On March 1, I wrote the following in a piece on rising bond yields and Commercial Bank Deposits:
‘banks are now pressured to lift the rates on their deposits. If they do, this will eat into their profit margin. If they do not, their reserves will dwindle, increasing the odds of a financial crisis’
And after the biggest one-day decline in bank stocks since Covid, that crisis may unfold faster than anticipated. In this piece, I will explain what is happening, how the pieces fit together, and what implications recent developments have for markets and monetary policy.
Forget about Silvergate and Crypto
With the S&P 500 Banks Index down a whopping 6.6% on Thursday, the biggest decline since June 2000, this is not about some bank operating at the crossroads of crypto and traditional finance. This is about potential systemic bank risk.
The focus is now on SVB Financial, the holding company for Silicon Valley Bank, the biggest bank in Silicon Valley. According to Statista, Silicon Valley Bank ranked as the 14th largest US bank based on total assets in 2022.
Duration risk and balance sheet management
At the end of 2022, Silicon Valley Bank had just north of USD 160 billion in deposits on its books. Like many other banks, it put a large chunk of that money ‘to work.’ Banks can earn additional income by investing in assets with a higher yield than they pay on their deposits. Silicon Valley Bank did so with roughly USD 80 billion, which it invested predominantly in US Treasuries and mortgage-backed securities.
Many investors, perhaps also those running a bank’s investment book, tend to forget that while US Treasuries and mortgage-backed securities carry little credit or counterparty risk, they are not ‘risk free.’ Treasuries and the like are characterized by duration risk, or interest-rate sensitivity. While bond traders like to make duration a complex matter, the concept is extremely straightforward. When market yields rise, bond prices must drop to also reflect these higher yields and vice versa.
To get an idea of how much rising yields hurt the value of bonds, the chart below shows the performance of US Treasuries since the start of 2022 (left axis) and their yield to maturity (right axis). ‘Safe’ US Treasuries are down 12% as yields have increased from just above 1.0% to above 4.0%.
Hold to maturity
Now, if you aim to hold your Treasuries until maturity, all the fluctuations in the value of US Treasuries, including the 2022 bear market, are just noise.