Bank Failures: Crisis or No Big Deal?

With the failure of Silicon Valley Bank, we've been fielding lots of questions from customers and referral partners.  Just how worried should you be?

How does the banking system work?

Consider how banks earn income.  Banks make money on deposits.  When a consumer deposits money, the bank doesn't keep all that cash in a vault somewhere.  In fact, they're only required to keep a very small percentage of consumer deposits - something like 10%.

So a consumer deposits $100,000 and the bank only has to hold onto $10,000.  They're going to use the other $90,000 to make money for the bank.  That $90,000 is getting loaned out to other customers in the form of auto loans and home equity lines of credit.  It's also used to invest in a range of fixed-income securities like government bonds.

Why do banks get in trouble?

Banks are vulnerable if depositors want more money than the bank has in reserve.  Once the bank has exhausted their reserves, they need to sell securities.  And the issue with selling securities is that their values may have fallen since they were purchased by the bank.  In fact, that's exactly what happened at Silicon Valley Bank.

Think about where interest rates have been for the last several years.  Very, very low.  Great news if you're trying to borrow money.  Not so great if you're trying to earn interest on investments.  Imagine if you purchased a security that was earning 2% interest a few years ago.  That same security purchased today might fetch 5% interest.  You'd lose your shirt if you sold that security today!

Yet, that's the scenario that occured at SVB - to the tune of billions of dollars.

Why didn't anyone notice?

Silicon Valley Bank was (legally) hiding not required to disclosure the fact that they were holding a heap of worthless investments.  Accounting standards don't require banks to adjust "held-to-maturity" securities to their current value on their balance sheet.  So SVB's balance sheet showed they were in the clear.

But when their stock started losing value, savvy investors began to dig deeper and noticed this inconsistency.  Investors pressured SVB, which drew even more attention.  Depositors began withdrawing money and SVB didn't have enough reserves to cover the withdrawals.  They were forced to sell $21 billion in assets and realize a $2 billion loss because those assets were at lower yields.  After realizing the losses on their balance sheet, the bank became insolvent.

What happens now?

Bank failures have the potential to be disastrous.  SVB was far from the only bank holding onto devalued securities.  If other banks come under scrutiny, the problem could begin to spiral.

So the Feds stepped in immediately.  Within days, they decided on a bailout, which they've been careful not to call a "bailout."  Instead, they're calling it the Bank Term Funding Program.  The BTFP allows banks to trade their underwater securities to the Feds at face value.

Problem solved?  Only time will tell.  But hopefully the Feds have learned their lesson.

The reason all these banks have underwater securities to begin with, is that the Feds were asleep at the wheel at the beginning of this inflationary period.  Once they awoke to the problem, they raised interest rates too much too quickly and created the very problem they're now having to fix.  But now that they're looking the other direction, the Feds should be forced to slow their roll and cool-it with their reckless interest rate hikes.

What should you do?

• Don't panic.  Two bank failures is hardly a "crisis."  The government is stepping in to fix the problem(s) and they should bend over backward to avoid a complete meltdown.
   
• Make sure your deposits are FDIC insured.  The government automatically covers deposits up to 250,000 per depositor, per institution, for each account ownership category.  If you have more cash than that lying around, ask your Financial Advisor about splitting it up between several banking institutions.  And even though the vast majority of deposits at Silicon Valley Bank were above that $250,000 threshold, the government decided to make all SVB depositors whole.
   
• Have a reasonable amount of cash set aside at home.  No, I don't think you need $50,000 in cash buried in coffee cans in the backyard.  But have an emergency stash.  Catastrophic bank failures aside, it's not a bad idea to have grocery money in case the power goes out or the Internet is down for a few days.