APRIL 4, 2023: Collapse of SVB: U.S. financials healthy despite crypto collapses
By Bernard R. Horn Jr., President and Portfolio Manager of Polaris Capital
Much has been written and discussed about the failure of Silicon Valley Bank (SVB) in the last few weeks. While Polaris Capital Management has never owned SVB, we wanted to address SVB’s collapse on the overall U.S. financials industry.
Founded in 1983, Silicon Valley Bank was a dramatic triumph until March 2023. The company grew with the success of the venture capital movement that created some of the greatest companies in the world, while reinvigorating the U.S. economy. SVB served as one of the central banking players in this eco-system. Consistent with its growth profile, the stock always traded at a high valuation multiple. Through its banking relations with start-up companies, it often acquired warrants that generated large gains, further supporting its high valuation.
Cryptocurrency became the bread-and-butter of the bank, following the heating market trend. As value investors, we have never invested in these types of companies on valuation alone… but we have also known that these high-flyers are also the ones most likely to crash.
1.) The height of the venture capital market and markets in general provided large inflows into venture funds, IPOs, and SPACs. SVB customers made large deposits with the bank, from $55 billion in January 2020 to $186 billion by the end of 2022. The bank invested its large cash liquidity in longer-term maturity bonds to obtain higher yields than could be obtained in short-term money markets, which resulted in a classic and potentially risky asset-liability mismatch. This risk came to fruition as the U.S. Federal Reserve raised interest rates to combat higher inflation; the result was a substantial decline in the value of SVB’s long-maturity bond assets.
2.) In a March 8, 2023 update, SVB indicated the bank’s venture sponsored and other customers faced cash burn rates twice that of 2021 levels resulting in the need to draw on their funds, creating a need for SVB to raise liquidity. The bank’s short-term liquidity reserves were not enough, so the bank sold its entire “available for sale” securities that had fallen in value. While the bank did not announce the sale of securities classified as “held to maturity”, the unrealized losses on this portfolio effectively eliminated the banks equity capital. In the March 8 update, SVB sought to raise new capital.
3.) Prior to, or when news of the capital raise became known, venture investors began advising their portfolio companies to withdraw their funds from SVB. This advice was exacerbated because almost 87% of SVB’s deposits exceeded the Federal Deposit Insurance Corporation (FDIC) insurance limit of $250,000. This movement circulated with modern day electronic light speed and within one day the bank faced $42 billion of withdrawals of $211 billion in total assets and $173 billion in total year-end deposits.
The collapse of SVB is the story of asset-liability mismatch mistakes, customer concentration in a high-risk customer segment, and an old-fashioned run on the bank. However, this collapse had a modern twist: the run was fueled by electronic efficiency/digital technology in a social media type frenzy. SVB has been coined the first “Twitter-fueled bank run”, as group chats, Slack messages and tweets from influential accounts caused tech execs and corporate customers to pull billions at lightning speed. There is no doubt that the confluence of social media and digital banking will come under debate by banks and policymakers in the future, but at the core, the true problem stemmed from SVB mismanagement and an overabundance of crypto assets.
That crypto angle is the reason why Silicon Valley Bank, Signature Bank and even Silvergate became intrinsically connected. As the SVB implosion unfolded on March 10th, the crypto industry grew increasingly wary about the financial stability of their banking partners. Two days later, regulators rushed to close Signature Bank, where around 30% of the bank’s deposits came from the crypto industry.
However, these banks are outliers in a relatively stable U.S. financials industry. While Signature and SVB were complying with regulatory requirements, the composition of their assets was not in line with industry averages. Signature had 5% of assets in cash, while SVB had 7%, compared with the industry consensus of over 13%. And SVB’s 55% of assets in fixed income securities compares with an industry average of 24%. And that says nothing for SVB’s lack of diversification, with a customer base of corporate/VC customers, reliance on the tech industry and a huge percentage of uninsured deposits. Putting all of their eggs in one basket worked great – until the bottom fell out.
We do not believe that most other well-managed U.S. financials are so homogeneous in composition, nor do they fall prey to short-term tactics; many have shied away from any crypto assets and others haven’t extended themselves so far as to have significant liquidity risk in a rising rate environment. Plus, the post-2008 safeguards and regulations (including the Dodd-Frank Act which increased capital requirements and stress tests, prohibited speculative trading and strengthened Sarbanes-Oxley) helped reign in risky business practices. (Interestingly, Barney Frank, co-author of the Dodd-Frank Act, was actually a board member at flagging Signature Bank.) Bank regulations were watered down in 2018, but by then most banks had already shored up balance sheets and capital ratios – clearly on firm footing.
But U.S. financials can’t rest on their laurels, lamenting their near-term but steep stock price drops on a jittery industry. Instead, this should serve as an opportunity to re-evaluate the value of security portfolios to determine the impact on equity capital. Other metrics to be considered: loan-to-deposit ratios, credit losses and tangible equity to assets. Banks with good liquidity, capital and diversified customer bases should weather this volatile environment without issue…
… which brings us to our next blog on the liquidity risks, capital deficiencies and general scandals leading to Credit Suisse’s downfall.
This blog was penned by Bernard R. Horn, Jr. in April 2023. Mr. Horn founded Polaris Capital (a leading Boston-based global and international value equity firm) in April 1995 to expand his existing client base dating to the early 1980s. Mr. Horn’s pure global value philosophy combines investment technology with traditional fundamental research. His 30+ year track record exceeds most current competitors in length and has produced admirable risk-adjusted returns since inception.
IMPORTANT INFORMATION: The views in this article were those of Bernie Horn as of the article’s publication date (April 4, 2023) and may be subject to change. Information, particularly facts and figures, are dated and in many cases outdated. Views and opinions of Bernie Horn expressed herein do not necessarily state or reflect those of Polaris Capital Management, and are not nor shall be used for advertising or product endorsement purposes. Polaris Capital is an investment adviser registered with the Securities and Exchange Commission. For more information about Polaris, please contact us at (617) 951-1365 or at clientservice@polariscapital.com
