Silicon Valley Bank became the biggest US lender to fail in more than a decade, creating fears of contagion as risk assets suffered a sharp decline in the immediate aftermath as news of the imminent collapse broke. The key question being asked by investors was whether this collapse presented a systemic risk across the US financial sector.
We believe that SVB’s failure does not present a systemic risk, with the Fed providing further assurances that they will cover all deposits of SVB, whilst also announcing a new short-term lending facility. Known as the Bank Term Lending Program, the new facility will make loans of up to 12 months in durations to banks, credit unions and savings associations, with qualifying assets to be used as collateral. Importantly, the qualifying assets will be valued at par, rather than at their market price which will prevent institutions from realising losses on their fixed income assets. Whilst many are viewing this as a bailout, the taxpayer will not be covering the costs, with the losses being covered by the $25bn from the Exchange Stabilisation Fund.
Whilst it remains our view that this collapse does not present wider risks to our portfolios, contagion spreads through irrational investor behaviour. The collapse of SVB was due to issues which appear to be specific to them, with large unhedged interest rate risk alongside a large exposure to cryptocurrency which resulted in them having to realise significant losses on fixed income assets in particular as investors rushed to withdraw deposits. The main channel of contagion stems from a loss in confidence of the financial system as a whole. A key point to remember is that SVB, despite being the 16th largest US bank with $209bn in assets, was not subject to the Fed’s stress tests which would have likely resulted in significantly different behaviour and risk management.
It remains unlikely that we see a similar collapse in the larger US banks, with regulations forcing a larger level of liquidity. Since the global financial crisis, US regulators have allowed smaller institutions to innovate with less policing of their balance sheets, whilst they have tightened regulations surrounding the more systemically important mega banks such as JP Morgan and Bank of America.
Market Fallout
Given the significant declines in US financial sector equities since the collapse of SVB, it appears that the Federal Reserve’s aggressive monetary policy tightening cycles is beginning to take hold. The rhetoric has shifted away from higher rates being positive for banks, with the belief that now banks will have to offer greater returns on customer deposits, which in turn will compress margins. At the time of writing, the S&P 500 Financial Index has declined almost 8% following the SVB collapse, with US regional banks selling off significantly before the Fed attempted to instil market confidence with their measures to shore up liquidity.
The dramatic fallout from the SVB collapse is having a considerable impact on market sentiment, with market volatility surging despite a move from the Fed to reassure investors. With investors rushing to safe haven assets, fixed income yields declined sharply. As a result, the bond market is no longer pricing in an interest rate hike by the US Fed in March, a large shift considering they were pricing in an increased 50bps hike at the beginning of last week. Financial stability is likely to be at the forefront of the Fed’s thinking despite inflation remaining uncomfortably high.
Our View
As long-term investors, we have maintained a cautious approach despite a brightening long-term economic outlook as we remain overweight fixed income, which will benefit from the dramatic decline in yields. We continue to believe that contagion risk is low, but we remain proactive, ensuring we are across the risks and prepared for a further decline in investor sentiment should investment conditions worsen.
It is important to note that the risk to the UK remains low despite yesterday’s sell-off in UK equities. The balance sheet of SVBUK which was sold to HSBC was just £8.78bn, with the bank stating that the deal would strengthen their commercial banking franchise. It is also a comfort that European and UK banks are put under strict stress tests by the relevant authorities, with all banks of a similar size to SVB inside Europe being subjected to the stress testing. We are continuing to monitor the impact that the rapid rise in interest rates is having on deposit flows and how this feeds through into interbank lending and liquidity within the financial system, however it is our view that this is a temporary situation and we do not see any contagion into the wider market.
We will continue to monitor the situation closely, and will communicate any changes in our regular market commentaries.
Important Information:
Past performance cannot be used as a guide to future performance and the value of your investment will fall as well as rise in value. You may not get back all of your investment and the final value of your investment will depend on the performance of your portfolio. The actual performance of an individual client’s portfolio may differ due to different funds being used and being restricted in relation to certain asset allocations. Performance figures quoted include fund manager charges but exclude adviser, discretionary, custodian and switch charges. Unless stated, income is reinvested into the portfolio. The information contained in in this document is for information purposes only. It does not constitute advice or a recommendation or an offer or solicitation for investment.
