The problems of two small banks on the West Coast are rippling across markets and causing new investor concerns about some of the country’s largest financial institutions.

Why? Three words: rising interest rates.

The Federal Reserve’s aggressive campaign to bring down inflation helped set the stage for major problems at two California lending institutions — SVB Financial (SIVB) and Silvergate Capital (SI) — as an outflow of deposits forced both to sell assets at a loss. Those assets were bonds.

Banks are big investors in assets like Treasury bills because they need lots of safe places to park their cash. Many financial institutions piled into these investments during a period of historically-low interest rates that spanned the early years of the pandemic, as banks took in tons of new deposits and lending was somewhat restrained.

But now the Fed is hiking rates at a rapid clip, with Fed Chair Jay Powell warning earlier this week the central bank may have to speed up the pace of its rate increases to cool the economy further. The problem that creates for banks is simple: higher rates lower the value of their existing bonds.

The withdrawals at SVB's Silicon Valley Bank have come from startups and technology firms, many of which also ran into new trouble once the Fed began raising rates.

The deposit outflow forced SVB to sell assets and take a $1.8 billion loss, a move the bank made “because we expect continued higher interest rates, pressured public and private markets, and elevated cash-burn levels from our clients as they invest in their businesses.” Its shares fell more than 60% Thursday.

In pre-market trading on Friday, SVB shares were down another 60% after overnight reporting from Bloomberg said VC firms ranging from Peter Thiel's Founders Fund to Union Square Ventures had told portfolio companies to pull their money from Silicon Valley Bank.

Forced sales, forced losses

Banks don't have to realize losses on bonds that may have gone down in value amid rising rates if they're not pushed to sell these assets. But Silvergate Capital and SVB Financial didn’t have that choice. Customer withdrawals at Silvergate Bank and SVB’s Silicon Valley Bank forced their hand.

At Silvergate, which caters to cryptocurrency clients, customers yanked their money in the panic that followed the 2022 collapse of cryptocurrency exchange FTX. Silvergate said in January that it had realized losses of $886 million from selling securities as deposits fell. That weakened the bank considerably. On Wednesday it said it would wind down its bank, and its shares plunged Thursday.

After disclosing the $1.8 billion loss and new capital raise, Silicon Valley’s CEO Greg Becker urged calm in a call with venture capitalists Thursday, according to The Information, asking these investors not to withdraw money. It now is seeking to raise $2.25 billion of new capital to cover the new losses.

The concern now among investors is that much bigger banks could be forced to do the same. That sent the stocks of giant financial institutions tumbling Thursday, including the biggest of the big: JPMorgan Chase (JPM) and Bank of America (BAC). A major bank index fell by the most Thursday in nearly three years.

The biggest U.S. banks are much stronger than they were in the lead up to the last big banking crisis, in 2008, in part because regulators forced them to hold more capital and survive numerous stress test scenarios over the last decade and a half. And the giants have more diverse funding and customer bases than banks such as Silicon Valley or Silvergate, which gives them many more options during challenging times.

Longtime banking analyst Mike Mayo said Thursday during an appearance on CNBC the biggest banks are "a pillar of strength and stability" and much more resilient than they were prior to the 2008 crisis. "The biggest risks are outside the largest banks," he said, and yet all banks are "getting painted with the same brush."

Bank stocks, he said, "have gotten Powelled," referring to the Fed chair.

"Going from zero to 5% interest rates in a period that is faster than any time in four decades, you are going to have casualties."

Federal Deposit Insurance Corporation Chair Martin Gruenberg highlighted the new interest rate risks facing the industry during a speech on March 6, noting that unrealized losses on available-for-sale and held-to-maturity securities totaled $620 billion at the end of 2022 across all U.S. banks.

"The current interest rate environment has had dramatic effects on the profitability and risk profile of banks’ funding and investment strategies," he said. "First, as a result of the higher interest rates, longer term maturity assets acquired by banks when interest rates were lower are now worth less than their face values. The result is that most banks have some amount of unrealized losses on securities."

These unrealized losses, he added, "weaken a bank’s future ability to meet unexpected liquidity needs."

The good news, according to Gruenberg, is that "banks are generally in a strong financial condition, and have not been forced to realize losses by selling depreciated securities."

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