Client Update: Silicon Valley Bank (SVB) Failure- 3/16/23

By Bruce Thompson on March 16, 2023

Follow Up on Bank Jitters; Brokerage Account Protections

Bruce Thompson, March 16, 2023

Correction

In our letter of March 13, 2023, the reference to “Pay on Demand” should read “Payable on Death.”

Banking System Stress

If you’re not a customer of Silicon Valley Bank (SVB) or the other banks that recently went into FDIC receivership, the key question is whether the issues are unique to those banks or systematic. Bank failures actually are not that uncommon; over the last ten years, 122 U.S. banks have been taken over by the FDIC as you can see here. 

Banks have been squeezed recently because the sharp rise in interest rates decreased the value of bonds held as part of banks’ capital reserves, some more than others. This chart, from JP Morgan Asset Management, dated as of December 31, 2022, shows that while all banks suffered unrealized declines in the value of their bond portfolios last year, SVB’s situation was extreme. 

Banks are required to maintain 6% in Tier 1 Capital reserve, representing the strongest form of capital that can be liquidated quickly to absorb losses. The value of bonds and other assets held in Tier 1 Capital must be “marked to market” to reflect changes in market values. However, new rules passed in 2018 exempted mid-sized (not large banks) from adjusting book values for certain high-quality assets, such as U.S. government-backed bonds.

If held until maturity, those bonds will be redeemed at full value. However, if a bank receives unusually high withdrawal requests from depositors, the bank must sell bonds to raise cash and then it must realize the losses, which reduces the reserve capital. In a nutshell, this is what happened at SVB. 

The SVB situation is exceptional for several reasons. The bank invested in long-term government bonds, which were hit harder by rising rates, in an attempt to generate additional profit margins. Its customers tend to have large deposits in excess of FDIC insurance limits relative to other banks, customers are concentrated in the venture capital sector, and they talk to one another, meaning SVB was especially vulnerable to a “run on the bank”. 

This created a perfect storm for SVB. Given tech’s difficult year in 2022, companies needed to withdraw more money than usual to meet operations. The bank had to sell bonds and realize the losses, which in turn reduced their Tier 1 Capital. Recently, when management tried to raise funds to shore up capital, they unwittingly spooked their savvy, connected, and largely uninsured depositors, causing a classic bank run.

While there will be economic reverberations from this, and other primarily mid-sized banks or weakly capitalized banks may come under pressure, there are critical differences with the mortgage-related banking crisis. 

Large “too big to fail” banks, such as JPMorgan, Citibank, and BankAmerica, have been required to adjust their bond values to market and this is reflected in their healthy capital ratios. The capital requirements are higher today as a result of post-crisis banking regulation, while a much larger proportion of the deposits at big banks are insured and spread over diverse customers. Importantly, investments held in banks’ capital reserves are by requirement higher quality; the issue today is with a decline in value of government-backed bonds, not subprime mortgages and leveraged derivatives. 

At some level, our banking system and markets are dependent on confidence in the system itself. The FDIC/U.S. Treasury/Fed moved quickly in the last week to support the banking system, which engenders confidence.

Brokerage Account Protections

With the recent heightened attention on the banking system, we’ve been asked about the safety of client assets held at independent custodians Fidelity and Charles Schwab. It is important to distinguish between protections afforded brokerage accounts and deposits held at banks. 

The SEC Customer Protection Rule requires brokerage firms to keep clients’ securities and cash segregated from their own so that, even if a firm fails, its customer assets will be safe. This alert from FINRA describes the multiple layers of protection in place.

Brokerage firms are also required to maintain SIPC coverage, which you should understand comes into play where clients’ assets might be missing due to theft or fraud. 

Here are circulars from Fidelity and Schwab describing their compliance with the SEC Customer Protection Rule and also specifying the types of assets and accounts at the firms that are covered by SIPC and FDIC. 

These protections should not be construed as guarantees against losses or fluctuations in the value of securities held in your brokerage accounts. 

Schwab has been in the news recently due to its ownership of Charles Schwab bank and we wanted to provide the attached letter from Schwab management, Our Perspective on Recent Industry Events. 

As discussed, problems at Schwab Bank would not put at risk securities held in custody in Charles Schwab brokerage accounts, such as money market funds, stocks, bonds, and mutual funds. Cash held in sweep accounts or CDs offered through Schwab Bank are protected by the FDIC up to their limits, generally $250,000 for an individual and $500,000 for a joint account.

Please don’t hesitate to reach out with questions or concerns about how these protections apply to your accounts. There are many highly secure solutions for cash management and your advisory team at LWM is happy to review them in conjunction with your specific needs. 

Disclosures:

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