Today we are going to address the “elephant in the room” in the stock market—Bank Stocks.
Since February 7th, 2023, the Banking Sector stocks have reversed from up 13.5% ytd to down 8.5% ytd. Most of this reversal has happened over the last week due to investor fear related to Silicon Valley Bank.
SVB announced large losses on a sale of its “Available For Sale” bond portfolio and a subsequent equity capital raise leading to fears across the banking sector of impending losses and new stock offerings.
So, should we be worried about an impending banking crisis? Well to answer that question, we’ll need to spend some time explaining bank accounting and capital regulations. Then we’ll discuss SVB’s unique problems and see if these issues will impact the broader banking system.
Bank Accounting and Capital Regulations
During the Global Financial Crisis of 2008-2009, many new regulations were imposed on the banking industry. One of these was the requirement to maintain a Liquidity Coverage Ratio above 100%. The LCR is designed to ensure that banks hold a sufficient reserve of “High Quality Liquid Assets” to allow them to survive a period of liquidity stress (or outflows) of 30 calendar days. This effectively forced the banks to own around 10-15% of their assets in “High Quality Liquid Assets” also known as investment grade bonds.
This regulation would have injected considerable volatility into the banks’ income statements as publicly traded bonds are volatile. In order to mitigate this volatility, the regulators created a new set of accounting standards for these assets. Banks would classify these HQLA investments into two buckets—Available For Sale (AFS) and Held to Maturity (HTM).
The HQLAs held in these two buckets would be treated differently than normal bank assets and would not be subject to “Mark to Market” accounting—meaning that the banks would hold them on their balance sheets at cost until maturity or sale. Fluctuations in AFS assets do get routed through the financial statements in accumulated other comprehensive income but neither bucket hits the income statement until the bonds are sold or matured.
This means that over time, banks build up unrealized gains or losses from these regulatory assets which do not appear on the income statement until a transaction occurs.
Another new regulation implemented after the financial crisis was a new standard for leverage. Banks would be required to hold 7% of risk weighted assets in Tier 1 equity (the systemically important financial institutions were required to be at 10%). This would limit the amount of leverage a bank could employ to boost returns thereby protecting depositors and creditors. As asset size fluctuates, banks are required to manage their equity to the new Tier 1 Capital Ratios.
SVB Financial Group (SIVB)
Silicon Valley Bank as you might guess is a leading bank in the Bay Area with a focus on start up companies and their investors. It is heavily exposed to the Venture Capital markets with its core clients usually in cash burn mode instead of cash savings mode. It is one of the larger regional banks in the US with a total asset value at the end of 2022 of $212 billion. At the beginning of this year, the bank had a CET1 Capital Ratio of 12.05% vs the 7% requirement.
Last year, the bank’s non-interest-bearing deposits (usually checking accounts) declined by 36% or nearly $45 billion. Evidently the outflow of deposits has persisted this year leading to the bank deciding to restructure its AFS assets. Unfortunately, the management team has done a very bad job allocating its assets.
At the end of 2022, only 35% of its assets were in loans but 55% of its assets were invested in AFS and HTM bond holdings. This level of HQLA is way above the regulatory levels needed and exposed the bank to much more asset risk than necessary. Not only did the bank decide to buy bonds instead of underwriting loans, but they also skewed the vast majority of HTM assets into long-term bonds. Of the company’s $91 billion in HTM assets, 95% were invested in bonds with a maturity longer than 10 years. The AFS assets also had 28% of the $26 billion portfolio in bonds with a maturity longer than 10 years.
You’ll remember that due to rising interest rates last year, bonds had a dreadful year. The US Aggregate Bond Index was down nearly 14% in 2022. This shift in bond prices built unrealized losses of $2.5 billion in AFS and $15 billion in HTM. For some context, the banks total Tier 1 Capital was $17.5 billion.
In a normal environment, this may not have been a problem, but given the bank’s core customers, deposit outflows have been large effectively forcing the bank to sell its AFS portfolio and book the losses. Two days ago, the bank announced that it had sold $21 billion of its AFS assets and realized a $1.8 billion after-tax loss. This wouldn’t have required an equity capital raise, but the bank then announced that it was seeking $2.25 billion in new equity capital.
The markets interpreted this event as a sign of imminent failure and began selling the stock. The regulator shut down Silicon Valley Bank this morning to protect depositors and creditors.
Spill Over
So, the big question now is—Are the issues facing SVB Financial Group unique to them or is this the canary in the coal mine for the banking industry? Given how the rest of the bank stocks are performing this week, investors have decided to sell first and ask questions later.
Before we give you our opinion, let’s take a look at an example of the Mega Banks—Citigroup.
At the end of 2022, Citigroup had total assets of $2,417 billion, a CET1 Capital Ratio of 13% and $201 billion of equity capital. AFS assets were $250 billion and HTM assets were $269 billion or 21% of assets. Only 5% of AFS assets were in bonds with a maturity longer than 10 years with HTM assets of 10 years or longer at 43%. Current unrealized losses in the AFS portfolio are $6.6 billion with $25.3 billion in the HTM portfolio.
Given the profile of Citigroup’s business and the fact that they have $1,909 billion in assets outside of the AFS and HTM portfolios, it seems unlikely that the bank will be forced to liquidate the majority of its HQLA holdings. Even if the bank were forced to liquidate the entire HQLA holdings the realized losses would be less than 16% of equity capital and we calculate that their CET1 Capital Ratio would still be above the 10% requirement.
Our view is that the major banks do not have the same balance sheet and liquidity issues facing SVB Financial Group. Investors are concerned about the built-up unrealized losses in the HQLA holdings, but the bulk of these losses will never be realized as bond holdings mature at par. The mega banks and largest regional banks should have plenty of excess reserves with the Federal Reserve to meet deposit outflows without significant shifts in their HQLA portfolios.
Here are some comments on this situation from Wall Steet Analysts:
VIVEK JUNEJA, ANDREW DIETRICH, SAI NETTEM, ANALYSTS, J.P.MORGAN
“Large bank stocks sold off sharply yesterday following events among a couple of smaller banks. We believe the sell-off was overdone as large banks have a lot more liquidity than smaller banks, they are more diversified with broader business models, have a lot of capital, are much better managed in regards to risk, and have a lot of oversight from regulators… We don’t expect a fire sale of securities from our banks, unlike at some smaller banks due to their liquidity positions and large, diversified deposit funding.”
EBRAHIM H. POONAWALA, ANALYST, Bank Of America
“We believe that the sharp sell-off in bank stocks yesterday was likely overdone as investors extrapolated idiosyncratic issues at individual banks to the broader banking sector. However, the sell-off also highlights a (belated) realization among investors that higher for longer interest rates are negative for the sector’s earnings per share outlook. While bank stocks could bounce in the short term on macro data that soothes inflation concerns, we believe that the group will struggle to shed the late cycle mindset that has taken hold among investors since last year. We remain biased towards maintaining exposure to the sector via mega-cap banks.”
ERIKA NAJARIAN, BANK ANALYST, UBS SECURITIES
“The sector’s knee-jerk reaction is understandable, but likely overdone. While the lion’s share of investors appreciated the uniqueness of SIVB’s situation, investor concerns over deposit outflow and mix shift are still heightened . If investors are concerned about deposit flow, why punish the stocks who have sticky, operational retail checking deposits? In the era where funding and liquidity is a top concern, we think the money centers, especially JPMorgan Chase & Co would be the best place to ‘hide.’ And Bank of America’s more than 6% decline in the stock feels too much for the institution that has one of the best and stickiest retail deposit bases in banking. Wells Fargo’s funding should have the least amount of ‘surge’ given its asset cap. And US Bancorp’s 7% decline is befuddling, given a very conservatively managed balance sheet.”
We expect a period of heightened volatility in the stock markets over the next few weeks as investors assess the potential impact. Hopefully, this will present opportunities to buy assets at attractive prices.
