Silicon Valley Bank collapse and what this means for markets

Venture capital and technology focussed-bank, Silicon Valley Bank (SVB) was placed into receivership on Friday 10 March by the California Department of Financial Protection and Innovation. The Federal Deposit Insurance Corporation (FDIC), the federal agency that insures deposits at US banks and takes control where there is a problem, was appointed as receiver. Highlighting the urgency of containing a ‘bank run’, Signature Bank (approximately half the size of SVB) was also closed by regulators this morning. The US Federal Reserve (Fed) has also released a statement today to shore up the banking system.

Whilst further information is expected to come to light in the coming days and weeks, this Special report summarises what happened at SVB, what will likely follow in the short term, and what impact the bank’s collapse is expected to have on the venture and technology ecosystem and wider market.

US Federal Reserve backstop announced this morning is reassuring for markets

Earlier this morning, the Fed Board released a statement saying that it will make available additional funding to eligible depository institutions to help assure that banks can meet the needs of all depositors. This action is designed to bolster the capacity of the banking system to safeguard deposits and ensure the ongoing provision of money and credit to the economy. The financing will be made available through the creation of a new Bank Term Funding Program (BTFP), offering loans of up to one year in length to banks, savings associations, credit unions, and other eligible depository institutions. The BTFP pledges US Treasuries, agency debt and mortgage-backed securities, and other qualifying assets as collateral. The BTFP will be an additional source of liquidity against high-quality securities, eliminating an institution’s need to quickly sell those securities in times of stress. Additional measures are to be implemented in a manner that fully protects all depositors, both insured and uninsured. 

The measures announced this morning were crucial in restoring trust in the functioning of the banking system and are therefore reassuring. Had the Fed and US Treasury failed to act, or been slow to act, they risked turning a liquidity crunch into something more systemic and economically impactful. Notwithstanding this, there are significant ramifications across various asset classes, which we summarise below:

• We remain underweight equities, including US equities.   
• The diversification benefit of bonds has been highlighted over the past few days with yields on the two to 10-year part of the curve falling 30-40 basis points (bps). The two-year note has seen its biggest two-day rally since 2008. 
• The clear linkage of this episode to the venture ecosystem will also likely add a further layer of caution for investors adding exposure in this area. This could, among other things, result in a tougher fund-raising environment, particularly for lower quality managers. It may also lead to lower valuations and lower deal activity more generally.  

The market expects this will have a meaningful impact on the growth/inflation outlook

Arguably, this may make matters more complicated for the Fed, at a time when it is trying to bring inflation back to its 2-3% target. Terminal, or peak, Fed Funds rate expectations have fallen from 5.7% to 5.1% in a matter of days. Meanwhile, the potential economic fallout can be seen by what it means for the January 2024 Fed Funds contract. Less than a week ago, it was priced for 5.43%. Now, it is priced for 4.47%. That is, the market is expecting this to have a meaningful impact on the growth/inflation outlook and expects the Fed will indeed need to cut rates in response. 

What does this mean for fixed income?

The announcement over the weekend saw bond yields experience their largest single-day move since 2008. It was a ‘flight to quality’ as money moved away from the banking system and into the safe haven of Treasuries. The two-year US Treasury yield rallied as much as 50bps on the expectation the Fed would also need to slow the pace of tightening.

Investment grade US bank credit spreads moved on average 15bps wider on the SVB news—however, the Fed Board has now announced it will make available additional funding to eligible depository institutions to help ensure banks have the ability to meet the needs of all their depositors. This will certainly help the fears of contagion ease and provide some stability to bank balance sheets, which could see some retracement in bond yields. Longer term, we remain overweight fixed income.

Australian bank balance sheets are in a very strong position and have all remained well capitalised. Any widening of investment credit spreads should be viewed as a buying opportunity.

What does this mean for equities?

Although it is tempting to suggest that Fed/Treasury intervention and a potentially lower path of interest rates is positive for equity markets, investors need to be wary of the economic impact of the SVB collapse. The fallout from SVB’s failure is yet to be felt, or reflected, in equity market valuations. We highlight several key implications:

• Risk premia should widen, as companies reveal the extent of their underlying exposure to SVB and reassess  vulnerabilities to external shocks.
• The interdependencies and linkages in US growth / venture capital have been highlighted and are more vulnerable than many realised. This suggests that the multiple ascribed to future earnings, all things equal, should be less.
• Although we are loathe to overplay contagion risks beyond some very specific players, the over-arching message remains that monetary policy acts with a lag, and we are starting to see the ramifications of that only now. We continue to believe that earnings expectations remain too high.
• Bank failures are not uncommon in the US. Generally, a few happen each year. In fact, is rare for there to be years like 2021 and 2022 where there were no bank failures in the US. The last time this occurred was in 2005 and 2006, as the Fed hiked rates from 1% to 5.25% (it stopped in July 2006 and held them there till September 2007). There is a degree of symmetry this time, as the Fed has increased interest rates from 0.25% to 4.75%. 
• Banks: One of the main differences between now and 2008, ironically, is also one of its problems. The banking systems is over-reserved. Banks are still paying very small rates of interest on deposits (in fact, banks have not really been competing on deposits at all). Depositors have been so used to receiving little return from their cash-at-call and term deposits that it took a 5% yield on three and six-month Treasury bills for them to notice. And when they did/do notice, deposits flee the banking system for more competitive (and less risky) rates of interest. There are two further implications in relation to this:

–    Fixed income is now a very competitive asset class and SVB’s collapse (and the subsequent performance of US 10-year bonds) tells us just how competitive it is. It took 5% at the front end of the curve for this to occur, but the relative attractiveness of equities in a higher interest rate environment remains challenged.

–    The speed of this unravelling is something that the world has not witnessed. Smart phones were not released until June 2007. The world is much more connected and instantaneous today, which made the speed of the response crucial. Failure to act in a quick and aggressive manner could have resulted in far-reaching economic consequences. 

–    Lastly, banks will need to compete more aggressively for deposits, raising the rates of interest on offer. This will have negative implications for net interest margins and overall bank earnings. 

What does this mean for venture capital funds?

Over the weekend, venture firms spent much of their time calling portfolio companies to assess exposure to SVB across deposits and credit lines, and to assist where possible in work-shopping solutions to address short-term cash needs. This was the most pressing issue as, in the absence of sufficient available cash, impacted companies would have struggled to continue to fund operations, most notably, payroll in the short-term.

Whilst the US government’s announcement this morning clearly reduces cash-related concerns for venture-backed and technology companies banking with SVB, and to a lesser degree the venture capital funds themselves, it is hard to see how the event will not have an impact on the venture ecosystem, at least in the short to medium term.

Both venture capital firms and their portfolio companies will need to ensure operating accounts and applicable credit is put in place (if not already) with other banking partners as soon as possible, and those that banked solely with SVB should certainly look to better diversify their relationships moving forward.

The clear linkage of this episode to the venture ecosystem will also likely add a further layer of caution for investors adding exposure in this area. This could, among other things, result in a tougher fund-raising environment, particularly for lower quality managers. It may also lead to lower valuations and lower deal activity more generally.  

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