What’s Protecting Your Savings and Investments? | Understanding the Silicon Valley Bank Collapse

“How did you go bankrupt?” Bill asked.  

“Two ways,” Mike said. “Gradually and then suddenly”.

– Ernest Hemingway, The Sun Also Rises (1926)

The “first gradual and then sudden” failure of Silicon Valley Bank offers an opportunity to revisit some of the financial system safeguards that have been put in place over the last century to protect the public’s savings and investments against the unpredictable risk of bank failures.

All banking institutions are afflicted with an intrinsic mismatch between their liabilities (generally deposits) and their assets (generally loans or investments).  To simply stay in business, a bank must earn more on its assets than it pays on its liabilities.  If assets and liabilities were perfectly matched, there would be little to no earnings margin generated (banks typically target a 10% return).  To generate higher returns, the bank’s assets must be invested and will inevitably be exposed to risk of loss and often to significant illiquidity.  The bank itself must have a strong enough balance sheet to absorb the risks in its asset portfolio while still having sufficient liquid capital in reserve to make good on its guarantees to depositors.

Because of this inherent asset-liability mismatch, all banks perform a delicate balancing act. Banks take risks with some of their capital to earn returns for their shareholders, while they keep a prudent amount of capital as liquid reserves, to cover their obligations to depositors.  If a bank takes on too much risk, and its depositors start to feel uncomfortable, they become more likely to withdraw their funds.  But in doing so, they leave less liquid capital available for other depositors who have even more reason to feel uncomfortable… creating a dynamic feedback loop. Nobody wants to be the last one in line in case the doors close. Everyone knows first rule of bank runs: “S/he who panics first, panics best.. The speed of the Silicon Valley Bank run was astonishing and highlights how technology in 2023 enabled a bank run to happen in mere hours.  

Public Confidence

Even a bank that is strongly capitalized and fully solvent (in exactly the way that Silicon Valley Bank was not) would be unlikely to survive a sudden bank run, where panicked depositors rush to withdraw their money first and ask questions later.  Only a small fraction of the bank’s capital is ever held in reserve.  If more than that fraction of the bank’s depositors suddenly wants their money back, the bank isn’t going to be able to satisfy all of them. It will default.

What keeps depositors from suddenly demanding their money?  Confidence that they’ll be able to get their money back.  In the case of Silicon Valley Bank, a loss of confidence started with an unexpected announcement of losses on their bond portfolio and a failed attempt to raise equity capital.  Fear and panic snowballed over social media, as tweets flew back and forth faster than anyone could respond to restore confidence.

One possible solution for a challenged bank is to seek liquidity from its industry peers.  The interbank-lending marketplace allows banks with excess reserves to lend to others that might be in need of additional reserves.  The problem here is that if the industry starts to doubt the solvency of one of the institutions, all the other institutions will quickly withdraw any financing that had previously been available, further weakening that bank and hastening its demise.  A loss of confidence in a bank is often fatal.

Reserves Banks

The best safeguard for depositors is to prevent bank runs in the first place by protecting public confidence.  The Federal Reserve Act was passed by Congress in 1913 following a serious banking crisis in 1907.  In its simplest form, the Federal Reserve allows its member banks to deposit or borrow reserves from the central bank as needed, without being reliant on their competition for financing.  The availability of reserves on demand made it more likely that a bank would be able to pay depositors on demand… which inspired greater confidence among depositors and prevented bank runs from starting.  The Bank of Canada (established in 1934) serves the same function in Canada.

A Reserve Bank can only assist banks with liquidity issues.  It can’t support a bank that is insolvent.  Such a bank might survive for a while—maybe even a long while—if depositors remain confident that they can withdraw their funds.  Banking is the ultimate confidence game.  But if that confidence is shaken, an insolvent bank is doomed to fail as depositors flee and no additional sources of liquidity can be found.

Deposit Insurance

The Federal Deposit Insurance Corporation (est. 1933) and its equivalent, the Canadian Deposit Insurance Corp. (est. 1967), provide a second layer of protection in case a bank does fail.  These are government-run entities that require banking institutions pay insurance premiums on their deposits, and provide their depositors with up to $250,000 of coverage per account category ($100,000 in Canada) in case the bank fails. Knowing that their deposits are insured gives depositors greater confidence that they don’t need to withdraw their money… and this confidence reduces the likelihood of a bank run and a subsequent bank failure.

If a bank does fail, the FDIC or CDIC steps in, takes immediate possession of its assets, and begins a process of allocating assets to creditors.  First in the priority sequence are insured depositors. Then uninsured creditors, and finally (in the unlikely case there is anything left) shareholders. To date “no depositor has ever lost a penny of insured deposits since the FDIC was created”.  In the case of Silicon Valley Bank, even uninsured deposits ended up being fully covered by the FDIC.

Regulatory Capital Requirements

To further lower the probability of bank failures, regulators impose requirements that banks hold sufficient capital to act as a buffer should their assets experience losses.  In the US, the FDIC sets minimum capital ratio requirements for participating banks.  In Canada, the Office of the Superintendent of Financial Institutions (OFSI) establishes capital adequacy requirements.  While the two systems are rather complicated and somewhat different, reflecting large differences in the US and Canadian banking industry structures, both sets of banking regulations ensure that the banking sectors remains resilient, promote public confidence, and provide additional protection to depositors and the deposit insurance fund.

Investor Protection Fund

Most of Northwood clients’ assets are held as not as deposits at a bank, but in the form of investment securities (stocks, investment funds, ETFs, etc.) at a broker/dealer.

Securities and property in brokerage accounts are insured by the Canadian Investor Protection Fund (CIPF) initially established in 1969.  Unlike the CDIC, which is a government run entity, the CIPF is now an industry Self-Regulatory Organization (SRO) including investment dealers, brokers, and mutual fund dealers.  The CIPF covers up to $1 million per account category (cash, RRSP, RESP) for eligible individuals’ accounts held at member firms.  There is no guarantee as to the value of the securities… just that the investor’s ownership of the securities and any cash balances is guaranteed if the dealer fails.  If a custodian were to fail, the CIPF would take over administration of the accounts and ensure that investors could access and transact their securities in a timely and orderly fashion.

So ultimately, should we be concerned about our savings and investments?

With multiple layers of protection backstopping our assets, we enjoy one of the safest financial sectors in the world.  Risks will always exist, but you can take some precautions to minimize those risks for financial security and peace of mind, such as selecting well-established institutions with sound balance sheets and FDIC / CDIC insurance for your banking needs, and using a CIPF-member dealer or custodian for investment securities.

Navigating through the risks ahead

The extraordinarily accommodative monetary policy of the last few years made it easy and profitable for companies, banks, and investors to take on more risk than was prudent, either through exposure to greater risks or through applying greater leverage.

In 2022, the tide unexpectedly turned, interest rates were hiked aggressively, and the tightening financial conditions have begun to expose some of those imprudent risks and reveal many cracks in the system.

As interest rates rose abruptly, the most speculatively valued stocks saw their market values plummet.  Property prices have trended lower, and even investments like long-term government bonds, generally regarded as “safe”, have endured sizable losses.  As asset portfolios have declined in value, balance sheets have been weakened, and we’ve starting to see bank sector failures, like those Silicon Valley Bank and Credit Suisse.  

In the corporate sector, in just the first 2 months of 2023, US bankruptcy filings have risen to the highest level since the aftermath of the Global Financial Crisis more than a decade ago. Companies like Avaya Inc. and Serta Simmons Bedding recently filed for bankruptcy with liabilities exceeding $1 billion.

Will there be more bankruptcies and defaults ahead?  Certainly, yes.  What’s will fail next?  Unfortunately, there’s no way to know for sure.  

Because it’s virtually impossible in practice to predict the sudden end-stage of bankruptcies, we believe the best way to avoid them is early, while they’re still in the gradual stage.  To do this, we rely on our roster of carefully selected subadvisors to help navigate around these potential risks by thoroughly researching every prospective stock and bond holding in their respective portfolios, and by avoiding those with fragile balance sheets, questionable valuations, or poorly compensated risks.  

Instead of indiscriminately holding shares of every stock on an exchange, whether or not it’s prudently managed or reasonably priced, in uncertain conditions like these it’s especially important to know the fundamentals of what you’re invested in and take appropriate precautions to preserve capital.  Prudent active management is the only possible way to avoid sudden losses, and the avoidance of sudden losses is the still the best way to generate steady, long-term returns.

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