If a week can be a long time in politics, in financial markets it can make investors feel as though their whole world has been turned upside down.

For years, analysts have consistently peddled the line that higher – or at least rising – interest rates are positive for banks because it means they can generate a bigger margin on their lending.

Instead, last week’s collapse of Silicon Valley Bank has shown that rising interest rates have a negative effect on the value of bonds, which in turn can impact a bank’s liquidity, especially if its deposits don’t match its loans.

Investors have panicked, leading to a sharp decline in share prices around the world, with banking one of the worst hit sectors. While markets in Europe had started to calm down as of Tuesday 14 March, there remain two unanswered questions – are more banks going to get into trouble and will the SVB incident prompt central banks to be less aggressive with interest rate hikes? We don’t know the answer to the former, but the latter looks plausible.

WHAT HAPPENED TO SVB?

SVB was a specialist lender with a focus on technology and venture capital companies. At the end of last year, the bank had assets including loans of around $210 billion and customer deposits of around $175 billion.

There are two reasons why SVB got into difficulty, both of which centre on the mismatch between its assets and its deposits. First, the bank had fewer deposits than loans, so to finance some of its investments it had to borrow money at progressively higher rates, just as Northern Rock had to borrow from the UK interbank market, which proved its undoing. Second, the bank was taking in short-term deposits and investing them in long-term assets like loans to companies and US government bonds.

Due to the popularity of venture-capital investing the bank’s deposits exploded from $60 billion to almost $200 billion in a short space of time, and it decided to invest a large chunk of this money in US government bonds when yields were very low. However, last year’s sharp rise in interest rates drove down the value of the bonds held by SVB and every other bank.

When customers started asking SVB for their money back last week, the bank had to sell some of its long-term bond holdings at a loss to raise the cash to meet the withdrawals. Once the market got wind SVB might be in trouble there was a full-blown ‘run’ on the bank, leading to a collapse in its share price.

Californian state regulators took over the bank and the US Treasury, the Federal Reserve and the Federal Deposit Insurance Corporation stepped in to guarantee all of SVB’s deposits and protect its customers.

COULD MORE BANKS BE IN TROUBLE?

As well as guaranteeing SVB’s depositors that their money was safe, in a re-run of measures introduced in the great financial crisis of 2008 US regulators agreed to let banks use the Federal Reserve’s ‘discount window’ to borrow cheaply to finance customer withdrawals if they needed to.

Despite the improvement in banks’ capital ratios since 2008, investors still have concerns over the ability of some US specialist and regional lenders to meet customer withdrawals so shares of First Republic Bank (FRC:NYSE) and Western Alliance (WAL:NYSE) slumped after the SVB debacle.

In the UK, shares of the big high-street banks Barclays (BARC), HSBC (HSBA), Lloyds (LLOY) and NatWest (NWG) have also been under pressure and by the evening of 13 March the FTSE 350 bank index had lost close to 10% of its value in a week.

Shares of smaller, less heavily capitalised firms such as Bank of Georgia (BGEO), TBC Bank (TBCG) and Virgin Money (VMUK), which rely on the stability of their deposit base, also fell on the stock market although there is no indication that any of them have any operational difficulties.

Ratings agency Moody’s believes the decline in bond values is temporary and most European banks have enough liquidity to meet any potential liability, allowing them to hold their bonds to maturity.

WHY DID HSBC BUY SVB’S UK OPERATIONS?

HSBC paid £1 to rescue the UK arm of SVB and protect its depositors. The company said the acquisition would strengthen its commercial banking arm and enhance its ability to serve ‘innovative and fast-growing firms’, including in the technology and life-science sectors.

The Bank of England said the deal would ensure ‘the continuity of banking services, minimising disruption to the UK technology sector and supporting confidence in the financial system’.

It also stressed no other UK banks were materially affected by the failure of SVB and the wider UK banking system was ‘safe, sound and
well capitalised’.

WHAT DOES IT ALL MEAN FOR START-UPS?

The immediate effect of the turmoil at SVB is likely to be that banks and other financial firms tighten their lending criteria making it harder for fledgling companies, which are notorious for burning through cash before they generate a profit, to borrow money.

Another effect is investors are likely to want to put a bigger discount on assets held in venture capital funds and potentially on private assets in general to compensate them for what they perceive to be increased risk. That doesn’t bode well for investment trusts invested in private markets.

WHAT DOES IT MEAN FOR INTEREST RATES?

As well as prompting a sell-off in bank stocks around the world, the collapse of SVB has spurred frantic buying of government bonds as investors look to reduce their risk exposure in favour of ‘safe’ assets.

That in turn has led to a steep decline in bond yields and in market expectations for interest rate rises by the Federal Reserve and the Bank of England over the next couple of months.

Whereas traders were worrying last week that Fed chair Jerome Powell was ready to raise interest rates faster than they had anticipated, this week all bets seem to be off.

Instead of a 50 basis-point hike, economists at investment bank Goldman Sachs now expect the Fed to leave interest rates unchanged on the next rate decision day (22 March) despite the bank’s primary aim being to rein in inflation, not alleviate strains in the financial sector.

While SVB may well have been an outlier, with investors worried about possible contagion due to unrealised bond losses on banks’ balance sheets and potentially a broader financial crisis, many observers are arguing the Fed should take its time to assess the impact of the bank’s collapse and allow sentiment to recover.

THE EXPERT’S VIEW FROM ING

One of the reasons that the Federal Reserve could deliver fast and impactful interest rate increases over the past year is that the system could take it.

Equity markets and bond markets may have crumbled, but as long as the system was intact the Fed could continue to tighten.

The SVB saga as a standalone mutes the ability of the Federal Reserve to over-tighten from here, as there is an implied threat to the system should the Fed be seen to be overdoing it.

Risk barometers like FRA/OIS and the cross-currency basis have spiked, but not dramatically so. This suggests the system has had a wobble but is absolutely not under immediate threat.

The down move in the yield curve points to a material reduction in the likelihood that the Fed overdoes it on rate hikes.

We argue that what equity markets do here is not that relevant. They can come under pressure, but the really important thing to monitor is the financial system. If that were to be materially threatened, the Fed could not hike at all.

We only have to look at the global financial crisis and the pandemic as templates that showed the Fed is single-minded when the system is under threat, and that is to cut rates and ease policy, significantly.

We are not at that point, and we most likely won’t get to that point. But if the inflation data refuses to dampen in a material fashion it places pressure on the Fed to make a tough choice. The simplest choice is to stick with a 25 basis point rise and let the market calm down of its own accord in the weeks and months ahead.

SHOULD I SELL ALL MY SHARES?

While the news around SVB has caused shockwaves across global stock markets, we do not see a reason to panic and sell shares.

Admittedly there is now a heightened risk of tighter regulation among banks which means investor sentiment could temporarily remain poor towards the sector. That will put pressure on banks to provide reassurance they have strong balance sheets and aren’t in trouble.

Most people hold shares in banks for generous dividends and we do not expect payouts to be cut from the UK banking stocks in the wake of the SVB crisis.

THE EXPERT’S VIEW FROM ALGEBRIS INVESTMENTS

‘Assuming the economic impact is relatively contained, we do not see a clear read-across (from SVB), particularly for the larger US and European banks, for several reasons.

Large banks are subject to more comprehensive and thorough regulation. For instance, in Europe, banks are limited in how much rate mismatching they can take on their held-to-maturity bond portfolios, due to Basel 4 regulations. This means that they will not face the same steep negative equity position that SVB found itself in with its deeply underwater securities book.

Hence, the average European bank has losses of just ~5% of tangible equity, compared to the 124% that SVB showed as of year-end.

‘Further, European and large US banks must deduct unrealised losses on securities accounted at fair value (i.e., marked to market on a quarterly basis, in contrast to held-to-maturity) from their regulatory capital.’

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