A Bank Run–Is the Sky Falling?

By Financial Principles on March 14, 2023

Headlines of runs on three banks leading to failures this month are admittedly eerily reminiscent of the 2008 financial crisis. It is understandable that investors may wonder if they should be concerned, or if their money may be at risk. While the situation is rapidly evolving, it is at current isolated to a handful of banks that serviced a concentrated customer base of speculative high risk businesses and is not indicative of a more widespread systemic issue in the financial system.

What has happened?

First, in order to understand what has happened, it is important to understand how a bank operates. Customers open accounts, and deposit funds with a bank. These deposits are a liability of the bank in that they owe them back to customers either on demand, or at an agreed-upon future time (i.e. a Certificate of Deposit). Banks then turn around and lend money to individuals and businesses. However, they cannot lend out all the deposits that they collect—or they would not have the funds to pay back to depositors. Therefore, banks must keep reserves. The Federal Reserve Bank sets reserve requirements for banks and any amount above the reserves are allowed to be lent by banks to individuals and businesses.

In the wake of the FTX bankruptcy, cryptocurrency firms were facing a cash need. Silvergate, a highly crypto-currency focused bank, saw deposits from crypto related businesses drop by 68% and while their investment portfolio was fairly conservative, they needed to liquidate assets in order to meet demand for withdrawals. On March 8th, Silvergate announced that it would wind down operations and close due to losses suffered.

Two days later, customers of Silicon Valley Bank (SVB) which lent heavily to technology start-ups, began withdrawing funds due to a fear of systemic risks extending to other banks. The “run on the bank” forced SVB banks to liquidate assets to meet demand for withdrawals. Regulators stepped in immediately and seized the bank’s operations. Two days later Signature Bank, which worked almost exclusively with cryptocurrency firms, was closed by regulators citing systemic risks.

But aren’t deposits insured and don’t banks have to maintain reserves?

Yes, and yes. Bank deposits are insured by the FDIC, but only up to $250,000. SVB had about $175 billion in total deposits and a significant portion of these deposits were uninsured (meaning more than $250,000). For example, one public company announced last Friday that 26% of its cash was held at SVB bank–$487 million—only $250,000 of which was insured. That means that more than one-quarter of this company’s cash was uninsured and “at-risk of loss.”

Banks are required to keep reserves to meet withdrawal requirements of customers. Primary Reserves are immediately available such as cash on hand in a bank vault, deposits due from other banks (i.e. you deposit a check from a customer of another bank). Secondary Reserves are securities that the bank purchases and can be liquidated in short order to meet short-term cash needs. These secondary reserves are generally comprised of very safe liquid investments like government bonds. The Federal Reserve Bank sets these reserve requirements on banks.

While banks have reserve requirements, it is important to note that even the healthiest banks do not keep enough cash on hand to repay all customers immediately if they all demand their deposits all at once. Bank runs are insidious because they become self-fulfilling. Fueled by fear, people begin taking out their bank deposits. As word gets out, fear may turn to full-blown panic as the remaining depositors rush to do the same before they are too late and the bank cannot meet their immediate demands.

How did this happen?

Due to Silvergate’s highly concentrated customer base being in the cryptocurrency industry, the FTX bankruptcy and broad declines in that market lead to a “cash burn” of required withdrawals by their customer base. Silvergate’s announcements created a fear of contagion which caused a run on similarly positioned banks (SVB and Signature Bank). These banks’ secondary reserves had a great deal of longer dated maturity government bonds which, while safe, liquid, and would eventually mature at par, had suffered losses due to the rapid rise in interest rates over the last year. Therefore, as depositors exited quickly not only were the banks required to dip into their reserves but had to do so at losses.

As we tell our clients, diversification is important. The concentrated customer bases of these banks put them at idiosyncratic risk to the rest of the banking industry. While other regional banks may have concentrated risks, the major U.S. banks are insulated from this niche environment with diverse and healthy balance sheets. Nonetheless, like having a high concentration risk in an investor portfolio, this bank run highlights how, “it’s not a problem, until it’s a problem.” Without depositors fleeing, or these banks managing a more diverse customer base for deposit inflows over the last year, their paper losses may have never turned into a liquidity challenge.

What now, and should I be worried?

Depositors at these banks have been protected and the systemic risk is limited. There are, however, long-term implications and a “wake up call” at hand. Regulatory oversight will increase, and the structure of the financial sector, especially for lending and balance sheets, may change.

We have reviewed each client portfolio for any exposures and further ensured that clients holding any Certificates of Deposit do not have exposure to any bank in an amount more than $250,000. Further, to the extent that clients have more than $250,000 of cash in their accounts, the “bank sweep” feature spreads this cash across three banks to provide FDIC coverage up to $750,000 of cash. For investors worried about the safety of their assets, their investments at major custodians are held separately, owned in their name, and not comingled with the assets of any affiliated custodian bank.

While these types of events create volatility, fear, and develop rapidly, it should not cause long-term investors to lose sight of their goals. At current, these issues are isolated to a speculative high-risk industry and are not indicative of a systemic risk and major banks remain well capitalized. As always, we are here for you — to offer guidance, answer questions, and calm fears (as best we can).

Please feel free to contact us at any time.