case of the US regional banking crisis, the ‘tide’ has been the unwinding of pandemic-era stimulus and rapidly rising rates, as my colleagues have written about previously.
During the pandemic, banks saw record volumes of new deposits as a direct result of huge stimulus packages. Another consequence of fiscal stimulus was improving balance sheets on both an individual and corporate basis. This meant banks’ deposits were increasing simultaneously with weak loan demand since the usual customers were generally flush with cash. In search of any return on these swelling cash balances, and with limited loan demand, banks looked to the securities market as a place to invest.
Take for example Silicon Valley Bank (SVB) which saw deposit balances grow from $61.8 B at the end of 2019 to $173.1 B at the end of 2022. This was predominately due to commercial clients in the venture capital, life science, and technology industries seeing strong growth. Over the same period, SVB’s investments in what are called ‘held-to-maturity’ securities grew from $13.8 B to $91.3 B. The ‘held-to-maturity’ distinction was given to any security which the bank intended to hold until it matured. This is primarily a nuanced accounting treatment, but from the regulatory perspective, classifying a security as being held to maturity meant that SVB was not responsible for recognizing any unrealized gains or losses that may have arisen. These securities were comprised of various investments that are prone to changes in interest rates.
As we have highlighted previously, duration will dictate the bond price decline possible when interest rates rise. Not only did the security portfolio on SVB’s balance sheet grow, but the duration lengthened from 3.9 years at the end of 2019 to 6.2 years at the end of 2022. As the company invested more in securities that had longer maturities, it suggested that the investments on the balance sheet would experience larger price declines in a rising interest rate environment than they would have previously. As the Federal Reserve began to rapidly raise rates throughout 2022, the price of the securities that were held on SVB’s balance sheet began to decline.
Unrealized losses (or losses on paper) increased to $15.6 B at the end of 2022, an amount which exceeded all the shareholder’s equity in the company at that point. On the liability side of the balance sheet, SVB started to see client deposits be withdrawn. As deposits declined from a peak of $198 B at the end of the first quarter of 2022 to $173 B at the end of 2022, it became harder for the bank to satisfy the cash demanded by its clients. Selling its security portfolio to fund the cash demanded by its clients wasn’t an option because the losses on this portfolio were larger than the equity on the balance sheet. To put it simply, SVB ran into a liquidity problem and eventually was closed by regulators.
DEFICIENCIES IN RISK MANAGEMENT AND LESSONS LEARNED
Risk management is a concept we employ in our investment process at QV. It’s also a concept we expect our portfolio holdings to implement. Looking at the regional bank failures in the US, one can see how best risk management practices were not followed.
As an example, understanding asset-liability mismatches is an important risk management consideration for a bank. With SVB, the bank had assets with longer maturities than deposits and no clear way to fund possible outflows. This became particularly problematic as the ‘investments’ on the balance sheet grew to be nearly double the loans. SVB increasingly looked less like a lending-institution.
Greed likely plays a part in why securities started to dominate the balance sheet and maturities were unreasonably extended. SVB sought higher yield on its investments, but although mindful of the reward, the risks associated with possible price changes on these investments were seemingly not considered.
From a regulatory perspective, despite being the 16th largest bank in the USA, SVB was deemed too small to need to comply with liquidity coverage ratio tests. As such, the regulatory environment it seems also allowed for deficiencies in risk management.
HOW ARE THE SMALLER BANKS THAT QV OWNS DIFFERENT?
When we look at the smaller banks that QV owns, we see better risk management practices. For example, Bank OZK is a regional bank owned in the QV Global Equity Fund. The company has no ‘held-to-maturity’ securities on its balance sheet (what got SVB in to trouble). The securities that Bank OZK does own amount to only 11.8% of Total Assets at the end of the first quarter of 2023, which is in stark contrast to the nearly 60% proportion on SVB’s balance sheet. Simply put, Bank OZK has stuck to its standards as a lending institution.
A focus on sound banking principles and risk management practices likely extends from the collective experience of professionals and lessons learned over numerous cycles. For example, the Chairman and CEO, George Gleason, has been involved with Bank OZK since 1979, implying he has experienced various interest rate regimes and market backdrops.
In both the Canadian Small Cap and Global Small Cap strategies, QV owns Canadian Western Bank (CWB). Like Bank OZK, only 11% of CWB’s assets are invested in securities, with nearly half of these with a maturity of less than 1 year. Again, CWB has focused on its purpose as a lending institution first and foremost.
From a regulatory perspective in Canada, CWB has been required to measure its securities at fair value, meaning that any unrealized losses or gains are already being reflected adequately. This demonstrates how a regulator with an eye for risk management is a supportive feature. Furthermore (and in line with a risk-managed approach) CWB has its own internal liquidity target that is more conservative than the regulators’ required liquidity coverage ratio.
Investing in financial institutions is not a riskless endeavour, if it were, there would be a negligible return opportunity. Deposits can be withdrawn, economic conditions can change, and competition can be fierce. However, with an attentive eye for managing risks, you can learn and avoid the failures of recent banks and institutions.