Is The U.S Heading To Another Banking Crisis?

For years, Silvergate Capital Corporation and SVB Financial Group were the most favored financial stocks of the momentum crowd on Wall Street, chasing after their shares that headed to the moon.

No more. Last week, the two stocks came down to earth as both financial institutions faced a liquidity crisis that placed them in the hands of regulators. As of Friday, Silvergate's shares were trading at $2.50 a share, down from its all-time high of $212 in November 2021, while SVB's didn't open for trade (they traded at $717 in October 2021).

Is this an isolated case or the beginning of another financial crisis? David Trainer, CEO of New Constructs, an investment research firm based in Nashville, thinks it is the former rather than the latter.

It's about the strategy of the two banks, lending money to subprime business clients.

"SVB Financial Group's struggles show the dangers of doing business with bad companies," he told International Business Times. "Many tech startups are zombie companies with no business models and aren't worthy of receiving any loan. SVB is now learning this the hard way."

While the two financial institutions could get away with this strategy during the bull market, they felt pain during the bear market.

"SVB's issues show that companies, including banks, need to be much more discerning about whom they do business with," Trainer added. "The market has been punishing companies with no business models since the bear market began in January 2022, and SVB's woes are the latest frontier in the market's reckoning. In addition, the market is tired of companies that do business with unprofitable companies or are unprofitable themselves."

Nonetheless, he doesn't believe there is a contagion risk for the rest of the banking sector on the heels of SVB's struggles.

"The deposit base from the major banks is much more diversified than SVB, and the big banks are in good financial health," he added.

Brian Dally, co-founder, and CEO of Groundfloor, a retail investor marketplace, sees a bigger problem, which extends to the entire financial sector due to the rising interest rates.

"The Fed is causing a liquidity crunch. It will show up in many expected and unexpected ways," he told IBT. "SVB shows us that a liquidity crunch can be a tough place for 'middlemen' - this is what banks, REITs, and fund managers are. In the case of SVB, we're seeing 'maturity risk' where because they invested so heavily into Treasury bonds, their investments declined in value as rates went up. This is fine if you can hold on to the investment until maturity, but they couldn't and had to sell."

Bank veteran Panos Angelopoulos provides further insight into how maturity risk or fixed interest rate risk—to use a more appropriate term--works and how it can become a severe problem for the banking industry.

According to broadly used capital adequacy rules, Banks must decide whether they classify fixed-income securities like Treasury and corporate bonds as "investment securities" or "commercial securities."

Investment portfolio securities are held to maturity; therefore, they don't have to be adjusted for capital gains and losses as interest rates change—something that can affect the bank's balance sheet.

By contrast, commercial portfolio securities are subject to mark-to-market rules, and therefore, they can result in capital gains and losses as interest rates change.

Banks have the incentive to classify fixed-income securities as investments in a rising interest rate environment. Thus, they don't have to raise capital to meet capital requirements as the market value of these securities declines with rising rates.

But that can change if they face a massive deposit withdrawal and they have to sell investment securities to raise cash.

"In that case, the entire investment portfolio must be re-classified as a commercial portfolio," Anelopoulos explains. "Thus, it could have a devastating effect on capital requirements."

Can it lead to a banking crisis? Angelopoulos thinks so, if the problem becomes widespread and existing shareholders and markets aren't willing to bail banks out.