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When Quantitative Tightening Leads to a Bank Failure in California

Headquartered in Santa Clara, California and with total assets valued over $200 billion, until last week, Silicon Valley Bank (SVB) was considered the 16th largest bank in the United States. It was also considered the main artery supplying capital and banking services to nearly half of the U.S. venture-backed technology companies, including the startup ecosystem that region is predominantly known for.

This ‘run on the bank’ was a combination of a few different events that created a perfect storm: the bank’s fixed income portfolio, mismanagement of duration, and liquidity crunch caused panicked customers, all combined with the Federal Reserve’s quantitative tightening.

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Quantitative Tightening and Second Largest Bank Failure

Before diving into SVB’s failure, it’s important to understand how quantitative tightening can severely impact fixed income portfolios, especially with longer durations. Quantitative tightening is the process through which a central bank reduces the amount of money in circulation by selling assets such as government bonds. The process of quantitative tightening can have a significant impact on the performance of fixed income portfolios, including changes in interest rates, yield curve shifts, and duration risk.

One of the most significant impacts of quantitative tightening on fixed income portfolios is changes in interest rates. When central banks tighten monetary policy, it can lead to an increase in interest rates. We have been seeing consistent, yet swift, interest rate hikes by the Federal Reserve, starting at the beginning of last year.

These interest rate hikes impact the value of fixed income securities, as the present value of future cash flows decreases when rates rise. As a result, investors holding fixed income securities have been experiencing unrealized losses and a significant decline in their portfolio values.

Additionally, the process of quantitative tightening can increase the risk associated with duration in fixed income portfolios. Duration risk is the risk that changes in interest rates will impact the value of fixed income securities. Fixed income securities with longer maturities typically have a higher duration, meaning they are more sensitive to changes in interest rates. Therefore, when central banks tighten monetary policy, it can increase the duration risk of fixed income portfolios that hold longer-term bonds.

Now in the case of SVB, as the Guardian explains, “The seeds of its demise were sown when it invested heavily in long-dated U.S. government bonds, including those backed by mortgages. These were, for all intents and purposes, as safe as houses. However, as aforementioned, bonds have an inverse relationship with interest rates; when rates rise, bond prices fall. So when the Federal Reserve started to hike rates rapidly to combat inflation, SVB’s bond portfolio started to lose significant value.”

Like any other fixed income portfolio, if the bank was able to hold on to its investments, longer-term bonds or other fixed income securities, until their maturity, then it would have received the entire principal back. However, the perfect storm was created with its clients—especially tech companies, including startups that typically burn through cash relatively fast—started drawing on their deposits. In the case of SVB, the bank didn’t have enough cash on hand to meet customer demand and had to sell its fixed income holdings at hefty losses; the unrealized losses, due to quantitative tightening, turned into realized losses for the bank.

“It took just 48 hours between the time it disclosed that it had sold the assets and its collapse.”

Impacts of SVB’s Failure on Municipal Governments

Although SVB was focused primarily on tech companies as its customers, its failure can still lead to the potential reduction in the supply of credit, including acting as the underwriter for municipal debt and/or investor in municipal debt in the area. As a large investor or market maker gets taken out, it can potentially lead to a higher cost in raising debt. This includes the short-term funding structure, such as credit facilities etc,, that SVB provided to many of its clients that will now be completely seized, restricting access to capital for many of its clients.

At the banking level, many local governments, their employees, and their vendors may have their banking relationships with SVB. As the FDIC took over the bank, these people didn’t have access to their accounts. Initially, it was unclear as to how much of their deposits would be covered by FDIC insurance; the standard limit is $250,000 per customer. The long-term impacts of the bank failure are yet to be seen. However, depositors for all other regional to large banks are cautious about potential cascading impacts on other financial institutions.

The Bottom Line

Although rare, financial institution failures often underscore the need for stronger regulations and an in-depth assessment of the impacts of monetary policy at the federal level. At an investor level, to potentially mitigate the impact of quantitative tightening on fixed income portfolios, investors must take a strategic approach.

One potential solution is to diversify fixed income portfolios by investing in a mix of different types of bonds, such as government, corporate, and municipal bonds paired with shorter maturities, which typically have lower duration and are less sensitive to changes in interest rates.

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Mar 15, 2023