Following no US bank failures in the last two years, two banks failed in the last three days—Silicon Valley Bank (SVB) and Signature Bank. As the situation evolved last week, investors, businesses, and regulators became increasingly concerned about SVB and risks to the broader economy. Over the weekend, US officials from the Federal Reserve, Treasury, and FDIC released a joint statement saying that all deposit holders at both banks will be kept whole, even their uninsured deposits, and the Fed established a new Bank Term Funding Program. In addition, the UK Prime Minister and Bank of England helped arrange the sale of SVB’s UK subsidiary to HSBC. Taken together, these actions significantly decrease contagion risks associated with the collapse of these two banks.
While the situation at SVB was idiosyncratic in some ways, sharply higher interest rates have resulted in material unrealized losses totaling $620 billion across FDIC-insured US banks as of year-end 2022. In the context of a $20 trillion banking system, 3% in unrealized losses may not seem like much, but there is potential for further losses to materialize and erode bank equity, especially as implications of rapidly rising interest rates have likely not fully materialized. This is particularly true as US banks’ holdings of long-term loans and securities (three or more years) have increased in recent years, reaching 39.7% of assets as of fourth quarter 2022. But community banks in particular are more exposed to longer-duration assets at 54.7% of total assets. Of course, most banks engage in substantial interest rate risk hedging to reduce the impact of changes in interest rates, which was not the case with SVB.
Leading up to and during recessions, banks typically face pressure from deteriorating asset quality, slowing loan growth, shrinking reserves, and rising deposit rates. Some of these pressures are evident now. Net interest margins have come under pressure as banks have been forced to increase deposit rates to compete with money market funds. At the same time, loan issuance has slowed, as banks have tightened lending conditions and demand for credit is softening. These pressures are likely more acute among smaller and regional banks, many of which have high exposure to commercial office real estate loans that have struggled since the pandemic.
However, the actions taken over the weekend to keep depositors at failed banks whole reduces the likelihood of runs on other banks. Further, the Fed announced Sunday that it will provide additional funding to eligible depository institutions via its new Bank Term Funding Program. This program will allow institutions to secure loans using qualifying securities as collateral. Notably, these securities will be valued at par, meaning an uplift in the collateral value of underwater Treasuries, agency debt, and mortgage-backed securities. Despite these actions, we still expect businesses to better diversify banking relationships and seek to minimize uninsured deposits, so poorly positioned banks will likely be under considerable pressure as we’ve seen in trading today.
Nonetheless, these two bank failures are consequential. SVB reported relationships with more than 70% of US venture funds and claimed a network of more than half of all venture-backed tech and life science companies in the United States. Thankfully, depositors will be able to access their funds to meet payrolls and other expenses this week. But we expect the disappearance of a significant and experienced provider of capital to the venture capital (VC) sector to tighten underwriting standards for startups at any stage, reduce access to capital, and potentially lead to a higher mortality rate for startups. As a result, valuations will likely adjust downward to reflect this changed environment. In the near term, while VC and growth equity firms set up credit facilities at new banks, LPs may see an increase in capital calls.
Stepping back, the VC industry was already on the road to recovering from its breathtaking two-year, COVID-era run when it posted its second and third best calendar year returns ever (trailing only 1999). VC transaction activity doubled, valuations soared, fundraising accelerated, “growth at any price” seemed to be the “deal du jour,” and many non-VCs piled in to participate. Post COVID, as the public markets sharply corrected, VC was adjusting to lower valuations, extending fundraising timelines, and reducing fund sizes, while GPs and companies alike have focused on stretching their capital for longer. The speed of adjustment is usually measured in months if not years; SVB’s failure will likely accelerate that timeline alongside a more discerning environment for new and follow-on investments. While we expect a decline in the returns for recent vintage years, the long-term return potential of VC remains attractive, and today’s dry powder should be deployed in a more rational environment for startups.
These past few days have underscored the importance of diligence on GP treasury management practices including basics, such as the use of sweep accounts to limit bank deposits to FDIC-insured levels. Evaluation of GP banking relationships and their guidance to portfolio companies is an essential part of manager due diligence. Investors should exercise caution in financial transactions around the messiness of bank failures. We view risk of fraud as heightened today as bad actors may seek to take advantage of the banking disruption. Best practice is to verbally confirm all changes in wiring instructions with trusted parties.
The recent bank failures are also a reminder of the importance of diversification. Owning assets with different economic bases of return is important in navigating periods of stress. The bank failures also provide additional evidence, on top of weak leading economic indicators and inverted yield curves, that US and euro area recessions are likely on the horizon. During recessions, provisioning adequately for liquidity is particularly important. Part of this provisioning includes considering counterparty risk, especially regarding cash exposures, and avoiding taking unnecessary credit risks. Now is the time to stress test portfolios to confirm adequate diversification and liquidity.
Published on 13 March 2023.