Bank Stocks Worth Betting On

Bankers have to contend with two big challenges. The first is credit risk. If the economy slides into a recession, borrowers may not be able to make payments on their loans. The second is interest rate risk. Rates can turn against banks in a lot of different ways. For one thing, short-term rates can rise more than long-term rates do, reducing the income that's generated from the difference between what a bank pays for deposits and what it earns from its loans. For another, as rates rise, the value of debt securities the bank had purchased at lower rates falls.

- James K. Glassman

Usually, it's the first challenge that gets banks into trouble. That's what happened to them in 2008 as real estate collapsed. But the now-infamous Silicon Valley Bank ran afoul of the second challenge. SVB was an unusual institution that held considerably more debt securities, such as government bonds, than it did loans. ($120 billion worth of securities but just $74 billion in loans). The bank was also too focused on a single sector-technology companies and the venture capitalists that supported them-and it had vast amounts of demand deposits ($110 billion), which didn't require SVB to pay interest but could be pulled out instantly using an iPhone.

Because of the way bank accounting works, SVB did not have to take a hit to its profits as its bonds fell in value, but depositors learned of the problem and started demanding their money. Federal regulators intervened, guaranteeing all of SVB's deposits-even if they exceeded the $250,000 federal insurance limit, as the vast majority did. The intervention prevented SVB's bank run from becoming contagious.

The management of SVB made a classic mistake by mismatching short-term liabilities (those demand deposits) and long-term assets (such as debt being held to maturity with an average duration of 6.2 years). Most banks don't do such things.

In my view, SVB was a salutary warning to the whole banking sector - as well as to regulators, who were at fault for not recognizing sooner that the bank deserved extra scrutiny because it grew so fast (SVB quintupled in size in five years). The system itself is sound and is now getting even sounder, but there's no doubt that banks are going to tighten their lending requirements, which will further slow the economy.