A FEW BANKS WENT THROUGH THE WINDSHIELD – AND A NOTE FROM OUR CEO

Indiana Trust Wealth Management
Investment Advisory Services
by Clayton T. Bill, CFA
Vice President, Director of Investment Advisory Services

• The US equity market, represented by the S&P 500 index, rose 1.4% for the week ending March 17.
• Regulators moved quickly to address the failure of three banks, including Silicon Valley Bank. How will recent events shape the Fed’s next interest rate decision which will be made next week? 

There is a saying that traces back to 1941: whenever the US government or the Federal Reserve jams on the brakes, someone will go through the windshield. You just never know who it’s going to be.

Last week, a few banks – including Silicon Valley Bank (SVB) – went through the windshield.

SVB catered almost exclusively to tech startup firms backed by venture capital funds. It had a massive intake of deposits in 2020 and 2021, 93% of which were over $250,000 and not FDIC insured. SVB mainly used those deposits to buy long-term US government bonds. It earned the difference between the interest it paid on deposits (basically zero) and what it earned on its bonds (about 1 or 2%).

For some time since last year, the bank was “technically” insolvent as its liabilities (mainly deposits) were greater than the value of its assets (bonds), which declined in value as interest rates rose.

That became a problem once SVB’s clients began asking for their deposits back at scale. Tech startups are a close-knit community, prone to herd behavior. SVB’s deposits were thus under-diversified and very much at flight risk. SVB collapsed, becoming the second largest bank failure in history.

Did SVB make mistakes managing its interest rate risk? Yes, but the larger issue was its concentrated, uninsured, quick-moving, well-informed, herd-like deposit base.

The Federal Reserve stepped in and guaranteed that all depositors would receive 100% of their funds at SVB. It also set up a new facility which would allow banks to post their held-to-maturity government bonds as collateral for loans at their par value, not their market value. These actions were rather extraordinary. Perhaps the quick and forceful intervention by regulators was informed by lessons learned in 2008.

Bank stocks slid over the last week, particularly stocks of regional and small banks. However, bank exposure in globally diversified investment portfolios is small. The overall US stock market is roughly flat since these events unfurled.

The main question for investors is, will the Fed continue raising interest rates to dampen inflation given recent events?

The episode has revealed tension between the Fed’s monetary policy stance (higher interest rates for longer than expected) and financial stability. The banking system is part and parcel of the Fed’s monetary policy approach: there is no separating the two. The Fed does not cite commercial bank failures as its preferred channel for interest rate policy to the real economy. The Fed is not wholly to blame for SVB, nor is it completely off the hook.

The historical analog to SVB is not the Great Financial Crisis of 2008. A better comparison can be found in May of 1984, when Continental Illinois was taken over by the US government. At the time, Continental was the largest bank failure in US history. Like SVB, Continental had a large uninsured deposit base and faced a run on its deposits.

The Fed and the FDIC deemed Continental “too big to fail” – the Continental failure was the genesis of that moniker. Regulators prevented the loss on deposits or bondholders and infused billions of capital into the bank.

As it does today, the US faced high inflation during that time. At its monetary policy meetings in May 1984, several Fed policymakers favored higher interest rates to dampen inflation. However, Chairman Paul Volcker said that financial market fragility from Continental Illinois had taken that option off the table.[1] That summer the effective Fed Funds rate was over 11%, but Continental’s collapse heralded the end of the Volcker high interest rate regime. The effective Federal Funds rate fell to 8% by the end of 1984 and reached 6% in 1986.

The failure of SVB will be on the minds of Chairman Jay Powell and current policymakers next Wednesday at the Federal Open Market Committee (FOMC) meeting, the part of the Fed that sets interest rate policy, when its next rate decision will be made.

A Note from our CEO, David R. Kibbe, JD:

Some clients have asked about the impact of recent events in the small and regional bank ecosystem upon Indiana Trust. Indiana Trust does not hold demand deposits or checking accounts for our clients, nor does Indiana Trust issue CDs or make loans. We are a single-purpose trust company. Indiana Trust is a state-chartered bank, regulated by the Indiana Department of Financial Institutions.

Our clients’ cash-equivalents are held in a US government select money market fund, investing in securities issued or guaranteed as to principal and interest by the U.S. government, its agencies, or instrumentalities.

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IMPORTANT DISCLOSURES: All info contained herein is solely for general informational purposes. It does not take into account all the circumstances of each investor and is not to be construed as legal, accounting, investment, or other professional advice. The author(s) and publisher, accordingly, assume no liability whatsoever in connection with the use of this material or action taken in reliance thereon. All reasonable efforts have been made to ensure this material is correct at the time of publication.  Copyright Indiana Trust Wealth Management 2023.