What investors need to know about the banking turmoil rattling markets

Policy tightening cycles almost always end with accidents. The savings and loan crisis in the early 1990s, the “tech wreck” in the early 2000s, and the housing crisis in 2008 each commenced following a series of US Federal Reserve interest rate hikes designed to ease inflation. It’s why the market has been so focused on inflation for the past year. If inflation proved sticky, then the Fed would have to continue to raise interest rates, growth would deteriorate, and the risk of crises would rise. Alas, concerns are now being validated.

This week, Silicon Valley Bank and First Republic have emerged as the first cases of banks with business models and balance sheets that are ill-prepared for a rising interest rate environment and the ever-growing risk of a recession. Are they the proverbial canaries in the coalmine for the US banking system?

Smaller specialty banks in the spotlight

Before we start conjuring images of old-fashioned bank runs of yore, let’s look at what is currently happening. The market’s focus is on smaller, regional financial institutions with specialty lending businesses. For example, Silicon Valley Bank¹ has a niche business in financing technology start-ups, which are now having challenges in raising money as the venture capitalists who had been funding them have become more risk averse. The start-ups are raising cash by pulling deposits from Silicon Valley Bank, which is being forced to sell assets to meet the rush for deposits. Silicon Valley Bank is primarily selling US Treasury bonds, which had lost significant value, resulting in greater losses than the bank had accounted.

To put this into perspective, Silicon Valley Bank is one-tenth the size of JP Morgan, the nation’s largest bank.² Nonetheless, it’s never a good sign when banks are forced to raise money on short notice. Investors, smelling blood, then turn their attention to the next bank exposed to interest rate risk and specific credit risk, and then the next. First Republic Bank, which has significant exposure to the coastal real estate markets appears to be next on the list. For what it’s worth, First Republic is one-twentieth the size of JP Morgan.³

Overall, US banks appear well-capitalized

The better news is that the US banking system, following a prolonged period of stringent oversight in the aftermath of the Global Financial Crisis, appears to be significantly better capitalized than it was in past crises, including 2008.⁴ The Federal Deposit Insurance Corporation estimates that the banking system, in aggregate, is well positioned to withstand the potential losses looming.

These banking episodes have tended to persist until there is a necessary policy response. The first rules in central banking are 1) do no harm and 2) protect the banking system. Interest rates are currently plunging as expectations for future rate hikes are being reined in.⁵

A long-term focus

To the long-term investors, it’s my obligation to remind that these types of events have historically created buying opportunities. Many investors who allocated money to the broad US equity markets during the savings and loan crisis, the tech wreck, and the housing crisis were ultimately well served.⁶