What Happened
The second and third largest bank failures in US history, Silicon Valley Bank (SVB) and Signature Bank, respectively, occurred within 48 hours of each other due to classic bank runs, when the ability of the banks to return depositors' money was questioned. This crisis of confidence caused hasty deposit flight at these institutions and forced regulators to step in and ringfence operations. Bank regulators enacted emergency procedures to assuage depositor concerns, stating in their press release on the afternoon of Sunday, March 12 that “The Federal Reserve is prepared to address any liquidity pressures that may arise.” In the wake of these failures and their aftershocks, what’s likely to come next?
Western Asset believes the SVB situation will not cause pervasive contagion to the US banking system. There is no guarantee another bank won’t see a run on deposits, but the emergency measures implemented over the weekend should help to restore confidence and stem further sentiment contagion. Unlike the global financial crisis (GFC)—which was a credit crisis exposing all banks to similar deteriorating assets (residential mortgages and other sub-prime loans) along with high interconnectivity at the largest banks through counterparty risk—the overall banking system today is fundamentally strong.
Silicon Valley Bank Was a Unique Situation
We consider the SVB episode to be a unique, idiosyncratic situation based on this bank’s: (1) business strategy focused on rapid growth (fastest deposit growth in the US over the last three years) and highly concentrated on the technology sector in Silicon Valley; (2) investment strategy, which left the bank negatively exposed to rising rates as opposed to the typical asset mix at banks that benefit from rising rates, and (3) unique balance sheet structure (e.g., high percentage of corporate, as opposed to retail, deposits that were uninsured and with a concentration in the tech/VC sector).
The situation with Signature Bank was also unusual given: (1) its connection to the crypto currency markets, which led to it being the second fastest growing bank in the US over the last three years and (2) also having a high percentage of its deposit base being uninsured, making Signature Bank an outlier like SVB.
As mentioned earlier, banking regulators quickly announced emergency measures to mitigate liquidity concerns. The first measure, guaranteeing all deposits at these banks including amounts over the traditional FDIC-insured $250,000 threshold, intended to assuage fears of principal losses. It should also be noted that even during the GFC all depositors were eventually made whole. The second measure relieves liquidity concerns through a new Bank Term Funding Program, which allows banks to obtain advances for up to one year in exchange for eligible collateral (generally Treasuries and agency securities) at par rather than a mark-to-market discount. Both policies attempt to stem the risk of rapid deposit outflows.
The Largest Banks Remain Attractive
Since the GFC, Western Asset has regularly published on why we’ve favored investing in the best/largest banks. A quick summary of this reasoning includes: (1) banks’ strong balance sheets and the highly regulated banking environment; (2) their diversified asset base and liabilities structure; (3) near-record earnings in recent years—expected to rise further in 2023 given higher interest rates and margins; (4) benign future technicals—these large US banks issued much more debt than expected in 2021 and 2022; (5) conservative credit ratings—for the largest banks we expect positive ratings momentum with one-notch upside across the board, and (6) attractive valuations—after the GFC, banks traded wide of the overall credit sector in spite of the significant fundamental transformation the banking industry has been through. We continue to see value across the capital structure in the best and largest banks.
Our View on Regional Banks
Regional bank valuations, represented by both equity prices and credit spreads, have swiftly repriced to much lower levels. Regional bank spreads used to trade inside of the GSIBs (global systemically important banks), but in the wake of recent events they have gapped much wider. Part of this move reflects contagion fear and general selling pressure. Debt issuance for regional banks is likely heading much higher given the forthcoming higher-scrutiny regulatory environment and the larger capital cushions that will be required. Other earnings headwinds may include higher deposit costs, higher FDIC insurance fees, and increased staffing needed to comply with and manage to a much stricter regulatory framework. Valuations for new issuance are likely to come with attractive concessions to secondaries. The challenge now is to discern when attractive relative value is being offered.
The Bottom Line
The US banking industry is fundamentally strong. It will take time for confidence to completely return, but good bonds don’t trade at good prices when the news is positive. For those willing to get back in the water, we’d suggest starting with the largest non-GSIBs. These “super regionals” are more regulated than their smaller counterparts and have a stronger and more diversified asset base and balanced liability structure.