The Taiwan Banker

With billions of dollars being lost due to two major regional banks crashing within the last six months, the failures of Silicon Valley Bank (SVB) and First Republic Bank (FRC) in March and April of 2023 have been one of the most impactful economic setbacks that the U.S. financial industry has faced since the 2008 financial turmoil. Specifically, bank runs led to the collapse of both institutions after having underperforming quarters. This study analyzes the major factors that led to the failures of both banks previously regarded as good models in the banking sector from the comparison of the financials of these two high-growth banks with their comparable peers. It is found that the failures of these banks were the result of mismanagement of resources alongside the vulnerabilities of the business models under the situation of the increase in interest rates paired with the slowing technology sector since 2022. In the past, bank runs have been commonly associated with bank failures when too many depositors of a financial institution withdraw their savings simultaneously.This results in banks having problems meeting the demands of their customers, creating widespread panic in the broader financial sector. With millions of clients losing their confidence in regional banks after seeing the two failing banks in March 2023, there was a trend of clients transferring their money to bigger national banks.To properly evaluate the causes of their failures by comparing the financials and performance with the peers, this study includes other fourteen of the largest commercial banks in the U.S. Table 1 depicts the banks included in this study and their values as of December 2022. The quarterly data for financial analysis from 2018 to 2022 using the major banking institutions are collected from Mergent Online.The largest three, Bank of America, Citigroup, and Wells Fargo own assets of more than one trillion dollars at the end of 2022. SVB and FRC are regarded as relatively small among the top banks in the U.S. but still economically significant, with total assets of $417 billion. In terms of the asset values, their sizes are similar to those of Citizens Financial and M&T Bank, but the two failed banks only have 60% to 70% equity values compared to these compellable financial institutions, suggesting their less safety cushion for downside scenarios. Table 1. The total asset and equity values of banks in this study: December 2022 Bank Asset Value ($ Thousand) Equity Value ($ Thousand) Bank of America Corp 3,051,375,000 273,197,000 Citigroup Inc 2,416,676,000 201,189,000 Wells Fargo & Co 1,881,016,000 179,889,000 Capital One Financial Corp 455,249,000 52,582,000 US Bancorp 674,805,000 50,766,000 PNC Financial Services Group 557,263,000 45,774,000 Bank of New York Mellon Corp 405,783,000 40,734,000 Fifth Third Bancorp 207,452,000 17,327,000 Citizens Financial Group Inc. 226,733,000 23,690,000 M & T Bank Corp 200,729,841 25,317,990 Truist Financial Corp 555,255,000 60,514,000 KeyCorp 189,813,000 13,454,000 Huntington Bancshares Inc 182,906,000 17,731,000 Northern Trust Corp 155,036,700 11,259,500 Regions Financial Corp (RF), 155,220,000 15,947,000 First Citizens BancShares Inc 109,298,000 9,662,000 HSBC 164,655,000 12,113,000 SVB Financial Group 211,793,000 16,004,000 First Republic Bank 205,109,000 17,119,000 Data source: Margent OnlineCommon issues From the financial analysis, it is found that the two banks share some common managerial issues that led to their demise. First, SVB and FRC were short on liquidity prior to the failures.Figure 1 shows the ratio of cash and equivalents held compared to the total assets of the two troubled banks and their peer average over the 20 quarters before the failure. A decreasing trend of liquidity can be found from the fourth quarter of 2021 for SVB while FRC consistently maintained less liquidity than its peers. The lack of liquidity led to the banks selling their assets at a reported loss when depositors started withdrawing money. The liquidity management issue compounded to bank runs in which the institutions were ill-prepared to confront unexpected economic challenges. Figure 1. Cash and equivalent over total asset: 2018 -2022The rapid growth that overwhelmed the management of the banks can be a critical issue. As presented in Table 2, both banks grew at a much more rapid pace than their peers, resulting in large amounts of uninsured deposits that were used to partake in risky business strategies. The growth rates of SVB and FRC can be considered anomalies as both institutions had double or triple the amount of growth of the average financial institution. For asset management of SVB, it invested heavily in long-term U.S. treasury bonds when prevailing interest rates were low but did not respond quickly enough to the increases in interest rates. The exponential growth in the two banks was the result of a high percentage of uninsured deposits being invested in loans. With the mindset of “go big or go home” which can arguably be intertwined with the involvement of crypto investments, SVB had a chance of becoming one of the largest banks globally. Table 2. The annual growth rates of the banking businesses: 2018 - 2022 Growth rate SVB (%) FRC (%) Industrial Average (%) Deposits 30.39 20.12 9.52 Assets 31.68 18.50 8.20 Loans 24.80 20.36 6.73 Securities 36.47 10.89 9.39 The two banks rely on liability, but not equity, to finance more heavily than their peers.Figure 2 shows equity-to-asset ratios and suggests the susceptibility of the two banks to financial shocks is not as strong as their peers. Banks with higher total equity would have a larger buffer in case of bank runs or any other unforeseen economic circumstances. SVB and FRC consistently remain below the peer average across the entire period, although FRC is slightly more linear compared to the more fluctuating equity value of SVB. Specifically, the two banks consistently were around two to three percent lower for all quarters from 2018 to 2022. On the other hand, Figure 3 shows the deposit-over-asset ratios of the two banks are persistently higher than their peers. The ratios for FRC are 10% - 12% higher while SVB maintains 20% higher than the industry average over the 5-year period.As deposits, largely with shorter time to maturity, are less sensitive to interest rate changes than bank assets such as loans and securities, the capital structures of the two banks might leave them vulnerable financially when the market interest rates increase.Since depositors can withdraw their money at short notice, highly depending on the deposit leads to many vulnerabilities to commercial banks.Figure 2. Total equity over asset ratio: 2018-2022Figure 3. Deposit over asset ratio: 2018-2022SVB and FRC hold more amounts of deposits when compared to peers. Observing the employee cost over the total revenue ratio over the 5-year period demonstrated in Figure 4, it can be found that FRC and SVB differ from the peer average by slim margins. However, the fact that millions of dollars can be either saved or lost with a two or three-percent difference suggests the two banks suffer from a lack of efficiency in salary spending. The general direction tends to depict SVB and FRC remaining slightly higher employee costs relative to peers while there are volatilities. Prior to the failures in 2023, the two banks experienced a higher employee cost than that of the other banks. As employee costs serve the important role of describing the efficiency in the financial industry, this ratio may reflect the lack of efficient practices at FRC and SVB. Figure 4. Employee cost over total revenues: 2018-2022SVB and FRC may be less efficient compared to the industrial average, resulting in the higher employee costThe business model of SVB is to obtain a high percentage of fixed-income securities over its total assets and attributed to its fatal financial stress. As its major clients are technological start-ups, SVB regarded investing in long-term U.S. Treasury securities as its major asset-managing strategy when it obtained a great sum of deposits in the past years. This allows SVB to generate stable cash flows by investing in low-risk securities. However, with the change in monetary policy made by the Federal Reserve increasing the interest rates, SVB did not decisively adjust the components of its asset portfolio quickly but eventually sold the bonds at a large loss of $1.8 billion. Differing from typical commercial banks that have loans as their main assets, SVB has a lower percentage of loans over total assets than the peers in this study, suffering a lack of asset diversification.Similar to SVB as a regional bank, FRC implemented a different business model by focusing on wealthy clients and corporations. The Federal Deposit Insurance Corporation (FDIC) ensures up to $250,000 in the case of a bank failure; however, a large majority of the accounts had over $250,000 deposited into the bank. Once SVB faced financial stress, the spread of fearful sentiment made clients of FRC quickly pull out their money, a total of $100 billion in just a few days, due to a lack of confidence. Due to the rising interest rates, both FRC and SVB were not able to sell their assets that suffered value declines to raise capital. Due to the loss of confidence in banking institutions from the SVB scare, FRC also inadvertently faced consequences, eventually being forced to be bought out by J.P. Morgan. Different causes leading to the same fate Even though SVB and FRC both collapsed around the same time, there are some unique factors to each bank that caused its demise. First, the asset portfolios differed due to their various business strategies.As shown in Figure 5, SVB consistently held a higher percentage of securities, doubling the average of peers in many of the quarters, particularly after 2020, but FRC owned fewer securities, indicating a difference in the investing strategy between the two banks. When a bank owns a high percentage of fixed-income securities as assets, there is an interest rate risk that leads to a loss of market value. The SVB was to invest in a large sum of securities to earn profit but failed to respond to the rapid increases in interest rates when lowering inflation become the priority for the U.S. central bankers. Contrastingly, this ratio for FRC was below the peer average, as FRC focused on expanding the business lines in loans and leases. Figure 5. Securities over total asset ratio: 2018 – 2022 It is also found the difference in the business models of the two banks from comparing the ratio of net loans and leases over total asset value in Figure 6. Since FRC’s business lines mainly lie on the provision of credit, it remains at ratios higher than its peers while SVB maintains low percentages throughout the 20 quarters. When examining the relationship between net loans and leases and securities, it is evident that there is an inverse relationship. SVB chooses to focus on a high percentage of securities, consequently resulting in fewer loans and leases. Thus FRC, from the components of assets, is of the typical nature of commercial banks. Figure 6. Net loans and leases over total asset ratio: 2018 - 2022 These two cases also suggest the failure of commercial banks may not directly be caused by the loss in their operations but by risk management and strategies. The change in the ratios of net income over total revenue demonstrated in Figure 7 suggests that SVB possibly had a more profitable banking model, for the most part, than the industrial average. However, this includes a lot more risk. A piece of evidence can be SVB has higher ratios of deposits over total assets compared to the industrial average. The business of FRC yielded profitability similar to the industry average but outperformed its banking peers in 2020. Though there was higher net income, depositors started to rapidly take their funds out when any unexpected event happened, and the bank quickly saw its demise. A bank run can be worse for the one with the higher number of deposits as it will have a harder time securing sufficient funds for its operations.Profit is not an issue at hand, rather it is the inability of the banks to turn assets into cash in a timely manner. Figure 7.Net income over total revenue: 2018 -2022The ratio of net interest income after loss provision over total revenue demonstrated in Figure 8 suggests FRC focused on the commercial banking business more than its peer average.On the other hand, the main business model for SVB to yield profit has changed to investing security in 2020, leaving it less reliant on traditional lending.As the loan loss provision is based on the estimate of the non-performing assets, the higher ratios of the banks can also result in the good quality of lending portfolios. No piece of evidence of mismanagement can be found in the aspect of generating net interest income. Figure 8.Net interest after provision over total revenue: 2018 -2022 While SVB is similar to industrial average, FRC outperforms in terms of loan portfolio management. ConclusionBank management has become increasingly challenging as many unprecedented factors in the present economy can trigger the failure of financial institutions.This study demonstrates the causes that built up to their collapses differed from one another although both FRC and SVB suffered the same fate of bank run. It is found that SVB allocated largely securities as its assets, which would lead to financial stress when the market interest rates increase.On the other hand, FRC was heavily reliant on large deposits, leading to financial stress if clients lacked confidence and made prompt and unbearable withdrawals. It is also found that FRC and SVB were similar in that both maintained lower liquidity but higher financial leverage than the industry averages several quarters before their failures, regarded as risky strategies for financial institutions. The insufficient liquidity holding and shareholder equities make the two banks financially vulnerable to respond to shocks in the market.To avoid turbulences in the future, financial institutions may want to ensure that they follow proper assessments of various risks regarding assets and liabilities. Furthermore, more liquidity to have the proper resilience to confront financial events such as bank runs should be considered for financial institutions. Works CitedBarr, Michael. 28 Apr. 2023, Review of the Federal Reserve’s Supervision and Regulation of Silicon Valley Bank.W. Paul Chiou is a professor of finance at Northeastern University in Boston, MA