Don't Panic: The "Too Big to Fail" Banks Have Ample Liquidity

After the failure of SVB Financial (SIVB.Q -50.00%), the parent company of Silicon Valley Bank, the entire banking industry sold off last week on fears over broader contagion and whether other banks could face similar issues.

While it's certainly a scary time and simply shocking to see such a large bank that had performed incredibly well for decades fail so quickly, I consider SVB to be more of an outlier and that the broader banking system is in much better shape, particularly among the "too big to fail" banks like JPMorgan Chase (JPM 1.44%) and Bank of America (BAC 1.70%). These banks have ample liquidity, as I'll explain below.

Why SVB Financial collapsed

SVB's failure was different than what occurred during the Great Recession in that it wasn't a credit story but a deposit, bond, and liquidity story. SVB catered heavily to the start-up, tech, and venture capital (VC) industry, so in 2020, when venture capitalists were deploying lots of capital and start-ups were raising money at huge valuations and going public in droves, deposits surged at SVB.

The fact that the Federal Reserve pumped trillions of dollars of liquidity into the economy through quantitative easing while interest rates were already at zero only made deposits explode even more across the banking system. This was especially true at SVB because investors were looking for yield, so they turned to sectors such as VC and private equity. Between the first quarter of 2020 and the end of 2022, total deposits at SVB had surged from roughly $61 billion to close to $175 billion, and deposits had been as high as nearly $191 billion earlier in 2022.

While this deposit surge was happening, lending activity was weak because of all of the uncertainty in the economy related to the pandemic. SVB had more deposits than it knew what to do with but nowhere to deploy them. So the bank put a lot of its excess deposits into longer-duration bonds like U.S. Treasury bills and mortgage-backed securities. These bonds are guaranteed by the U.S. government and very safe from a credit perspective. But they are also subject to interest rate risk. When things were going well, the returns were magnificent. In late 2021, SVB generated a return on equity of more than 23%.

SIVB Return on Equity data by YCharts

However, it's clear now that management moved too early when reaching for yield, locking into bonds at low rates that had maturity dates that were further out. At the end of 2022, the weighted average duration of SVB's held-to-maturity (HTM) bond book was 6.2 years.

Then came 2022 and the Fed tightening monetary policy at an accelerated rate. That action helped things quickly spiral. The Fed raised rates aggressively to combat inflation and began pulling liquidity out of the economy through quantitative tightening. Suddenly, SVB's bond book was underwater because bond yields, which tend to move in line with the broader interest rates, soared, thus pushing bond values down.

At the end of 2022, SVB had tangible common equity of roughly $11.8 billion. However, unrealized losses in the bank's available-for-sale (AFS) bond portfolio, which are bonds the bank plans to sell before maturity, totaled more than $2.5 billion. Meanwhile, losses in SVB's HTM book totaled more than $15.1 billion, so the bank was technically insolvent.

Regulators and investors knew this insolvency existed, but they rationalized that those bond losses are simply losses on paper. If the bank continues to hold the bonds until maturity the losses will be recouped when the bonds are cashed in.

However, SVB is unique in that most of its deposits are tied up in the tech and start-up sectors. As tech valuations plunged following the boom in 2021 and interest rates rose quickly, VC deployment slowed significantly, while the cash burn of start-ups and early-stage tech companies accelerated, which started to draw down deposits. SVB saw more than $38.5 billion of its non-interest-bearing deposits (useful funds on its balance sheet that the bank pays no interest on) leave between the first quarter of 2022 and the end of the year.

Management speaking on SVB's fourth-quarter earnings call said that client cash burn had started to slow and offer some relief. But that apparently was not really the case. SVB announced on March 8 that it had to sell its entire AFS portfolio last Wednesday for a $1.8 billion loss. That signaled to many people that the bank would have to dip into its held-to-maturity portfolio and essentially wipe out all of its equity. Then behind-the-scenes messages started to leak from the likes of investors like Peter Thiel to his associates that they should move their money out of the bank. On March 9, depositors pulled some $42 billion of deposits from the bank.

JPMorgan Chase and Bank of America are better positioned

There are a lot of reasons that JPMorgan Chase and Bank of America, the two largest U.S. banks that are effectively "too big to fail," are in a much better shape than SVB Financial and are unlikely to fall victim to the same problem SVB Financial got itself into.

First, let's compare the three banks' bond portfolios, tangible common equity, and cash positions.

Data sources: Bank financial statements and regulatory filings. AFS = Available-for-sale (bonds). HTM = Hold-to-maturity (bonds).

As you can see above, while SVB's bond losses could easily wipe out all of its equity, JPMorgan Chase could comfortably cover all the losses in its bond portfolios at the end of 2022. JPMorgan Chase, thanks to great leadership from CEO Jamie Dimon, has managed liquidity the best by far, keeping an outsize position in cash and not deploying deposits into bonds too early. 

Bank of America didn't do nearly as good of a job and truthfully it's a little bit alarming to see it sitting on such big potential losses in its HTM portfolio. But in addition to looking at other factors that impact the bond portfolio, remember that SVB had extreme deposit concentration in the tech and start-up sectors and not a very diverse deposit base. The bank had 106,420 deposit accounts with less than $250,000 (and therefore insured by the FDIC), and 37,466 deposit accounts with over $250,000 in them. In fact, the heavy majority of SVB's deposits were sitting in these accounts at the end of 2022 and therefore were not insured by the FDIC.

Bank of America has one of the more diverse deposit bases in the world when you think about all of the different industries it serves, the bank's geographic diversity, and the range of consumers. At the end of 2022, it had over $1 trillion of consumer banking deposits. Bank of America also has 112,777,302 depository accounts with less than $250,000 in them, which makes it far less likely to experience the kind of bank run that SVB did.

The large banks are likely to benefit

Executives at SVB did a very poor job with asset and liability management and did not adequately prepare for a situation in which interest rates would rise quickly and deposit outflows would accelerate.

JPMorgan and Bank of America have done a much better job of managing liquidity, especially JPMorgan, and neither bank has close to the same deposit concentration risk as SVB.

Ultimately, as depositors worry about other banks with large unrealized losses lurking in their bond portfolios, they might head for safety by putting their money in the large, "too big to fail" banks. That's something to keep in mind as an investor.