Modelling stock market returns

For me, investment management represents an attempt to select those risks which are balanced with commensurate returns (emphasis on the ‘commensurate’) and discard those risks which are not. And to that end, I, like every other asset allocator, trust in all kinds of models; derivatives of the famous Capital Asset Pricing Model, for example, and various Mean-Variance Optimisation models too.

Such models are certainly useful. But my faith in the validity of their output has its limits.

I’m not the only sceptic in the congregation. Those in my field often sound a maxim borrowed from computer scientists, warning of the peril associated with the many inputs. ‘Garbage in, garbage out’ they quip.

Being a deeper doubter, I have to confess that even that maxim troubles me. I don’t doubt its veracity in the physical sciences, but I notice that it gives rise to a belief among investment managers that higher-quality assumptions yield higher-quality outcomes. The danger is that increasingly intricate inputs generate increasing confidence in modeled outputs. I consider that to be a mistake.
I mention all of this because I want to present a simplified model to inform some sort of answer to the following questions…

What kind of returns might we see from investment in the British stock market over the next 10 years or so? (Spoiler: around 8.8% annualised, perhaps).

How attractive are British stock prices in the aggregate, is the market overpriced, underpriced, or fairly priced? (Spoiler: the market is likely moderately underpriced).

… and before I do, I want you to regard that model with an appropriate level of scepticism.

Having said that, it is a model that assists me in forming a suite of Capital Market Assumptions (CMAs, target risk and return rates for various classes of equity and bond investments) which, in turn, have all kinds of valuable practical applications both internally and externally. If you’re one of those wealth managers providing a cash flow planning service, for instance, you are – knowingly or unknowingly – reliant on a series of CMAs.

Looking back and looking forward

The simplest forecast I can make is to assume that the next 10 years will mirror the prior 10 years. It’s an approach that has its merits, prime among them is that it requires just one readily-available input set. It’s easily adapted too, if I suspect that the next 10 years will be a little better I can add, say, 1% or subtract 1% for the reverse.

For reference, investment in the UK stock market returned around 6.0% annualised over the most recent decade.

The fatal flaw in this approach is that the worse my reference market has performed, the less I expect of it in the future, and vice versa. That doesn’t sit right with me. Contrast, for example, the -1.5% annualised return between March 1999 and March 2009, and the +11.3% return between March 2009 and March 2019.

That’s why my preference is for a model that leaves room for greater future returns when past returns have been low and lower future returns when past returns have been high.

As luck would have it, there is another simple model that fulfills that obligation. It is based on Professor Jeremy Siegal’s observation that the ‘earnings yield is a good predictor of long-term real returns.’ I take the ‘good predictor’ part with a pinch of salt, but, that being the case, all I need to do to form a target for the long-term real return is to divide 1 by the reference market’s P/E ratio. (Prof. Siegel has a much more sophisticated view on the ‘earnings’ part than do I, but the principle is the same).

Taking a P/E ratio of 12.1 for the UK market, I get a ‘real return’ of 8.3% (1 divided by 12.1). To convert the ‘real return’ into a ‘nominal return,’ it is necessary to add a little extra for inflation; adding 2% gives me a 10.3% annualised target rate. Again, this is an approach that has its merits.

The flaw is that it lacks a reference timeframe, limiting its application for my purposes – I want to target a specific investment horizon, equal in this instance to ten years.

Imperfect as both models are, they do provide valuable context, something with which to compare my own modelled results.

Long run ‘expectations’

There is a popular model among asset managers often described as the ‘building block’ approach. The design, sophistication, and application of that model vary greatly among practitioners but the ‘blocks’ almost always number three, comprising ‘valuation change’, ‘growth’, and ‘income’. (Sidenote: I’m not sure where this approach has its genesis but Sebastian Page, in his excellent book ‘Beyond Diversification,’ tips a nod in the direction of a 1984 paper by Jarrod Wilcox titled ‘The P/B-ROE Valuation Model’. Having reviewed that paper, I can certainly see the resemblance).

It’s a model I like; it’s simple, easily adapted, and well-suited to my application requirements. Let me see if I can bring it to life…

Supposing you instructed me to ignore any effect from income payments (dividends for example) and estimate at what level the UK stock market might be in 10 years. There is an uncomplicated way to form a guessed answer. I mentioned earlier that the P/E ratio for the UK market currently stands at 12.1, meaning that the current level is 12.1 times the market’s aggregate earnings.

It follows then, that all I have to do is guess what level earnings will be at in 10 years and multiply it by what I believe the P/E ratio will be.

An example will help…

Assuming the aggregate price level for the UK stock market is 100 today, the underlying earnings will amount to 8.3 (100 divided by 12.1). If I grow those earnings at, say, 4.3% for each of the next 10 years, I get an earnings target of 12.6. I’ll further assume that the P/E ratio will rise from 12.1 today to 14.0 by then. Our future market level is 12.6 (future earnings) x 14.0 (future P/E ratio) = 177.

That is equivalent to an increase in the current level of 5.9% annualised.

Needless to say, I have no way of knowing what the P/E ratio will be in 10 years, nor do I know at what rate earnings will grow, but I can begin with reasonable estimates to form a ‘central’ forecast and work out from there.

Thus far, I have ignored the income building block in our three-block approach. This is the trickiest feature in my view. Over the years, I have adopted several different modes for estimating its impact on returns. I’ve settled on simply assuming that the current dividend yield remains constant and that those dividends are re-invested at the end of each year. Assuming a yield of 3.8%, the effect is to increase my 5.9% ‘capital return’ to an 8.8% annualised ‘total return.’

(Sidenote: I’ve included a brief description for each of those inputs at the end of this article).

Overpriced, underpriced or ‘fairly’ priced?

8.8% sounds attractive to me. But is it?

And if it is, how attractive is it?

Investment in stocks (also known as equities) is a very risky enterprise. Investment in UK government bonds (known as gilts) is less risky. (There are those that will dispute this, but they are wrong for all kinds of reasons). To entice investment, stocks need to offer a return greater than that offered by less risky investments. That extra bit of return is known as the ‘equity risk premium’.

If I purchase a gilt today which is due to mature in 10 years, I can expect to get an annualised return somewhere in the region of 3.7%, that being the current ‘redemption yield’. The difference between that yield (3.7%) and our expected stock market return (8.8%) describes a positive equity risk premium of 5.1%. The equity risk premium is an important consideration in my approach to investment.

I have what I describe as a ‘minimum required equity risk premium’. Markets that are ‘underpriced’ will offer a higher premium than my minimum and markets that are ‘overpriced’ will promise a lower premium.

Currently, my minimum for the UK is set at 3.6%.

That being the case, my model suggests that the British stock market is underpriced.

Conclusion

I’m inclined to accept that modeled outcome, I think it reasonable. The conditions under which I would expect to see significant discounting are undoubtedly present – there has been a long run of unwelcome news associated with the United Kingdom (witness, for example, four Prime Ministers in seven years), and that is something that very often fosters low prices.

Of course, even if my model correctly characterises the UK stock market as underpriced, there is no way of knowing when it will revert to a more neutral price level. The model I have described is not a trading tool, it has no application in the short run. Indeed, it may well be that British stocks trend toward a wider underpriced state in the months ahead; there is certainly plenty to be cautious about both at home and abroad.

In the long run, though, I think there is a good case to be made for owning British stocks.

A note on the input estimates I have used

P/E rising from 12.1 to 14.0: I assume that today’s P/E reverts to the mean.

4.3% growth: I assume that earnings rise in line with the OECD’s 10-year forecast for nominal GDP.

3.8% income: I take the current dividend yield and assume that the implied payout ratio remains static throughout.

3.6% UK equity risk premium: I use Professor Aswath Damodaran’s approximation for the historic equity risk premium in the US markets over the last 50 years (4.4%) and adjust it for the 0.8 relative standard deviation of the UK market (standard deviation of UK market divided by standard deviation of US market).

The outlook for interest rates

In mid-September last year, when Bank Rate stood at 1.75%, I wrote here describing what I considered to be a reasonable outline for the path for interest rates in the UK. I suggested a target of 4.5%, perhaps reached by August 2023. I also admitted that I’d be slightly surprised if the Bank of England did get as far as that. In other words, I felt it wise to plan for 4.5% but my intuitions lay with a slightly lower terminal rate.

Last week, on 23 March, the Bank of England’s Monetary Policy Committee (MPC) voted to increase Bank Rate by 0.25%, taking it to 4.25%.

For my outline to prove oddly accurate, the Bank will need to hold rates steady in May and June, before hiking one last time in August. That’s not remotely implausible. Meanwhile, at a little under 4.5%, the current 4.25% rate is in line with my intuited target. Accordingly, I thought it useful to share an updated outlook. (Spoiler: I’d be a little less surprised if we make it to 4.5% now, but my sympathies still lie with a peak rate at the current level).
The most recent increase marks the eleventh consecutive hike in the British policy rate, tracking an increase from 0.1% in December 2021 to 4.25% in March 2023. That’s the fastest pace of increase we’ve seen for a generation, and it matches a similarly abrupt rise in inflation.

A day before the MPC was due to vote, the Office for National Statistics published its assessment for the year-on-year increase in the Consumer Price Index (CPI) for February. In the event, an accelerated rate – from 10.1% in January to 10.4% in February – stood in bold contrast to expectations at the Bank for something closer to 9.8%. The core rate of inflation (CPI less food, energy, alcohol and tobacco) increased too, from 5.8% to 6.2%.
In hindsight, the accelerated pace ought not to have been such a big surprise. The core rate in the eurozone, published a few days earlier, signaled a pick up from 5.3% to 5.6% and headline CPI inflation was higher on the month in Germany (9.2% to 9.3%), France (7.0% to 7.3%) and Ireland (7.5% to 8.1%), among others.

One of the underlying causes of the hurried pace is the same in the UK as it is in France and Germany, and will be immediately apparent to anybody that has tried to buy a lettuce, laitue, or kopfsalat of late. Compared with the same time last year, food prices are up 18.0% in Blighty, 14.8% in France, and 21.8% in Germany.

Besides food costs, the MPC noted ‘surprising strength’ in clothing and footwear bills before observing that those prices ‘tend to be volatile and could therefore prove less persistent’. Let’s hope that is the case. The MPC has a lot riding on decelerated inflation.

Indeed, the minutes from the March MPC meeting reveal a reinforced commitment in that direction. ‘Bank staff still expected CPI inflation to fall significantly in 2023 Q2…’ and ‘…to decline further beyond’. Their confidence is underpinned by ‘developments in administered energy prices’. Members discussed the recent decrease in the Dutch Title Transfer Facility (TTF) spot rate for example, which has seen wholesale prices for liquified natural gas fall from €58.3 per MWh at the time of the February meeting to €41.9 today. That’s relevant because the ‘gas’ sub-component in the CPI basket stands 129.4% higher than it was last year. There is a somewhat circuitous line of influence from prices in the Dutch TTF market to those you and I pay for gas, but assuming that TTF gas prices remain static until August, the year-on-year decrease in the TTF contract will amount to something like -79%. (I calculate the average price in August last year to be €201.0 with a peak as high as €303.6 on 26 August 2022). There is a similar, though less spectacular, pattern in oil prices too. The Brent Crude spot price stands at $74.6 today compared with $123.6 on 6 August 2022, marking a -40% fall.

But, while energy price declines will help to cool the hotter parts of the inflation basket, the MPC expects prices in the services sector of the economy to ‘remain broadly unchanged in the near term’. Unfortunately, services inflation is buoyed at 6.6%, significantly higher than the 2.0% inflation target. If we are to see CPI back to within the MPC’s comfort zone (1% to 3%), we will have to see services inflation come down too. (CPI has averaged 2.4% since the turn of the century, over which time services inflation has averaged 3.3% and goods inflation has averaged 1.5%).

So, while the MPC sees encouraging downward movements in energy prices (which in turn will have further less-direct downward effects on inflation in various goods), the same cannot yet be said of services inflation.
That is why seven of the nine-member MPC voted for the 0.25% increase established at the March meeting (the remaining two voted for rates to be held steady).

So where do we go from here? The answer is, of course, that I don’t know. I don’t know if inflation will sustain a decline toward the 2% target, or if it will get stuck somewhere above the 3% bound. And I don’t know if conditions in the British banking system will remain stable enough for rates to be sustained at or above the current level. The outlook is uncertain. All I can do is speculate…

And I am speculating in the direction of a pause at this moment in time. In fact, there are good reasons for the MPC to hold the main policy rate steady when next it meets in May.

First, is the deteriorating condition of the global banking system; in which British banks have an important role (HSBC, Barclays, and Standard Chartered are among those identified as ‘global systemically important banks’ for example). As it stands, the Bank of England’s Financial Policy Committee judges that the UK banking system maintains ‘robust capital and strong liquidity positions…’ sufficient to ‘…continue supporting the economy in a wide range of economic scenarios, including a period of higher interest rates’. And while I don’t doubt the resilience of British banks, I am a little concerned about the volatility that we are seeing in the market for G7 government bonds. Ideally, the central banks would foster a period of calm, and I think a pause would go some way to achieving that.

The second reason is that, although patchy, there are welcome signs that inflation is abating. In addition to the declines in energy prices, the growth in average weekly earnings has eased from 6.9% in March 2022 to 5.7% more recently. Market-implied rates of future inflation have also eased. I calculate the 5Y-5Y implied inflation rate to be 3.3% today, very close to the average over the last 23 years or so. The Bank of England/Ipsos Inflation Attitudes Survey also reveals expectations for calmer inflation in the next 12 months (3.9% compared with an average response of 3.1% over the 14 years of the survey’s life) and over the longer-term (3.0% compared with an average of 3.2%). If nothing else, the MPC will be gladdened to see that the current high rates of inflation are not becoming entrenched in the minds of consumers.

Finally, the first and second points combined present a case for a wait-and-see approach, at least in the short run. In the space of a little over 12 months, the Bank of England has raised rates from near zero to 4.25%. The full effect of those increases has not yet been felt across the economy – in central bank parlance interest rate movements have a ‘lagged and variable effect’. Take the example of those consumers with a 2-year or 5-year fixed-rate mortgage, a sizable proportion of which will remain unaffected by rate hikes thus far. The longer Bank Rate stays at the current level, the more effective it will be. A pause in the current hiking cycle would not represent a retreat in the fight against inflation.

What, then, is my updated outlook for interest rates, and how does that compare with prices in the market today?

Given the extraordinary level of uncertainty that is characteristic of the outlook, it feels a little unwise to stick with a 4.5% peak rate when the current rate is 4.25%. Accordingly, I’m going to nudge my terminal rate expectation toward 4.75% and target the August or September meetings to coincide with that peak.

Having said that, my intuition remains anchored around the current level. The Bank of England and the Federal Reserve have raised rates aggressively and the European Central Bank is following close behind. Right now, I’m seeing inverted yield curves in places I’ve never seen them before. That makes me feel uneasy.

Prices in the market are reflective of similar concerns. The most obvious manifestation of this is the yield on the 2-year gilt which has fallen precipitously, from 4.1% at the beginning of March to 3.2% a few days ago. (Gilts, treasuries, and bunds at the 2-year horizon are very sensitive to changes in expectations for policy interest rates). Beyond gilt yields, prices in the sterling swap market suggest to me that participants are positioning for Bank Rate to reach 4.5% ahead of August and to remain there until the close of the year. (There is, I think, a hint of a risk in prices that Bank Rate will peak at 4.75% in August). Further out, at the end of next year, Bank Rate is priced at 3.75% or thereabouts.

There is no meaningful difference between my expectations and market prices at this time. Accordingly, I’m not taking any large bets either way.

What happened at SVB?

To understand what has happened in the US, and to appreciate that some banks are better run than others, you need a basic-level understanding of how banks work. And to that end, what follows is a caricature description – a cartoon bank of sorts – comprising only those features required to illustrate the problems which led to the spectacular collapse of Silicon Valley Bank (SVB)…

Cartoon Bank

At the broadest level, Cartoon Bank borrows money from you and me in the form of deposits and lends it to others in the form of loans (commercial lending, residential mortgages, etc.). The rate of interest the bank offers to depositors, say 1%, is lower than the rate it charges on loans, say 4%. In that case, Cartoon Bank is earning 3% on its operations. That 3%, in banking parlance, is known as the net interest margin.

To maximise its net interest margin, the bank wants to borrow capital from us at the lowest viable rate and it wants to loan it out at the highest viable rate. Of course, running a bank is not without its costs and, absent other revenue-generating activities, Cartoon Bank’s profits will fall short of its net interest margin.
Meanwhile, you will notice that there is a problem. Setting aside any fixed-term savings products that the bank might offer, deposits can be withdrawn at any time and in any amount. And not all of that money is sat in the bank’s vault safe from Wile E Coyote, our bank has lent some of it to the Road Runner.

Happily, Cartoon Bank is prudent and it keeps sufficient cash on hand to cover the kind of withdrawals that are typical on any given day. And since anticipated withdrawals are a fraction of total deposits, there is room for some ‘investment’…

Aside from (1) cash in the vault, Cartoon Bank places (2) reserves with the central bank, invests in (3) interest-bearing securities which are considered to be free from the risk of default, and provides (4) loans. To further our understanding, it is worth looking at each category in a little more detail…

1. Cash (notes and coins) held in the bank’s vault yield our bank nothing at all. Indeed, vaults are expensive to maintain and insure, so the bank is making a loss on these holdings.

2. Cash remitted to the central bank (bank reserves) is very safe indeed. If Cartoon Bank deposits £10 billion with the Bank of England for example, there is no question at all that the same £10 billion will be available tomorrow. In fact, the deposit will be worth a little more than it is today because the Bank of England pays interest on those reserves in line with Bank Rate.

3. ‘Interest-bearing securities which are considered free from default risk’ play an important role for the bank. They include government bonds (British gilts, US treasuries, etc.) and government-guaranteed bonds (US-agency mortgage-backed securities, etc.) which would normally yield a return a little higher than that offered on reserves. They also have the benefit of being reasonably liquid (they can be quickly and reliably sold, or they can be used as collateral to quickly borrow cash). But while they are free from the risk of default, they are subject to something called ‘interest rate risk’ (more on this later).

4. Loans are at the heart of Cartoon Bank’s business. They are the most profitable since the rates the bank can charge on these are much higher than the yields it can secure on the other three asset types. Loans do not come without their risks though, in addition to some interest rate risk the dominant risk for the bank is that a proportion of those loans may not be repaid. In other words, Cartoon Bank will bear default (or credit) risk on its loans.

Note the following return profile for each of those assets…

1. Cash in the vault promises a low negative return for the bank.

2. Central bank reserves promise a low positive return.

3. ‘Interest-bearing securities which are considered free from default risk’ promise a moderate positive return.

4. Loans promise a high positive return.

…and the risk profile for each of those assets…

1. Cash in the vault is free of risk (barring unlawful activity).

2. Central bank reserves are entirely free of risk.

3. ‘Interest-bearing securities which are considered free from default risk’ present moderate risks (interest rate risk).

4. Loans present high risks (interest rate risk and default risk).
And so, the return profile pulls Cartoon Bank away from maintaining a high cash/reserve balance toward maintaining a high interest-bearing securities/loan balance while the risk profile pulls in the opposite direction.

Each of the four categories of ‘investment’ represents assets on Cartoon Bank’s balance sheet and deposits represent liabilities of the bank. Ordinarily, all is well so long as a bank’s assets are worth more than its liabilities (and those assets can be easily drawn upon if deposit withdrawals exceed ‘expected’ levels).

What are the risks?

The risk, from our perspective as depositors is that Cartoon Bank is unable to one day return all of our money. For those Banks which are authorised by the Prudential Regulation Authority in the UK, that is a risk that is to some extent mitigated by a form of deposit insurance which guarantees the full return of up to £85,000 (or up to around £1,000,000 for a term of six months for certain ‘temporary high balances, such as the proceeds from private property sales’). In the main, balances over £85,000 should be considered to be at risk.

There is a similar scheme in place in the US, where SVB was based, with a limit of $250,000.

Depositors can further mitigate these risks by limiting deposit sizes to the insured amount and/or undergoing a sufficient level of due diligence.

One risk, from Cartoon Bank’s perspective, is that deposit withdrawals exceed expectations and capital cannot be raised quickly enough to meet those withdrawals. To mitigate the risk of unexpected deposit flight, it is wise for a bank to try to attract a diversified deposit base – both in size (with as many deposits under the insured limit as possible) and in customer profile (an ice cream sales company will have a different deposit/withdrawal pattern to an umbrella sales company for example).

It is similarly wise for banks to protect against default risk on their loans. Default risk cannot be eliminated, but it can be limited with good underwriting practices and, again, some diversification in the profile of loanees.
But what did it for SVB was its poor handling of ‘interest rate risk’.

Interest rate risk?

Interest rate risk (sometimes called ‘duration’ risk) is not immediately easy to grasp, but an example will help…

Suppose you have £100 to invest over the next 2 years and you decide to purchase a 2-year British government-backed interest-bearing security, or what is more commonly known as a gilt. (The equivalent in the US is known as a ‘treasury’). In this example, you buy a gilt with an associated rate of interest of 1%, that is to say, you have a £100 claim that pays £1 each year.

Fast forward one year and suppose that the prevailing rate of interest is now 2%. Investors can buy newly issued gilts which pay £2 each year. There is no question about how much your gilt is worth when it matures in 12 months (it will be worth £100 when the government returns your money in full) but what if you needed to sell it in today’s world? You will be competing with the newly issued gilts that pay 2%. Only a fool would buy your 1%-yielding gilt for £100 when he could buy a similar gilt paying a 2% rate.

There is a way to make your gilt almost as attractive as the new 2% issues though; you could drop your asking price.

If you drop your asking price to £99 you may well attract a buyer since the new buyer will receive £1 in interest and a further £1 more when the gilt matures for the full £100 in 12 months. That’s the same return as that offered by newly issued 2% gilts.

The reverse is also true, by the way. If the prevailing rate of interest had fallen to 0.5% rather than increased to 2%, you might be able to sell your gilt at the higher price of £100.50. In that case, our new buyer would receive £1 in interest but make a £0.50 loss when the bond matures at £100, thus yielding the new buyer a return of 0.5% in line with the prevailing rate.

Put simply, ‘interest rate risk’ describes the risk that the value of your gilt (or US treasury, etc.) will periodically differ from its maturity value (or the price you paid for it) in line with movements in interest rates.

Interest rate risk is one of the more controllable risks. Whilst complex, and sometimes expensive, there are measures that can be taken to mitigate its ill-effects almost entirely.

Are bank failures common?

Now that we understand, at least to some extent, what banks do and how they do it, we are in a position to better understand what went wrong at SVB. Before we take a closer look, I thought it useful to fit some context around what is a very well publicized banking collapse. Specifically, how many banks are there in the US, and how common is it for a bank to fail?

The Federal Deposit Insurance Corporation (or FDIC) is an ‘independent agency created by Congress to maintain stability and public confidence in’ the US banking system. It is the FDIC that provides the insurance guarantee for deposits up to $250,000 and it is also the lead agency, working alongside the Federal Reserve and the Department of the Treasury, tasked with resolving banks that go into (or are likely to go into) receivership. According to the FDIC, a total of 563 US banks have failed in the last 22 years or so. Naturally, the Great Financial Crisis is responsible for the bulk of those failures. I count 507 failed banks between 2008 and 2014, but there were multiple cases in 2002 (11), 2015 (8), 2017 (8), 2019 (4), and 2020 (4).

According to the FDIC’s latest quarterly report (March 2023), there were 4,127 commercial banks and 579 separate ‘savings institutions’ operating under their auspices. Taken together these organisations have total assets worth $23.6 trillion. The total for deposits amounts to $19.2 trillion.

Silicon Valley Bank is widely reported to have been among the largest banks in the US. The Federal Reserve’s most recent ‘Large Commercial Banks’ release (December 2022) supports that assertion, ranking its $209 billion of consolidated assets in 16th place. The full list reveals a somewhat lopsided distribution though. The largest bank is JPMorgan Chase with assets valued at $3.2 trillion, meaning that the largest bank is more than 15 times larger than that ranked 16th. The top 10 banks in the US account for a little over half of the $23.6 trillion market. There is a very large pool of small banks. Indeed, if I’m not mistaken there are something like 2,000 FDIC-registered commercial banks each with consolidated assets of less than $300 million.

Actually, I noticed that the FDIC makes public the number of ‘problem banks’ it has in its sights. The names of those banks are kept secret but currently, there are 39 problem banks – something of a low I understand – with total assets between them amounting to $47.5 billion.

Failures among the US’s large pool of small banks are not common, but neither are they rare.

What happened at SVB?

I recall reading in the Wall St Journal that SVB was home to around half of all the venture-capital-backed technology and life sciences firms in the US. I took that to mean that there were no ice cream sales companies, and no umbrella sales companies among its customer base; its deposit base was close to being homogenous.

During 2021 and 2022 those deposits increased from around $50 billion to $189 billion, making 2021 the bank’s most profitable year in all of its 40-year existence. I calculate the average deposit size at SVB to be around $5 million, frighteningly higher than the $250,000 insured limit. In other words, given the risk of a near-total loss, the vast majority of SVB’s depositors were incentivised to remove their capital at the merest hint of trouble.

Worse still, what did the bank do with a large proportion of those deposits? It bought around $120 billion of interest-bearing securities (US treasuries and agency-guaranteed mortgage-backed securities) when interest rates were at historical lows. And it chose not to mitigate the interest rate risk that it was taking on those securities. The subsequent increase in interest rates meant that the market value of those securities fell to around $100 billion.
The rise in interest rates also saw costs increase for the bank’s customers and venture-capital firms began to draw down on those deposits at a rapid pace, forcing SVB to sell some of its securities and realise a loss of $1.8 billion. It was this loss that came to light in a regulatory filing on 8 March, prompting a noticeable fall in the stock price of SVB’s NASDAQ-listed parent. Shares in SVB Financial Group fell from $268 on the day of the filing to $106 after, prompting the exchange to suspend trading in its stock.

A shift of that magnitude in my bank’s share price would very likely get my attention. And so it was with SVB. It is reported in the Wall St Journal that a staggering $42 billion of deposits were withdrawn on 9 March.
The end came on 10 March, less than 48 hours from the fateful filing, when the FDIC, Federal Reserve, and Treasury resolved to close the bank and take control of the bank’s deposits and assets. The speed of SVBs collapse was breathtaking.

What will be the fallout?

You may have heard comparisons drawn between the collapse of SVB and what occurred in 2008, comparisons that seemed to gain momentum during a climactic week of travails at Credit Suisse (now taken over by UBS). I’m not among those drawing a connection, not right now at least. I do expect further failures (or forced consolidations) but I expect they will be limited to the smaller banks. Indeed, the large banks are beneficiaries, hoovering up a significant proportion of the deposits now fleeing smaller banks.

Of course, the difficulties faced by the community banks will have an impact more broadly. Small companies borrow from small banks and the lending facilities offered by those banks add up. The total availability of credit across the US will likely fall as the small banks look to strengthen their balance sheet and avoid anything that might spook their deposit base (rising defaults on their loan book for example). At the same time, the smaller banks will have to increase the rate of interest they pay on their deposits and the result will be to narrow their net interest margins.

Less lending from less profitable banks very likely means lower growth. The prospects for a near-term recession in the US are increased.