US regional banks face a challenging future after the collapse of SVB

More than a dozen suspend trading. A crisis has emerged among US regional banks in recent days, as the collapse of Silicon Valley Bank has pushed the sector to its limits and raised questions about its stability.

The failures of SVB, with $209 billion in assets, and Signature Bank, with $118 billion in assets, represent two of the three largest bank failures in US history, eclipsed only by the collapse of Washington Mutual in 2008.

Meanwhile, trading in more than a dozen regional banks was suspended on March 13, with one, First Republic, falling 61.8 percent in a day before being suspended, according to data from Morningstar. At the end of last year, First Republic had $212 billion in assets and $176.4 billion in deposits, with about 70 percent of its deposits uninsured. This is above the median of 55 percent for regional banks, and the third highest in the group after SVB and Signature Bank, according to an analysis by Bank of America.

Fears of contagion, either within the banking system as a whole or specifically within US regional banks, have increased rapidly following the failures of SVB and Signature, with many regional banks seeing long lines of customers trying to withdraw money over the past two days.

Richard de Lisle, manager of the VT De Lisle America fund, warned that there could be further fallout if other regional banks have found themselves “in a similar predicament” by putting excess liquidity into mortgages “to earn a little more”.

However, he stressed that SVB’s customers made it particularly vulnerable, describing its depositors as small tech with money from venture capital funds, which are “more sensitive than American retail in small towns”.

Although de Lisle has no regional banks, he has a high concentration of his portfolio in community banks, defined by the Federal Reserve as those with less than $10 billion in total assets.

Charles-Henry Monchau, CIO at Syz Bank, said that while SVB’s collapse can be seen as an “extreme and hopefully isolated event”, the situation has rapidly deteriorated for US banks.

A combination of bond losses on balance sheets from rising interest rates and a drain on excess liquidity has hit banks hard, although the SVB was particularly reliant on deposits, which made up 89% of its liabilities, and had a large exposure to the technology sector.

This was “especially true for smaller regional banks”, Monchau added, as they are even more exposed to this from a liquidity and funding perspective as “the inversion of the yield curve really hurts their business model”.

Guy de Blonay, fund manager at Jupiter Asset Management, said there is “ not a banking crisis in the making”, as rising interest rates and quantitative tightening put pressure on banks, but regulatory intervention had put a “powerful backstop” in place.

Questions about the lax regulation of regional banks have also started to bubble up after the collapse of the SVB. Russ Mould, investment director at AJ Bell, noted that SVB met “all regulatory and capital adequacy ratios required of it”, while its bonds and debt also had an investment grade credit rating from the leading agencies.

Therefore, he said, some may question whether the regulations were “correct”, especially in their decision to give government bonds a zero risk weight when measuring a bank’s risk-weighted assets.

SVB fallout to slow down the deregulation of banks as part of the Edinburgh reforms. However, de Lisle argued that regulation in the US “is better than anywhere in the world”, as the FDIC keeps a “close eye” on smaller banks, meaning he did not expect extra regulation.

On the other hand, de Blonay argued that he expected more liquidity regulation for smaller banks, noting that the SVB was not subject to liquidity stress tests and liquidity coverage ratio requirements. Regional banks have lobbied over the past 15 years to reduce regulation of the sector and make them more legally separate from larger national banks.

A notable push was the 2018 softening of the threshold that banks are considered systemically risky and subject to stricter supervision from $50 billion to $250 billion. The SVB had $209 billion in assets at the end of last year.

In a speech this week, US President Joe Biden said: “I will ask Congress and bank regulators to strengthen the rules for banks to make it less likely that this kind of bank failure would happen again.”

De Blonay noted that this made an increase in regulatory scrutiny for liquidity-related bonds “inevitable”, which would be positive for larger banks as it would reduce capital arbitrage.

De Lisle also drew attention to the Federal Deposit Insurance Corporation’s lifting of the $250,000 limit on investor protection at the SVB, and wondered whether it would be extended to all depositors, adding that the regulator would “no doubt clarify shortly”.

De Blonay agreed: “It is important to recognize that by enabling the FDIC over the weekend to protect SVB depositors, the Federal Reserve has de facto provided protection to all depositors in the U.S. banking system.”

Looking ahead

A concern for small and medium-sized investors in the US is that as regional banks look increasingly risky, their pool of available options for exposure to financial assets will be diluted.

Chris Crawford, portfolio manager of the Strategic Long Short fund at Eric Sturdza Investments, said his fund has only a 4% exposure to commercial banking and exited a position in a regional bank last week.

Crawford now has only one small regional bank, at 2% of the portfolio, citing its “attractive footprint and very conservative balance sheet”.

However, he stressed that the fund found better access to financial information through stock exchanges, investment banks and asset managers, as they have “less direct interest rate exposure and deposit dependence than a traditional commercial bank”.

Jupiters de Blonay also said it is likely that investors will increase their preference for larger banks over smaller ones, and lean towards retail-centered banks over the more commercially oriented players.

“Greater competition for deposits could lead to lower net interest income over time and affect valuations. Indeed, the sector already looks very attractive,” he added.

Ultimately, de Lisle concluded: “Regional and community banks will still exist. Perhaps new rules will be created to prevent it from happening again, but Silicon Valley had uniquely large depositors and a niche position.”

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