With the Crisis Around Silicon Valley Bank (SVB) Resolved, the Focus Shifts to First Republic Bank (FRC), and the Crypto Sector Now Risks Becoming “Unbanked”

The Federal Reserve is trapped, and it has no one to blame for the oncoming financial wrecking ball but its hubris. While the timely action by the US Treasury, the FDIC, and the Federal Reserve averted the crisis that the depositors of the Silicon Valley Bank (SVB) faced over the weekend, the focus has now shifted to finding the next canary in the coal mine, and the First Republic Bank (FRC) appears to be the logical domino at risk. Meanwhile, with Silvergate and Signature Bank both rendered defunct, the crypto sector is facing the specter of becoming “unbanked.”

From SVB to First Republic Bank – A Moral Hazard Testament

Ever since the Great Financial Crisis (GFC) of 2008, banks in the US have had an implied incentive to take excessive risk, with the understanding that these institutions will be bailed out by the US Treasury and the Federal Reserve if the proverbial shit does hit the fan.

As we noted in a dedicated post last week, the crisis began on Thursday when Silvergate bank, impaired by around $8 billion that the bank lost in the FTX saga, announced that it was winding down its operations. Later that day, SVB announced that it would book a $1.8 billion after-tax loss on a fire sale of investments intended to boost liquidity. SVB also announced that it would try to raise $2.25 billion via equity offerings. However, the bank failed to raise the required capital, prompting the regulators to shut it down on Friday.

So, what prompted the biggest banking crisis since Lehman? Well, as the Federal Reserve continued to increase the benchmark interest rate, deposit accounts quickly lost their luster. Why should depositors accept interest rates of between 1 and 2 percent when they can earn 4 percent-plus in a riskless fashion by holding US Treasuries through maturity? Moreover, SVB catered primarily to the tech sector and startups, many of whom banked exclusively with SVB as part of the debt covenants with the bank. As the Federal Reserve continued its monetary tightening policy to extinguish the inflation conflagration, many of these tech startups started experiencing a cash crunch amid a general slowdown in the US economy, made worse by the fact that many of these entities had gone overboard on hiring during Covid.

Meanwhile, SVB held long-duration debt securities as assets on its balance sheet without adequate hedging. This means that the bank suffered on two counts: depositors started withdrawing cash to invest in high-yielding treasuries, prompting the bank to sell its high-duration securities at ever greater discounts to meet these deposit withdrawals. Bear in mind that high-duration securities are much more sensitive to interest rate changes, which means that their fair value declines at a faster rate as interest rates rise.

By Friday, with SVB failing to raise the required capital to remain afloat, regulators had no choice but to shut down the bank. This then gave rise to an even bigger crisis. The vast majority of the deposits at SVB were uninsured by the FDIC. Moreover, with many payroll processors also using SVB, a huge chunk of the startup sphere in the US was at risk of losing immediate payrolls.

Nonetheless, over the weekend, the US Treasury, FDIC, and the Federal Reserve worked together to resolve this crisis. In a surprise move, Signature bank, which had also become unviable in the aftermath of Silvergate’s winding down of operations, was shut down by the regulators. Bear in mind that Silvergate and Signature banks accounted for the vast majority of the crypto sector’s banking transactions (more on this later).

Additionally, the FDIC was authorized to protect all depositors of the SVB, and not just insured ones. Specifically, the FDIC was authorized to use its Systemic Risk Exception (SRE) to protect the uninsured depositors of SVB and Signature bank. Should the two banks’ assets not cover the depositors’ claims, the FDIC’s Deposit Insurance Fund (DIF) would fill the shortfall. As of Q4 2022, the DIF had a balance of $125 billion.

In another major step, the Federal Reserve announced a new program, dubbed the Bank Term Funding Program (BTFP). Under this program, distressed banks can post eligible collateral (Treasuries and agency securities) at par value and receive funding with maturities of up to one year. Since this program accepts collateral at par value, it would allow banks to sidestep the issue of mounting unrealized losses that result from selling high-duration securities in a rising interest rate environment. This program will be backed by $25 billion from the US Treasury’s Exchange Stabilization Fund (ESF).

Despite these sizable steps, concerns remain that the banking contagion has not been resolved. Consider the fact that the shares of the First Republic Bank (FRC) are down nearly 70 percent in early pre-market trading today! This comes after the bank tapped additional liquidity from the Federal Reserve and JP Morgan.

Some analysts believe that the size of the BTFP’s backstop is just too small to inject meaningful liquidity in banks that are facing mounting unrealized losses from a fire sale of high-duration securities.

Meanwhile, with banks failing left, right, and center, investors are paring bets on further interest rate hikes. This might also mean a higher level of structural inflation in years to come.

And, more banks are expected to fail.

Crypto Sector at Risk of Becoming Unbanked

As SVB went defunct, Circle’s USDC stablecoin emerged as one of the biggest victims in the crypto sphere, with $3 billion of stablecoin reserves trapped in the failed bank. The USDC soon broke its peg with the US Dollar. However, in an emergency move, Circle then announced that it would use its own “corporate resources” to fill the reserves shortfall, with USDC redemption expected to resume on a 1:1 basis on Monday.

Meanwhile, with the closing of the Signature bank, Circle announced that SigNet-based minting and redemptions would be halted. Instead, going forward, the stablecoin issuer will rely on BNY Mellon as its major banking partner.

Meanwhile, as the crypto sector was rocked by volatility, Binance announced that it was converting the residual $1 billion of its Industry Recovery Fund from BUSD stablecoin to major cryptocurrencies, including Bitcoin, Ethereum, and BNB.

As the crypto sector is rushing ahead to find new banking partners, it remains at risk of becoming wholly unbanked, especially in light of the oncoming guidance from the SEC and other regulators for banks to exercise caution when dealing with crypto entities.

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