Money

Two Key Lessons From the Banking Crisis

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The failure of Silicon Valley Bank (SVB) and the general health of banks has been all over the news recently. There are many fascinating aspects of this story. One is parsing out the roles different parties and policies played in the bank’s failure. Another is the short and long-term implications as to how this crisis is being dealt with.

While interesting at policy and societal levels, these issues are out of our control and generally irrelevant from a personal planning perspective. However, there is one aspect of this story that every reader of this blog planning for or navigating their retirement should be paying close attention to: risk management.

How did SVB’s poor risk management lead to its failure and set off the ensuing cascade of events? Are you making similar mistakes in your own retirement portfolios and plans, setting yourself up for catastrophic outcomes.

Volatility and Liquidity Risk

Too often, the terms volatility and risk are used interchangeably when discussing investments. This is incorrect. Volatility is only one investment risk.

During your accumulation phase, volatility actually works to your advantage when asset prices drop. Most successful investors develop a systematic way of deploying their money as they get it.

A common example is dollar cost averaging the same amount of money each pay period into retirement accounts. When asset prices drop, the same amount of dollars buy you more shares of the same asset than they did the prior cycle.

As you approach retirement, and especially once you are in it, the opposite is true. Volatility becomes a massive risk. A dramatic drop in asset prices when you need to sell those assets means you will need to sell more to produce the same amount of income.

This brings us to liquidity risk. This is the risk that you will be unable to meet your short-term obligations when you need to do so. An investment may lack liquidity because you can’t access your money or because the value of the asset has dropped in the short term due to volatility.

SVB could not meet customers’ rapid withdrawal demands and became insolvent in a day. In the case of individual retirees, if you have to sell too many assets too quickly, especially early in retirement, you will deplete your portfolio to the point where it can not recover. 

This is basic risk management 101. Yet those charged with managing risk for the 16th largest bank in the nation fell victim to it. We should all be humble enough to recognize our own potential risk management blind spots. Let’s learn from this risk management failure.

Duration Mismatch

Why was SVB in a position to be vulnerable to a bank run? SVB was a bank that catered to venture capitalists and start-up companies. When times were good, they had an abundance of deposits.

Part of the reason times were so good for this bank was because interest rates were so low. This spurred record levels of investment in the start-ups and left those companies flush with cash to deposit.

As every bank does, SVB was looking for ways to make money off of these deposits. In a low interest rate environment, the bank bought U.S. government treasuries with intermediate to long durations to try to squeeze a little extra yield out of their investments. 

These are extremely safe investments IF you can hold them to maturity. This wasn’t a repeat of the subprime mortgage induced banking crisis. SVB wasn’t using customer deposits to buy Bitcoin or other highly speculative investments out of extreme greed.

Under anything but outlier conditions, SVB would have gotten away with their poor risk management. However, these were not normal circumstances. Interest rates increased rapidly. This led to a considerable loss in the value of bonds with longer durations.

Despite the paper losses, SVB would have still been OK if they could have held onto these assets until they matured and could be redeemed for full face value. However, they were not able to do so.

Depositors caught wind of SVB’s precarious situation. They started withdrawing their money. They then told others who quickly followed suit. This created a bank run. 

In a single day SVB customers made $42 billion of withdrawals. SVB couldn’t meet demands and was out of business the next day.

Lesson 1: Limit Volatility Risk and Maintain Liquidity

Retirees face similar risk when needing to create income from volatile portfolios in retirement. We are typically, and rightly, most concerned with the volatility of the stock portion of our portfolio. 

However, many of us may have become complacent during the past decade plus when stock prices have more or less only gone up. As a result, many people are holding excess volatility risk by owning more stocks than we should.

We have actually gone through multiple bear markets in the past few years. This includes one in December of 2018 and another in March of 2020. Many of us forgot they even happened because markets rebounded so quickly in both circumstances. We need to remind ourselves that markets can take a decade or longer to recover.

Related: The Next Bear Market — How Bad Could It Get?

We also have been lulled into believing we can diversify away the volatility risk of stocks by holding bonds. For almost 40 years, this has held true as interest rates have been lowered in times of financial crisis. So as stock prices dropped, bonds consistently served as a ballast for portfolios.

The SVB duration mismatch is one many individual investors are also experiencing. We are being reminded in real time that not all bonds are created equally. Bonds with long durations can be very volatile in times of rapid interest rate changes. When rates are increasing, your existing bond values will drop.

Related: How Low Can Your Bond Values Go?

We need enough safe and liquid assets to ride out periods of volatility.

“Black Swans” vs. “White Swans”

Some people will argue what occurred was a “Black Swan” event, which by definition:

  • Is an outlier event, outside the realm of regular expectations,
  • Has an extreme impact, and
  • Was unpredictable, though we try to concoct explanations for it after the fact.

The term “Black Swan” is greatly overused. The banking crisis is what Jordan Grumet would call a “White Swan” event. These equally destructive events result from predictable and normal risks that we tend to overlook.

The banking crisis is the result of the combination of two events:

  • A large and rapid increase in interest rates, and 
  • A run on the bank.

Allan Roth recently explained that what happened in the bond market in 2022 should statistically be predicted to happen “about once every million years.” Bank runs are rare events in this day and age.

Predicting the exact way things unfolded was indeed nearly impossible. However, the idea that these were unknown risks that couldn’t be planned for is laughable.

Lesson 2: Protect Against “White Swan” Events

It was simple to see that intermediate to long-term bonds had horrible risk-reward ratios with extreme low interest rates.

I published an article on that exact topic nearly three years ago to the day I’m publishing this one. I’ve been sounding this alarm and sharing risk management strategies to deal with it for over 5 years on this blog. We should all be aware of the potential for increased volatility risk and decreased returns in times of high stock valuations and low interest rates.

Bank runs and failures are rare today. It’s understandable that prior to last week they were not front of mind to you and I. However, it is inconceivable to think bank runs weren’t a known risk to those that manage risk for a bank.

Retirees will never be subject to a bank run. We do face analogous risks of spending shocks that are real possibilities, even if unlikely. The need to meet these potential spending spikes increases volatility and liquidity risk. There are at least three that we should be planning for.

The easiest to deal with is being sued by someone for a liability claim. This is highly unlikely but potentially devastating. So you should do what you can to limit your exposures. Also, make sure you have adequate liability coverage with auto, homeowner’s, and umbrella insurance policies.

The second, a major health condition, is more common. So despite the potentially high expense, we all need to protect against this with adequate medical insurance. We should also optimize lifestyle choices to mitigate this risk.

The third is divorce near or in retirement. This is unfortunately common and you can’t insure against this risk. You can recognize the risk, invest in your relationship, and plan for the worst case scenario.

Are You Managing Risk Adequately?

The banking crisis that is currently unfolding is sending shock waves through our financial system. There is a lot of noise surrounding these events.

Politician Rahm Emmanuel has a well known quote. “You never want a serious crisis to go to waste.” 

I encourage you not to waste this crisis. Use it as a personal learning opportunity. Apply those lessons in your personal planning. Don’t repeat these risk management mistakes.

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[Chris Mamula used principles of traditional retirement planning, combined with creative lifestyle design, to retire from a career as a physical therapist at age 41. After poor experiences with the financial industry early in his professional life, he educated himself on investing and tax planning. Now he draws on his experience to write about wealth building, DIY investing, financial planning, early retirement, and lifestyle design at Can I Retire Yet? Chris has been featured on MarketWatch, Morningstar, U.S. News & World Report, and Business Insider. He is also the primary author of the book Choose FI: Your Blueprint to Financial Independence. You can reach him at chris@caniretireyet.com.]

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