Client Update - 17th March 2023
Aside from the Budget announced yesterday by Jeremy Hunt, the majority of our focus in the last week has been the developing situation within the banking sector, as issues with a small number of regional banks in the US have led to markets questioning the asset base of larger banks, such as Credit Suisse. Whilst the Swiss National Bank has immediately supported Credit Suisse, resolving the short term issues, it is interesting to revisit the root cause of the problem.
What started a week ago with the collapse of a specialist and evidently error strewn regional bank in the US, has grown into more widespread concern over how the rapid rise in interest rates have started to cause some issues in the global banking sector, particularly in the smaller regional banks that have been able to take more risk due to deregulation under President Trump in 2018.
Silicon Valley Bank (SVB), as the name would suggest, was a key supporter of fledgling tech companies in Silicon Valley and unfortunately went out of business last week. I should of course say at this point that at no stage have we had exposure to this bank in our portfolios and we absolutely do not believe this is a repeat of the banking issues in 2007/8.
Rewind a few years and the COVID pandemic saw a huge rise in liquidity from a supportive central bank and this manifested into speculative finance from venture capitalists and much of this cash found its way to tech startups. SVB saw deposits increase from $62 billion to $189 billion in just two years and as it was unable to lend out the deposits as quickly as they were coming in, SVB decided to invest a large part of this cash in long-term fixed-rate government securities (Treasuries) and mortgage-backed securities (MBS) to gain a higher return. It is worth noting that at this time, interest rates were zero bound. The long dated bonds they purchased did give a higher return to the bank, but was at a fixed rate that was therefore at risk from short term interest rate rises. When these rate rises duly arrived last year, these longer term bonds lost SVB a lot of money as when rates rise, the capital value of these bonds fall. If SVB was able to hold onto these bonds, it would not have had to crystallise this loss, however the high inflation environment was not supportive of tech firms and the depositors started to ask for their money back to continue to run their businesses. This demand for a return of capital forced SVB to sell its long term bond book at a huge loss.
So, higher interest rates have indeed greatly contributed to the collapse of SVB, but the poor management of its asset base has also been a crucial constituent of its fall. Instead of parking the enormous inflow of deposits in short maturity assets to gain a small return, SVB decided to invest a large chunk in bonds and also MBS in order to increase their income when interest rates were low. The Mortgage securities tend to have a low interest rate sensitivity during periods of declining interest rates. However, in a rising interest rate cycle, the sensitivity increases as homeowners decide to stay put and retain their favourable borrowing costs. This poor risk management meant that the bank faced paper losses in excess of its capital reserves. As the deposit flight accelerated, this resulted in the paper losses becoming crystalised. SVB then approached the market on Wednesday 9th March to try and raise more capital to replace the losses on the bonds that it was forced to sell. The panic that ensued led to its downfall. Fearing the loss of their deposit, Venture Capitalists urged their portfolio companies to withdraw their deposits, and this ultimately led to the demise of SVB.
The US Federal Reserve (FED) rapid rate rising policy has now broken something, albeit a bank with significant structural issues. The market subsequently searched out the next victim in the banking space, and zeroed in on Credit Suisse, that had come under significant pressure in the last few years anyway. The Credit Suisse issue has been contained with excess liquidity once again being promised to support banks as required, but we must remember Credit Suisse has been suffering for many unrelated reasons for years now and is less than 1% of the European Bank index.
The FED has already announced significant support to US banks in the last week to stop any contagion. The fear was that given growing outflows in the regional banks, they would have to sell some Treasury holdings at a loss to repay their depositors. Typically, banks are allowed to hold these assets at cost value assuming they are held until maturity. If everyone is forced to crystalise these losses, then an enormous amount of capital will be lost. The FED have therefore addressed this direct issue head on.
On Sunday night the FED announced the creation of a new backstop facility, allowing deposit taking institutions to pledge Treasuries, MBS and other assets for collateral to avoid further distressed sales of assets and in addition, all depositors will be protected in joint action by the Treasury and FED resulting in no company facing losses on its deposits.
In terms of regulatory oversight, SVB was initially subject to strict regulation, but these were loosened in 2018 under President Trump. Arguably, if SVB faced the same stress tests as the big US banks were subject to, they would not have been able to adopt their risky strategy. Thankfully, the larger banks are much more conservative and their deposits are from a much wider array of customers, not highly exposed cash consumptive tech firms (93% of SVB deposits were corporates – which is very unusual).
In the immediate aftermath, investors now expect the FED to be much closer to halting its rate hiking cycle to focus instead on financial stability rather than inflation. It should be remembered that the broader plumbing put in place by the FED in the wake of 2008 should prevent this problem from becoming a wider concern. Markets may well remain jittery until there is further evidence that the situation has been contained, while central banks have received a wake-up call to be cautious with further rate hikes from this point onwards. The European Central Bank have already led the way yesterday by still implementing their planned 0.5% rate rise – suggesting the FED will not stop quite yet.
Away from the banking system it is also worth commenting on the Budget unveiled by Jeremy Hunt. The main eye-catching announcement was for the abolition of the pension Lifetime Allowance – focussed on trying to stop NHS consultants from leaving their posts due to punitive tax charges when they vest their pensions. Hot on the heels of the announcement was Labour saying they fundamentally disagree with this decision and would restore the lifetime allowance immediately should they gain power next year. This is an area that requires careful consideration for clients, alongside the increased annual contribution allowances, moving from £40k a year to £60k from 6th April 2023.
A ‘back to work’ budget was the theme presented by the Chancellor with measures aimed to encourage the 8 million or so economically inactive into work. Things aren’t as bleak as forecast last November mainly due to falling energy prices and higher tax revenues. This will reduce Government borrowing this year and next by £30bn less than expected. But anyone hoping that we would see major tax cuts was disappointed. Whilst the economic backdrop is better than expected, the Government faces challenges of persistent low economic growth and public sector pay demands which makes broad relaxation of the tax burden unlikely for the foreseeable future.
As always, with so much news to digest, we remain sharply focussed on risks as and when they develop, however we are also seeing green shoots of recovery in areas of the markets that have struggled in the past year as central banks now move towards their end game. We also have a new Budget providing plenty of financial planning opportunities. Things will get better from here, so please do have a good weekend.