As you have no doubt read, the country is in the midst of a sudden banking crisis, the largest since 2008 - though it in no way rivals that episode. In recent days, three financial institutions have failed and been taken over by regulators: Silvergate Capital, Silicon Valley Bank (SVB), and Signature Bank of New York (SBNY). Silvergate and Signature each had significant crypto exposure, but Silicon Valley Bank got into trouble by taking too much interest rate exposure with its investment portfolio while having a concentrated deposit base.
In response, the FDIC announced that all deposits of SVB and SBNY will be guaranteed, even those over FDIC deposit insurance limits, and the Federal Reserve created a new lending facility, the Bank Term Funding Program (BTFP) to provide one-year loans to banks and accept Treasuries and federal agency securities at par as collateral. As a result, we expect this banking crisis will be contained, as discussed below.
That move will no doubt be criticized politically (“bailouts of depositors!”), may raise long-term risks, and could add to inflation pressures. But as a near-term step, it may go a long way toward resolving the current financial crisis. Here’s why accepting Treasury securities as collateral at par is important: Banks essentially take in deposits and they use most of those funds to make loans and buy bonds. When interest rates rise, as they have substantially over the past year or so, the value of those bonds falls. They only fall temporarily as they are still worth par at maturity, but that doesn’t matter when there is a “run” on withdrawing bank deposits as banks have to meet those by selling their bonds at losses. Since banks are leveraged, sales of enough bonds at large enough losses can make a bank insolvent, as it did SVB. This new bank lending program from the Fed allows banks to meet any liquidity needs by pledging these bonds trading below cost rather than being forced to sell them and take losses. The 2008 financial crisis was a credit crisis and investment losses due to bad credit can be permanent. On the other hand, losses due to the rapid rise in interest rates can be temporary if the bonds can be held to maturity, so this is an easier problem to bridge. But it has many implications.
When the Federal Reserve is in interest rate tightening mode, it tends to continue until inflation declines to its goals or until it “breaks something” (i.e., causes a financial crisis), or causes a recession and unemployment rises (slowing demand and inflationary pressures). It’s possible this crisis may cause the Fed to pause or change direction, but that’s not a sure thing since, so far, this financial crisis has been limited to certain banks that are not in the largest tier of financial institutions. Moreover, the Feds actions and those of the FDIC have likely gone a long way to diffuse the issue. And a rapid decline in interest rates in recent days has increased the value of bonds and reduced pressure on stressed bank balance sheets.
However, when one thing “breaks,” it often has farther-reaching implications. For example, while larger banks have oversight that precludes similar interest rate risk that SVB took, there may be other regional banks in a similar boat, other banks may have exposure to these institutions through credit default swaps, foreign banks may have similar issues, many money market funds hold foreign bank paper which could impact their values, an unusual amount of moving cash around in the system could cause unanticipated liquidity stress, or something else entirely unanticipated. These next few days may be interesting – we’re certainly monitoring developments closely.
In the meantime, out of an abundance of caution, we’re executing the following steps today:
- We’re reducing balances in Schwab bank deposits to under the FDIC insurance limit for all accounts for which we have trading authority (Note that this is done by buying “purchased” money market funds which have 1-day liquidity rather than same-day liquidity – let us know if you need same-day liquidity for an amount in excess of the FDIC’s $250K insurance cap.)
- We’re swapping regular “purchased” money market fund holdings for purchased money market funds that only hold Treasury securities for all accounts for which we have trading authority (both the standard and the Treasury money market funds come in a more-than-$1-million-balance and a less-than-$1-million-balance variety).
Note also that securities held by Schwab as custodian are not subject to risks to Schwab’s balance sheet or to Schwab Bank. Neither Schwab nor its money funds have any direct exposure to the three failed institutions referenced above. And regarding Schwab Bank, it has a strong liquidity position and its deposits are considered “stickier” than those of most banks as they are overwhelmingly composed of smaller balances (for example 80% of Schwab Bank’s deposits are under $250K vs 2% for SVB and 20% for SBNY.)
We don’t think these Schwab bank deposit and money market fund moves will prove to have been necessary, but the give-up of only 0.15% per year in interest is in our view a very modest cost for this prudent action given the fact that historically, a financial crisis can take surprising turns and twists. We continue to believe this one will soon blow over and be relatively contained - so much so that it may not even dissuade the Fed from raising interest rates at its next meeting. But we’re still taking the most cautious posture possible with cash deposits as there is so little “cost” to do so.