Irvine • Dallas

The US Economy is geographically diverse with particular regions often having specialized economies. Because of this, the Federal Reserve doesn’t operate just a single hub bank in Washington, but rather several banks dispersed across the country that operate with regional knowledge. For example, the Federal Reserve Bank of New York has specialized insight into the banking sector, the Federal Reserve Bank of Chicago works closely in the commodities and heavy machinery sectors and the Federal Reserve Bank of Dallas has specialized knowledge on the energy sector.1 In a similar vein, regional banks serve to provide specialization on local economies with valuable insight, contacts etc. to facilitate better lending standards. There exist regional banks in the Northwest that specialize in lending to aircraft manufacturers, regional banks in the Midwest that specialize in lending to the agricultural sector, etc. The health of these lending organizations is intertwined with the local economies in which they serve. Therefore, it is understandable that Silicon Valley Bank’s financial well-being would be closely tied to the high-growth technology sector of the Bay Area.

Even though regional banks serve an important role in the free flow of capital to the US economy, the total number of deposits at these types of depository institutions is the minority. We reviewed 488 depository institutions that are publicly traded. Of the 488 banks, 474 can be categorized as regional. The share of total deposits to these regional banks is 26.4%. The majority of deposits are with large banks such as Wells Fargo, JP Morgan, etc.2

Silicon Valley Bank saw a rapid influx in deposits as the technology sector boomed post-pandemic with indiscriminate cash pushing IPOs and M&A activity to incredible levels. From the beginning of 2020 through 2021, the total deposits at Silicon Valley Bank more than tripled.3 The simplified business model of a bank is to take in deposits and offer some rate of return on those deposits as incentive to place your cash there. The banks then lend the funds out at a higher, longer-term rate and take the spread between the two as well as the risk assumed. In the case of Silicon Valley Bank, the influx of deposits was used to purchase longer dated mortgage-backed securities with a yield of approximately 1.5%8, which at the time probably didn’t seem too risky and made up nearly half of their deposit base. When the Federal Reserve raised rates at an unprecedented rate in 2022, the value of those investments declined substantially, which caused some solvency concerns for the bank.

Bank solvency is simply assets (cash, loans due and investments) minus liabilities (deposits) equaling the book value of the bank. Negative book value can mean the bank could not return all of the deposits, which can cause people to pull their money from the bank quickly (“bank run”), which in turn exacerbates solvency questions. The last reported book value for Silicon Valley Bank was just 10%6 of the reported investments value, which means that the double-digit decline in asset values in 2022, which hadn’t yet been fully accounted for on their balance sheet, could have potentially put the book value in negative territory. In our review of the nearly 500 banks, only 5 had ratios as low as Silicon Valley Bank, and on average the ratios were nearly 3X better and unlikely to be negative given the asset price declines in 20222.

To decrease the likelihood of bank runs when solvency concerns exist, the Federal Deposit Insurance Corporation (FDIC) will insure deposits up to $250,000 per individual at each bank7. Silicon Valley Bank, being a bank to venture capitalists, tech start-ups, etc. had larger than typical account sizes. It was reported that as much as 97% of the deposits were in excess of the FDIC limits5, rendering the insurance useless and thus not preventing a bank run. When we look at other large regional banks, the number of uninsured deposits is closer to 65%5. When looking at the largest banks such as JP Morgan, Citigroup, etc. that figure is less than 10% on average.

Overall, we see the Silicon Valley Bank issue as an outlier, in that the severity of the situation is unlikely for the banking sector broadly. Even though regional banks on average have mostly uninsured deposits, on average solvency is much better that what was seen at Silicon Valley Bank. And even if there are bank runs at regional banks across the country, the banks make up just a quarter of all deposits and their market values make up less than 1% of the S&P500.2 We do not see the situation as painless, but the severity is nowhere near the scale of the derivatives issues that existed during the Great Financial Crisis. Already, we have seen bank borrowing through the Fed Discount Window spike, which is typically an indicator that lending will tighten. Less lending typically means less economic activity which can lead to a recession, which has been largely expected by economists.9

There could be a positive from all of this. The biggest weight on asset prices over the past year has undoubtedly been the Federal Reserve rate hiking cycle. When inflation figures come in higher than expected, asset prices fall as the market fears more rate hikes. Now that the rate hike cycle has officially broken something in the economy, albeit a small piece, it is possible that the Fed would approach future rate hikes with more caution, which would be a tailwind to all assets.