March 23, 2023 Letter to Clients

In response to the recent failures in the banking system, we are sending this supplement to our quarterly market commentary to provide an explanation and our thoughts moving forward. There is an old expression that the Federal Reserve (Fed) hikes rates until something breaks. The Fed has aggressively hiked rates, 450 basis points, in a little under a year. With the recent bank failures, the Fed having to step in to backstop depositors, and with regulators developing a plan known as the Bank Term Funding Program (BTFP) to calm markets and mitigate further runs on banks, many would argue that that “break” has now occurred.  The Fed may not agree, and it remains to be seen how rates are handled moving forward.  We are closely monitoring the situation and the potential implications of policy actions on the financial markets and the economy. 

  In its simplest form, banks gather deposits from customers, both individuals and corporations, and pay those customers a short-term interest rate.  They then invest some of those deposits in fixed income securities, such as US Treasuries or mortgage-backed securities.  Depending on the duration of the fixed income portfolios, similar to individual investor’s portfolios, some banks experienced substantial market declines during 2022 as a result of the interest rate hikes (recall that as interest rates rise, the value of existing bonds decline).  With their fixed income portfolio losing value, the banks have less money to repay their depositors when withdrawals are requested.  If some depositors request withdrawals, it’s not really a problem. But if enough depositors want to withdraw their money at the same time, you have what is known as a bank run, which can be compared to yelling “Fire!” in a crowded theater.  In the case of Silicon Valley Bank (SVB), this run risk was exacerbated given some unique circumstances as explained below.  

Silicon Valley Bank: What Prompted The Collapse 

SVB was unlike a traditional retail bank in that its customer base was highly concentrated in start-ups and companies relying on venture capital funding, not retail customers, such as you and I.  In 2020 and 2021, it is estimated that given the financial climate and the high level of funding their customers were receiving, the deposits into SVB grew at a rate of 3-4x the rate of a traditional retail bank.  As described above, SVB invested this money in long duration fixed income securities, essentially tying up short-term deposits in long-term investments. 

Fast forward to 2022, the financial climate changed, and their customers were no longer receiving the funding they once were. Therefore, thus not receiving the requests to use their cash deposits to meet operating expenses and keep their companies afloat were coming in. To meet this demand for cash, SVB liquidated their fixed income securities at a loss.  This in turn created a capital issue, which turned into a credit issue.  To meet their obligations, the bank announced a capital raise, which came as a surprise and spooked customers. This prompted a bank run with a massive outpouring of cash, and in SVB’s case, it was to the tune of $42 billion by the end of day on March 9th,  which ultimately led to the regulators coming in and taking over the bank the next day. SVB’s highly concentrated customer base (which is not usual for a retail bank) created a run risk and that coupled with their liquidity risk, created the core of their issues.   

Other banks making the news are Signature Bank, which was shuttered by New York state regulators. The bank's connections with cryptocurrency seem to have frightened depositors after SVB collapsed, prompting a run on the bank's deposits which, in turn, prompted action from regulators.  First Republic has become the latest US bank to be rescued, the 14th-largest bank in the US, catering to high-net-worth individuals with high levels of uninsured deposits and an unusually large loan-to-deposit ratio as they loaned out more money than it has in deposits.  Like SVB, First Republic also has a concentrated customer base and in First Republic’s case, it is wealthy, sophisticated depositors who had the knowledge and means to move their money out very quickly when unsettling news began to surface.  It remains to be seen if First Republic’s rescue is successful, as firms including JP Morgan, have infused over $30 billion into the bank to shore up confidence.  One takeaway from both the SVB and First Republic mess is that the amount of money depositors keep in a bank, along with a bank’s customer base, plays an important role.  Both had an unusually high concentrated customer base, something other banks such as JP Morgan do not. Having a diversified group of depositors may not have prevented their troubles, but it quite possibly could have assisted them.   

Credit Suisse: 

Bank collapses have not been limited to the US, with Credit Suisse, Switzerland’s second-largest bank and long considered one of the world’s most important banks, dominating headlines with their recent collapse.  This poses a much bigger concern for the global economy than US regional banks, given that Credit Suisse is a global systemically important bank, having offices in at least 50 countries and charged with overseeing the wealth of many of the worlds’ wealthiest people and companies.  

The issues faced by Credit Suisse are very different than that of the US banks.  What propelled them to the forefront of financial news most recently is the announcement by Saudi National Bank, Credit Suisse’s largest shareholder, that they were no longer able to offer financial support due to regulatory issues, news which came on the heels of the SVB and Signature Bank collapse.  While current events are still unfolding, at the time of this letter the Swiss government has stepped in to allow the acquisition of the bank by UBS, Switzerland’s largest bank, without the required shareholder approval.  UBS has already announced plans to align Credit Suisse’s investment and banking business with their own more conservative culture.  While it wasn’t rising interest rates that triggered Credit Suisse’s recent troubles, it does serve as a reminder that as interest rates rise, vulnerabilities become more transparent.  

At LePage Financial, we have always emphasized the importance of having a solid cash position in the bank, outside of your investments, for everyday and unexpected expenses.  That said, we would like to provide some important points regarding the protection of your cash held in a bank, through the FDIC.   

Federal Deposit Insurance Corporation (FDIC)  

The Federal Deposit Insurance Corporation (FDIC) is an independent agency that maintains stability and public confidence in the nation’s financial system.  The FDIC protects bank depositors against loss of their insured deposits if an FDIC-insured depository institution fails. To determine if your bank is FDIC-insured, you can contact or visit the bank directly or visit the bank’s website and look for the FDIC logo.  

  •  The standard deposit insurance amount is $250,000, per depositor, per FDIC-insured bank, per ownership category.  
  • Not all financial products at a bank are covered by FDIC.  Investment products that are not deposits, such as mutual funds, annuities, life insurance policies, and stocks and bonds are not covered by FDIC insurance.  
  • If you have questions or concerns regarding your coverage, it is recommended you speak directly with your bank to gain a better understanding of your coverage.  

As a result of the 2008 Global Financial Crisis, banks are now required to be better capitalized. The government has learned a lot of hard lessons on how to handle bank failures and the root causes of the current banking issues are very different.  All that being said, we anticipate some additional fallout from this episode and continued market volatility as the ramifications of recent events are fully understood.  On the bright side, the Fed may now understand that its rate-hiking cycle has destabilized the financial system.  Promoting financial stability is one the Fed’s core functions, in addition to its dual mandate of price stability and full employment.  As such, we expect the Fed to be more cautious in future rate hikes, potentially leading to a more stable rate environment.  

In every economic and market cycle, there are risks, and there are opportunities.  We may not know for certain what will happen next, and risks do remain, but today’s calculated risks are tomorrow’s opportunities.  Once again, we rely on history to remind ourselves it is beneficial to remain invested during periods of volatility because the stock market recovery tends to happen before it is clear that the worst is behind us.  We encourage clients to remain disciplined in their long-term investment plans and rest assured, we are here to discuss any questions or concerns you may have or to have a conversation about your investment strategy. 



Steve LePage