JPMorgan Chase (JPM -0.82%), America's largest bank by assets, recently announced the hiring of five new bankers to bulk up the tech and venture capital banking group it launched in 2019. While banks make new announcements all the time about launching different business lines and hiring new bankers, this recent announcement by JPMorgan is a bigger deal in my opinion because tech banking is such a great business and also such a niche business. This is also a unit that JPMorgan investors should pay attention to, because the bigger and more material to earnings it gets, the better it could be for the bank.
Lending to VCs
Tech and venture capital banking is a niche segment of banking, meaning it's a specialized segment of the market that only a handful of banks offer. It requires lenders with specialized skills and relationships with venture capitalists, and within the start-up ecosystem. It can also be very risky as start-ups have a high failure rate. However, if done correctly, tech banking can be tremendously profitable.
On the venture capital side, the primary product for most banks in this space is called the capital call line of credit. These are short-term loans to venture capital and private equity companies that are trying to execute quickly on investments they are making in start-ups or businesses. At Silicon Valley Bank (SIVB -0.18%), the bank that really pioneered tech banking, I know capital call lines can carry an interest rate that tracks the prime rate minus a quarter of a percentage point. In today's climate, that would be an interest rate around 3%.
Why is this important? During 2020 and even now, deposits flooded into the banking system, which is normally a good thing. But banks had nowhere to deploy those deposits and are still struggling to do so because we have been in a recession. That left banks with a tough decision: Invest the excess liquidity in the bond market to eke out some more yield or wait until opportunities open up. Most banks decided to wait on the bulk of their excess liquidity because bonds, like the 10-year Treasury note, still only pay a paltry yield.
However, last year, as investors were starved for yield, the private markets were one of the few areas that exploded. Recessions tend to birth a lot of new entrepreneurs because unemployment rises and more people are forced to go out and try to make it on their own. It can also be a time for disruption. The pandemic forced the majority of the country and world to operate remotely, which accelerated the use of digital technologies.
Ultimately, banks with capital call lines had the ability to deploy their excess liquidity, and at a rate far superior to what one could achieve in the bond market. That makes tech banking more resilient than a lot of other lending segments because it can flourish during a downturn. Capital call lines are also considered very safe -- Silicon Valley Bank has had net zero losses in this lending segment since it started originating the loans in the 1990s.
The other big component of the tech group is banking early-stage companies and start-ups. Banking doesn't just mean holding a start-up's deposits, but also offering payment services such as transfers and direct deposits and providing lending products as well.
There's a reason that 90% of start-ups fail, and it's because they are risky companies with very little proven traction. But because they are riskier, banks can typically get incentives from the start-ups such as warrants that entitle them to shares in a future initial public offering. For instance, it recently came to light that Silicon Valley Bank, which agreed to bank the cryptocurrency exchange Coinbase in 2014, has an outstanding warrant in Coinbase's upcoming IPO. The warrant gives the bank the ability to buy more than 400,000 shares of Class B common stock at just over $1 per share, making that warrant worth as much as potentially $152 million.
Banks can benefit from start-ups in other ways. For instance, if JPMorgan banks a start-up and then five years later it does an IPO, the bank can hopefully use this relationship to pass the start-up to its world-class investment bank, which could make a good deal of money by serving as the underwriter in the IPO. Start-up founders, when successful, also turn into high-net-worth individuals the bank can use its previous relationship with to cross-sell other products to such as jumbo mortgages and asset and wealth management products.
During the pandemic and over the last decade, banks that specialize in tech and start-up banking such as Silicon Valley Bank and First Republic Bank (FRC 0.55%) have outperformed the sector. So it's great to see JPMorgan getting further into this area, especially because its tech group can further complement its investment bank, and also identify individuals to which the bank can cross-sell other products.
Tech banking has also performed well during recessions and can benefit from higher rates because the interest it can charge on capital call lines moves with shorter-term rates. Additionally, it is a niche segment of banking that makes it hard for other banks to jump into. Given the fact that JPMorgan excels in nearly all aspects of banking, I have no doubt it can build up its tech division to be a strong performer as well.