March 2023 (Part I) – How to Protect Your Cash from the Risk of Bank Failure

Dear Investors and Friends,

In his most recent letter, Warren Buffett said, “our CEO will always be the Chief Risk Officer- a task it is irresponsible to delegate.”  The importance of thoughtful and comprehensive risk management was highlighted last week and this weekend by the failure of 3 banks: Silvergate Bank, Silicon Valley Bank (SVB), and Signature Bank.  As we move into what will likely be a period of continued market volatility and economic turbulence because of the Fed’s tightening in response to high and enduring inflation, we wanted to take this opportunity to let our readers know how they best can protect their cash from the risk of bank failure.

Silicon Valley Bank – What Happened and Why

Despite being considered in sound financial condition as recently as Wednesday of last week, SVB, the 16th largest bank in the United States, and the 2nd largest US bank failure after Washington Mutual, was put into receivership on Friday.  How and why did SVB fail so quickly and spectacularly?  Let’s work backwards.

1. Of the bank’s $173 billion in deposits, depositors tried to pull $42 billion from the bank on Thursday.  The scale of attempted withdrawals was so large that the bank ran out of cash, a classic run on the bank. California’s bank regulator said the run “caused the bank to be incapable of paying its obligations as they come due,” and took possession of the bank on Friday.
   
   
2. The run on the bank was triggered by a letter that the bank’s CEO sent to shareholders on Wednesday that it had realized a $1.8 billion loss to its equity capital due to the sale of US treasuries and mortgage-backed securities and outlined a plan to raise $2.25 billion of capital to shore up its finances.
   
   
3. Why did the bank suffer a significant loss to its equity capital?   Simply put – an asset / liability mismatch.  The bank grew its deposits by $130 billion from the end of 2019 to the end of 2021 and invested most of these deposits in longer duration assets (duration measures sensitivity to interest rate movements).  When interest rates increased, the value of SVB’s deposits (i.e., the bank’s liabilities) were unchanged, while the value of its longer duration assets fell, resulting in a hit to equity capital.  SVB’s unrealized losses on its securities portfolio at the end of 2022 jumped to more than $17 billion.

Financial Institutions & The Importance of Confidence

Per its December 31, 2022 financials, SVB had a Tier 1 Common Equity Ratio of 12%, nearly double the 7% required limit, but failed in the blink of an eye simply because ~25% of its depositors wanted their money back at the same time.  It remains to be seen if depositors at SVB will lose money, but it is a certainty that equity holders will be massively impaired if not wiped out.  Even if depositors are not compromised, which appears likely at the time we are writing this, not having control of their capital for even a brief period of time could be incredibly detrimental, not to mention gut-wrenching, while they are at the mercy of regulators and the bankruptcy process.

SVB highlights an obvious, at least in retrospect, but often overlooked fact that a financial institution is no better than the confidence that its depositors place in it.  For SVB, that confidence evaporated overnight. Because confidence can be so capricious, and because most of us must custody our cash and financial assets at 3rd party financial institutions, it is critical that we take the appropriate steps to protect ourselves.

How to Manage Cash and Protect Yourself from the Risk of Bank Failure

There are 4 measures that a thoughtful, well-prepared individual / institution takes to protect themselves.

First, avoid holding more than $250,000 in a bank account or CD.  All single accounts owned by the same person at the same bank are added together and insured up to $250,000 by the FDIC.  All deposits owned by a corporation, partnership, or unincorporated association at the same bank are added together and also insured up to $250,000 by the FDIC.  Hence, any deposits over and above the $250,000 FDIC limit become general unsecured creditors in bankruptcy.  This was a lesson learned the hard way for companies like payments-technology firm Circle, which had $3.3 billion on deposit at SVB, and for streaming device company Roku which had $487 million of its $1.9 billion on deposit there.  Of the bank’s $173 billion in deposits, it is estimated that over $151 billion exceed the FDIC insurance limit.

Second, hold cash above the FDIC limit in short duration US Treasuries. Short duration US Treasuries are secured by the full faith and credit of the US government and are considered by many to be the safest securities in the world from a default risk perspective. In addition, short duration Treasuries have limited interest rate risk. In fact, GAAP allows institutions that hold US Treasuries that mature within 90 days or less to be considered “cash” on the balance sheet. Hence, by holding US Treasuries, you are effectively insuring all your cash against bank failure. We will address the risk to US Treasuries from the debt ceiling in a future letter.

Third, rigorously monitor the credit quality of the financial institution that custodies your assets and move your assets out of that institution if it becomes stressed. All U.S. banks are regulated and required to provide financial statements and standardized health metrics to regulators. The Tier 1 Common Equity ratio, the Tier 1 Capital Ratio and the Total Capital Ratio are great places to start your analysis.

Fourth, only hold US Treasuries in a “cash” account. Sometimes, like in the case of SVB, a financial institution jumps to default. In other words, everything appears fine until it isn’t, and investors never have an opportunity to move their capital to another, more credit worthy, institution. For this reason, it is critical that you only hold your US Treasuries in a cash account. Cash accounts are much safer in the event of a bankruptcy of your financial institution because the property in cash accounts remains in the name of the holder and is expeditiously transferred out of the bankrupt entity to a healthy financial institution. One should never hold securities in a margin account without a good understanding that margin accounts will likely end up as general creditors in bankruptcy and hence recover only a fraction of their assets after what could be years in bankruptcy proceedings.

Our purpose for this letter was to demonstrate that there are better ways to protect cash, for amounts more than $250,000, than a bank account (whether checking, savings or certificates of deposits). RCM exercises the risk management principals discussed above for all its clients across all its strategies.

Please reach out to us with questions and comments. Thank you for trusting RCM with your capital. It is a privilege for us to serve you.

Dave and Mike