Could something similar happen in Canada?

American business tycoon Warren Buffett once famously observed: “You don’t know who swam naked until the tide went out.”

Silicon Valley Bank was exposed last week to rising interest rates, leading to an old-fashioned bank rush – where bank customers rush to withdraw their money all at once.

The failure of the 16th largest bank in the United States highlights the vulnerability of its niche business model in the digital age.

Could something similar happen in Canada? For Canada’s largest banks, the answer is no. But for smaller, niche financial services firms, recent history suggests they shouldn’t be complacent.

A vulnerable business model

The first step in assessing any vulnerability in Canada is to understand why Silicon Valley Bank failed.

Silicon Valley Bank was running a risky business. This used short-term cash deposits from technology customers buy longer-dated US mortgage bonds. This maturity mismatch can be profitable in good times, but can destroy an investor in bad times.

The rise in interest rates over the past year resulted in losses of $2 billion on Silicon Valley Bank bonds. Faced with a possible deterioration in credit, the bank tried in vain to raise equity to consolidate its balance sheet.

When this news spread on social media, it led to fast online deposit withdrawals which emptied the liquidity reserves of the Silicon Valley Bank. US regulators seized the bank to stop the bank run.

Short-term deposits fund long-term obligations

Silicon Valley Bank’s vulnerability can be seen by comparing its balance sheet to its peers. At the end of 2022, Silicon Valley Bank depended on short-term customer deposits to fund more than 80% of its $212 billion in assets.

Silicon Valley Bank funding versus peer funding in the US and Canada.
(Michael R. King), Author provided

The five closest regional banks – Capital One Financial, First Republic Bank, KeyCorp, M&T Bank and US Bancorp – had a similar share of assets. But the Four major US banks – JPMorgan Chase, Bank of America, Citigroup and Wells Fargo – had more diversified funding.

Silicon Valley Bank invested that cash in mortgage bonds and other securities, representing 60% of its assets. Silicon Valley Bank’s figure was nearly three times that of its closest counterparts and more than double the US Big Four.

A bar chart that compares the assets of Silicon Valley Bank with the assets of its five closest peers, the four largest US banks and the five largest Canadian banks.
Assets of Silicon Valley Bank compared to the assets of its peers in the United States and Canada.
(Michael R. King), Author provided

To offset this risk, Silicon Valley Bank held more cash than its closest peers at 6% of assets. But when the run on the banks began, the sell-off of bonds at a loss was not enough to compensate for the electronic withdrawal of deposits.

How safe are Canadian banks?

Could a similar bank run occur north of the border? The answer for Canada’s largest banks is no.

Canada’s Big Five Banks — Royal Bank, TD Bank, Scotiabank, Bank of Montreal and CIBC — remain among the safest in the world. They are large, diverse and well capitalized. They have experienced leadership and are closely monitored by a respected banking supervisor.

The Big Five Canadian banks have nearly identical funding profiles to the Big Four US banks. The larger share of Big Five lending arguably makes them safer, because most Canadian mortgages are insured by Canada Mortgage and Housing Corporation.

The financial markets share this assessment. As of yesterday, the stock prices of the Big Five Canadian banks had fallen by an average of 16% over the past 52 weeks, similar to the 13% drop for the Big Four US banks.

In contrast, Silicon Valley Bank’s share price fell 80% before trading halted last Friday. And the five closest peers to Silicon Valley Bank were down 40% on average.

Innovation increases risk

This analysis does not mean that there are no vulnerable players in the Canadian financial system. Silicon Valley Bank demonstrates that innovative and niche business models are more vulnerable.

An FDIC sign that reads 'Each depositor insured at least $250,000' displayed in a window
An FDIC sign is displayed on a window of a branch of Silicon Valley Bank in Wellesley, Mass., March 11, 2023.
(AP Photo/Peter Morgan)

This pattern corresponds to the history of bank runs. The UK hadn’t had a bank run for 140 years until the demise of Northern Rock in 2007. This niche lender relied on short-term funding from other banks to fund long-term mortgages. This lag caused the lender to tumble when interbank markets froze early in the year. 2007-08 global financial crisis.

Canada had a partial bank run in 2017. Home Capital Group was a specialty lender that provided uninsured mortgages to less creditworthy Canadians. This risky activity was financed by high-interest savings accounts and other deposits. When Home Capital’s depositors lost faith, the partial bank run was only halted when a group of Canadian institutional investors threw Home Capital a $2 billion lifeline.

Three pillars underpin trust

These bank runs are a reminder that confidence in the banking sector is based on three pillars: risk management, deposit insurance and banking supervision.

All banks use leverage, making risk management a key success factor. Canada’s largest banks have demonstrated this capability for many decades, most recently during the global financial crisis.

Eligible deposits in Canada are insured by the Canada Deposit Insurance Corporationa Crown corporation that insures up to $100,000 per account held at member institutions.

Federal financial institutions are supervised by the Office of the Superintendent of Financial Institutionswhich monitors capital levels and risk taking.

These three pillars are tested rising interest rates revealing weaknesses in the global financial system. A decade of cheap money has fueled many innovations and niche business models.

With an ongoing economic downturn, further failures of the global financial system are inevitable.

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