The deposit game: A warning shot has been fired The deposit game: A warning shot has been fired The deposit game: A warning shot has been fired

The deposit game: A warning shot has been fired

Peter Garnry

Head of Equity Strategy

Summary:  The US equity market got a big jolt yesterday as SVB Financial plunged 60% as one of the most prolific venture capital firms advised its clients to withdraw cash from the bank forcing the bank to sell out of its bond holdings creating a USD 1.8bn loss and the need for raising equity capital. SVB Financial is down in pre-market trading as the market is nervous about whether the bank can stay afloat. Depending on the US jobs report we could see significant intraday volatility into the weekend with the open on Monday being a key test for the equity market that has profoundly changed with the massive surge in zero-dat-to-expiry options.

A test of the ODTE options market?

Yesterday’s big moves across US banks, which we cover in the next section, pushed down the S&P 500 futures by 1.9% extending the negative momentum in today’s session by another 0.4%. If the US jobs reports later today at 13:30 GMT fails to calm the market then the sell-off could accelerate into the close with potentially the first real test of whether zero-day-to-expiry (0DTE) options are a systemic risk to the wider equity market. In recent weeks JPMorgan has argued that they pose a significant risk in terms of accelerating a decline under the right conditions while Bank of America has agued that the options book is often balanced and thus 0DTE options are not a problem. Cboe was also out yesterday arguing why these very popular options are not a problem. 0DTE options are now close to 45% of the daily equity options volume in US equity markets.

Despite the big moves yesterday in US banks and hawkish messages earlier this week from Powell on inflation and the direction of policy rates the VIX Index did not react as much as feared increasing only 3.5-points closing at 22.61. This VIX level is at a small premium above the 19.8 average historical level, but actually trading significantly above the current realised volatility.

Back in early 2018, the VIX blow up was a profound event in volatility markets that exploded in the hands of investors following years of short volatility positions had been building to a fragile size of the volatility market. Today, the question is whether the next volatility event will evolve around the 0DTE options. It all depends on whether we get an intraday gamma squeeze which is the concept that if we get a big negative move intraday and the option market makers are short gamma (the rate of change in an option’s delta as a function of the underlying price), then the only way to hedge the options book is to aggressively sell the underlying (in this case the S&P 500) accelerating the move on the downside.

Whether we will observe this behaviour today is not given explained by our Chief Investment Officer Steen Jakobsen on today’s Saxo Market Call podcast and it all depends on the reaction to today’s US jobs report. Depending on how trading goes today in SVB Financial the real risk is the weekend and the subsequent open print on Monday.

VIX Index | Source: Bloomberg
S&P 500 futures | Source: Bloomberg

SVB Financial and the deposit game

Back to the real driver of things yesterday namely SVB Financial, also known as Silicon Valley Bank. Its shares fell 60% yesterday triggered by Silvergate Capital’s decision to liquidate its business following the implosion of the crypto market. SVB customers were pulling deposits out of the bank as the prolific venture capital fund Founders Fund advised its startup companies to withdraw funds from SVB. This deposit outflow forced the bank to sell bonds worth $21bn at a combined post-tax loss of $1.8bn forcing SVB Financial to announce a public offering of common stock worth $1.25bn and $500mn of depository shares. This news jolted the equity market sending US banking stocks down across the board with First Republic Bank (-17%), Signature Bank (-12%), and Zions Bancshares (-11%) leading the declines. But even major banks such as JPMorgan Chase was down as much as 5.4%.

SVB Financial is 18th largest US bank and key for the venture capital ecosystem in Silicon Valley with a balance sheet of $212bn as of 31 December 2022 and 8,500 employees. The reason why there is a panic around the deposits is because of venture capital firms advising clients to pull their deposits because the companies that are last out of the door could lose some of their operating cash. Many startups raise significant amount of money in VC rounds that often give them one or two years of runway operating at a loss. All this excess capital is often placed at banks and SVB has been a big recipient of this excess cash growing their deposits from $10bn in Q4 2009 to $173bn in Q4 2022. In the event of a bankruptcy this could be a systemic blow to many startups and increasing the risk their operations, in addition to creating big problems for venture capital firms. This is only one of the reasons why the hedge fund manager Bill Ackman has been out saying that the US government might consider bailing out SVB Financial as the bank is too important for the startup ecosystem. SVB shares are down additionally 44% in pre-market trading.

S&P 500 banks | Source: Bloomberg
SVB Financial share price | Source: Bloomberg

Why did SVB Financial get into trouble and could it happen to other banks?

It should be noted that SVB Financial is an unique case because of the enormous excess cash it gets from startups. Deposits are $173.1bn out of $212bn in total assets on top of an equity of $12.3bn. A large part of the deposits are placed in bonds at various maturities and thus as interest rates have moved higher these bonds have fallen in value. This is not a problem if these bonds can be held to maturity as the unrealized losses disappear as the bonds get closer to maturity. The key here is the funding side from deposits. If enough deposits are pulled out of the bank it then forces the bank to sell these bonds before maturity realizing significant losses and sizeable reduction in equity increasing the bank’s leverage and thus the regulatory banking risk. As of Q4 2022, SVB Financial had fixed-income securities worth $121.5bn with $91bn in held-to-maturity bonds with an average duration of 6.2 years which roughly means that this portfolio is down 10-12% meaning unrealized losses of $9-11bn equal to the equity value and this come on top of the $1.8bn loss on their available-for-sale bonds.

Could this happen to other banks? We see the systemic risk to the overall banking system to be small as SVB Financial is an unique bank with a high securities-to-assets balance sheet. The deposit-to-loan ratio in the US banking system is also more healthy than pre-pandemic, but if the SVB Financial fallout creates a lack of trust in the system it could drive up stress and general funding costs. It should be noted that total US deposits are down 4.3% from their peak in April 2022 which is the biggest decline in more than 20 years and in itself unusual. Higher inflation and more expensive adjustable mortgages are sucking money out of households drawing down their deposits to meet expenses. If this trend continues other financial institutions could be forced to liquidate a portion of their bond portfolio incurring losses and a hit to the book value of equity and then new troubles could arise, so the SVB Financial fallout is indeed a warning shot in the financial industry. This risk is increasingly bigger for financial institutions with higher securities-to-assets balance sheets like SVB Financial and for smaller financial institutions.

SVB Financial fixed-income securities | Source: SVB Financial
US deposits | Source: Bloomberg

In the case that deposits become the musical chairs game one odd fallout from the regulation after the financial crisis of 2008 is that all the big banks that are designated systemically important financial institutions (SIFI) will be the big winners. The SIFI classification means that these banks have implicit backing by the government and thus in a race for deposits or uncertainty over deposits depositors at smaller banks could move their deposits to SIFI banks. The long-term outcome would be a further consolidation of the banking system and lowering future competition to the obvious welfare loss of the wider population.

A Swedish pension firm was on the wrong side

One of the side stories to the fallout in SVB Financial is the fact that Alecta, a Swedish pension firm and the 5th biggest occupational pension company in Europe, owned 4.45% of SVB Financial shares as of 31 December 2022. According to our estimates the average cost basis per share on this position is $355 and with SVB Financial trading at around $38 in pre-market trading this is a loss of SEK 9bn and SEK 10bn in the worst-case scenario. This is roughly 1% of the pension firm’s total assets which were SEK 907bn on 30 September 2022 according to Alecta’s website. We can see in the public filings that the accumulation of SVB Financial shares started in early 2019 and accelerated significantly during the 2020 rebound rally. The position did not increase in 2021, but then as SVB Financial shares fell in 2022 Alecta doubled its position. How did one of Europe’s largest occupational pension companies end up losing up to 1% of their assets (mark-to-market the loss is likely bigger from the peak in SVB Financial) in a single investment? The short answer is poor risk management and overconfidence in the venture capital system. Alecta likely took a position in SVB Financial because it was a liquid proxy on the venture capital ecosystem which is inherently illiquid, but SVB Financial provided the liquidity just like REITs provide the liquidity in real estate exposure.

Alecta position in SVB Financial | Source: Bloomberg

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