Silicon Valley Bank – systemic risk or a storm in a teacup?

On Wednesday 8 March 2023 the California-based bank, SVB Financial Group (SVB) which specialises in lending to technology firms announced its intention to proceed with a share offering. This attempt to raise capital followed the announcement that SVB had made a $1.8bn loss on asset sales during the first quarter of 2023, causing its share price to fall by more than 60% before trading was halted on Friday 10 March. Alongside this, investor and depositor concerns as to the bank’s stability led to a run on SVB’s deposits. In response, the Federal Deposit Insurance Corporation (FDIC) took control of the firm that same day. Over the weekend the FDIC also took control of another smaller lender ‘Signature Bank’, which had been exposed to the sharp sell-off in crypto currency assets in recent quarters. In the wake of SVB’s collapse, US regulators announced a range of emergency measures to protect depositors and an emergency lending programme, providing liquidity to US lenders.

Feeling the (higher interest rate) strain

SVB’s collapse reflects the strain that sharp rises in interest rates have exerted on the US financial system. The firm was hampered by losses on its Treasury bond holdings, alongside an increase in depositor outflows. While SVB, and the other banks that have been highlighted in financial markets as being at risk, are all relatively small firms, for most global investors the concern is not directly about exposure to these firms. Rather it is that these banks may represent canaries in the financial coal mine. While the wider impact of SVB’s collapse continues to unfold, at this point we see swift action from US regulators as a positive step to help insulate the fallout. We also believe the risk of contagion to the European financial sector is modest. This is due to accounting differences, the adoption of Basel regulations and little or no deposits outflows affecting European banks. In the UK, the rescue purchase by HSBC of SVB’s UK arm will mean that deposits will be protected.

UK and Europe – tech lending lite

For smaller banks in the US such as SVB, unrealised losses on ‘available-for-sale’ (AFS) assets are only reported following their sale, in this case to meet significant depositor outflows. By contrast, all European banks, regardless of size must report marked-to-market losses on AFS assets against their capital reserves. This means that European banks facing outflows can sell AFS assets without facing capital impairments. Consequently, we believe the European financial sector will prove more robust in the face of continued interest rate rises. Furthermore, both lenders taken over by the FDIC last week were specialised, with a significant degree of concentrated exposure to the technology sector. There is no real equivalent to this specialised technology lending within the UK and Europe, where most lenders benefit from diversified loan books with modest exposure to the technology sector.

LGIM’s position on short-duration bonds

Since the final quarter of 2022 LGIM’s dynamic strategies have been defensively positioned with an underweight position within risk assets. More recently we have held a positive view on government bonds, in the belief that they should bolster portfolios during significant equity market declines. As equity markets led by the financial sector have fallen in recent days, this has come to fruition and we have seen significant declines in government bond yields, most notably at the front end of the yield curve. In response, we have tactically downgraded our short-term view for government bonds locking in gains from this price appreciation. While policymakers will want to support the banking sector and prevent a loss of confidence, we believe the Federal Reserve will ultimately return to its top priority of fighting inflation. As such, over longer time horizons we think the fundamentals remain moderately constructive for the asset class. It has been encouraging to see the defensive qualities of bonds return during this short period of market stress, given the absence of such qualities last year.

Strict lending rules make recession more likely

We continue to monitor the lagged impacts of monetary policy tightening on economic and financial conditions and look for where further cracks in the system may appear. Although the market impact of SVB’s collapse continues to play out, and short-term predictions are challenging, we are confident that bank lending standards will remain tighter as lenders aim to shore up their balance sheets. This will continue to drag on economic growth and supports our base case forecast – that most developed economies are likely to enter recession before the end of this year.

All data is sourced from Bloomberg as at 09 March 2023 unless otherwise stated.