Thoughts On ... Banking 101

March 17, 2023 | Matt Barasch


With the collapse of Silicon Valley Bank (SVB) and the resultant fallout over the past week, we thought we would explain in layman’s terms what has happened and what the likely impact will be on the Canadian banks.

Some Banking Basics

In our efforts to keep this simple, we are going to skip some of the more nebulous details.

Deposits are a short-term loan: When you put deposits in the bank, you are essentially lending money to the bank. Now, this loan is guaranteed up to a certain amount by the government (the amount is $250k in the U.S. and $100k in Canada), and as long as you are below the government guarantee amount, you feel pretty good about this loan. In fact, most people don’t even think of it as a loan, but rather a safe place to put excess funds and earn some interest on their money. One other thing we would add, when you make a deposit in the bank, you are specifically making a short-term loan to the bank. You could, demand the money the next day if you so desired, so even though many deposits stay at the bank for years, it is important to picture them as short-term loans. Most banks have diverse depositor bases, so the risks of rapid drawdowns in deposits is generally very low.

Which creates a mismatch: As the amount of deposits in the bank grow, the bank will lend out some of the funds to borrowers for mortgages, to grow their business, to buy new equipment, etc. But some of this money will be invested by the bank usually in super safe U.S. treasuries, highly rated corporate bonds and mortgage backed securities (MBS), which are also very safe. Now, the loans banks make and most of the safe stuff they buy tend to be longer term in nature. This creates a bit of a mismatch for banks, as remember - deposits are inherently short-term – while the lending side is inherently long-term. As long as deposits are pretty stable, there is no issue, but if deposits start to get rapidly drawn down, the mismatch can cause problems.

Banks are exposed to interest rate changes: Now, since banks own a lot of long-term loans - either to individuals or businesses or through ownership of treasuries, corporate bonds and MBS’s – they are very exposed to changes in interest rates – especially rapid rises in interest rates. When you buy a longer-term bond, as rates rise, the value of that bond will fall. Obviously, rates rose a lot in 2022, so one could imagine that these massive portfolios of long-term bonds suffered significant losses. Let’s look at a chart, which captures the size of the problem:

Hedges can significantly lower the risk: Now, as you can see in the chart, commercial banks own more than $4 trillion of government bonds (vs. less than $2 trillion a decade ago), which would suggest a lot of risk. But, and this is a big but, banks are well aware of this risk. In order to combat it, banks will typically hedge a significant amount of their loan portfolios, so that if rates do rise, the bank is not negatively exposed to it. We won’t get into the details of how banks do this, but it’s relatively easy to do and removes almost all of the risk of rising interest rates.

Banks have a choice: Finally – one last piece – the massive books of government bonds the banks own can be categorized in one of two ways – Available for Sale (AFS) and Held to Maturity (HTM). If these bonds are categorized as AFS, changes in the value of the bonds must be recognized in the bank’s capital, as the definition of AFS basically says -“we bought this bond with the idea that we may sell it at some point, so month to month changes in value matter to our capital.” Of course, if you hedge your exposure, which most banks will do with their AFS bonds, the changes in values of the bonds don’t matter that much as the hedges will offset the changes.

Conversely, changes in the value of HTM bonds do not impact capital because you are essentially saying – “look, we are going to keep these bonds until they mature, so who cares if their value changes from month to month.” Because HTM bonds are inherently designed to be held until the issuer of the bond pays you back, these will not be hedged from an interest rate perspective. In fact, accounting rules essentially provide a dis-incentive for hedging these bonds, so while some hedging will be done with HTM bonds, it will not be nearly to the degree that we see it with AFS bonds.

A red flag might be a bank that had a high percentage of bonds in its HTM account as this would not show up in capital and is likely to be significantly unhedged.

What happened to SVB?

Let’s think of this in terms of a checklist of things we would want a good, conservative bank to have:

Unfortunately, SVB failed badly on all three metrics.

X Depositor Base: SVB’s depositor base largely consisted of technology companies given its location in the Northern California technology corridor. This worked great over the past few years as the technology sector exploded with start-ups and venture capital money; however, when the space hit hard times in 2022, the deposit outflows for SVB were significant.

X Well-hedged bond portfolio: Coming into 2022, SVB’s bond portfolio was only about 10% hedged, which is extremely low. By the end of the year, it was almost entirely unhedged, meaning the run-up in interest rates throughout the year decimated the value of these bonds and hence SVB’s capital.

X High % of bonds in AFS to properly reflect capital: As you might have guessed, SVB made liberal use of the HTM account, which essentially masked the losses they were suffering on their unhedged bond book. Ultimately, SVB was forced to recognize these losses because it needed capital to pay back depositors and once it did, it’s capital was wiped out.

As a result, the downfall of SVB was swift in very much a vicious circle kind of way. The large outflow of deposits forced the bank to raise capital to cover the deposits, which in turn ate into SVB’s capital, which worried existing depositors, who withdrew their money, which led to more need for capital.

What about the Canadian Banks?

Let’s again use our checklist to analyze where the Canadian banks stand:

Depositor Base: The Canadian banks have a very-diversified depositor base, making the risks of an SVB-style bank run very low. Four of the Canadian banks – RY, TD, BMO and CM – have U.S. banking exposure, but exposure to the Tech sector ranges between 1-3% of their loan books, so even in a worst case scenario, losses would be limited.

Well-hedged bond portfolio: A perusal of the Canadian banks’ disclosure suggests that they are well-hedged against the recent rise in interest rates. Even if they were forced to realize all of their losses on AFS and HTM securities (in light of SVB, the risk of this is very low as regulators have already essentially ruled this out for other banks), the overall hit to capital for each of the Canadian banks would be 10% or less on an after-tax basis. Conversely, when SVB was forced to realize its losses to cover deposit outflows - this amounted to more than 100% of SVB’s capital.

High % of bonds in AFS to properly reflect capital: Again, the Canadian banks appear to have been very conservative as it relates to hedging and very conservative as it relates to use of AFS. Some of this is the result of a stricter regulatory regime in Canada than in the U.S. and some of it results from a more conservative approach that many larger U.S. banks have taken to risk.

No direct risks … but contagion: the biggest risk to the Canadian banks and quite frankly any bank at this point is likely a contagion similar to what we saw in 2008/09. This could best be described as investors become so spooked by what is happening to a handful of regional U.S. banks that the selloff broadens to include well-capitalized banks from all over the world that did not engage in the same risk taking. Indeed, we have seen the Canadian banks decline over the past couple of weeks; although, the share declines have been contained when compared to other financial institutions:

With significant steps already taken by regulators to contain the fallout, we would not be surprised to see share prices stabilize in the coming days; although, sometimes fear can overcome logic over short periods of time.

Non-bank Implications

Probably the biggest development outside the banking sector that we have seen is the massive rally in U.S. government bonds.

This is occurring for two reasons: 1) there is a flight to safety in times such as this and the U.S. dollar and U.S. bonds remain the safety valve for global investors, especially in times of distress; and 2) investors have become skeptical that the Federal Reserve will be as aggressive raising interest rates from here given the challenges in the banking sector.

Final Thoughts

The collapse of SVB is yet another challenge in what has been a challenging 15-months for investors. As we have pointed out in the past, times such as this tend to create opportunities as investors will crowd to the exits, sending the share prices of great businesses that have no direct and little indirect exposure to the crisis lower. We are beginning to see some of those opportunities develop and we expect to see more in the coming weeks and months given the economic challenges that we have previously outlined.