The sudden collapses of Silicon Valley Bank (SVB) and First Republic Bank sent shockwaves through the financial landscape. While neither bank was systemically important, their unexpected failures prompted emergency measures to guarantee deposits and set regulatory agencies in motion to review perceived gaps in banking supervision.
State-chartered banks play a vital role as insured depository institutions, and when they are unable to sustain capital requirements, it can shock the public market, increasing contagion risk and economic uncertainty.
As we explore how banking activities are regulated in the United States and the repercussions of deposits shifting to large banks, consider the opportunities to protect your investment portfolio. Banking stress can arise from many circumstances, and understanding the causes of these events can prepare you to navigate a range of market influences.
Banking Regulation and Contagion Risk
As the central bank of the United States, the Federal Reserve supervises banks and financial holding companies, ensuring compliance with regulations for the protection of public interest. Congress established the Federal Reserve to conduct monetary policy, maintain a healthy economy, and stabilize the financial system by influencing credit conditions to contain risk.
The Federal Deposit Insurance Corporation oversees state banking and works with the Federal Reserve to create a safety net for depositors when banks fail.
Fear of contagion risk and bank panic led Congress to pass the Emergency Banking Act of 1933 to stabilize the financial system during economic downturn. When the Federal Reserve progressively raised interest rates to fight inflation in early 2023, SVB experienced significant investment losses.
The risk of financial contagion is simply the ability of a crisis in one market or region to spread due to the connection of monetary systems. There is an inherent push-pull relationship between the economy and commodity markets. While the goal of regulatory measures is to prevent financial crises, restore public confidence, and diffuse contagion risk, that’s not always the result.
In the case of SVB, the influence of federal banking regulators compounded banking stress and increased panic among depositors, which led to a run on the bank and:
- Increased banking regulations to ensure capital liquidity and prevent unmanageable outflows
- Reevaluation of deposit insurance policies and whether the $250,000 cap is sufficient to prevent bank runs
- Consolidation of deposits to large banks despite intervention measures to restore public confidence in smaller depository institutions
The most significant impact for investors in real estate will be a consequence of migrating deposits. Small and regional banks hold 67 percent of commercial real estate loans. If deposits are withdrawn and transferred to larger banks and money market mutual funds, it will put capital constraints on local lending institutions.
It may become much more difficult to find lenders with competitive terms for real estate financing. These shifting dynamics may not have an immediate impact on your investments, but they should inform how you structure your portfolio to withstand banking stress and mitigate risk.
Identifying Contagion Risk
To understand the level of contagion risk within your portfolio, evaluate your investments with consideration for two factors: market risk and idiosyncratic risk.
Market risk looms much larger within the context of contagion because it represents the complex danger posed by sociopolitical and economic influences, such as interest rates, exchange rates, and natural disasters. This affects the performance of investments across the entire market, and due to its systematic nature, market risk cannot be eliminated.
The other half of this dichotomy, idiosyncratic risk, is limited to a specific asset class and is not correlated with larger macroeconomic factors. It varies based on influences such as the management and financial policy of a company or regulations of a singular investment sector, such as biomedical research, renewable energy, or cannabis.
3 Indicators of Contagion Risk
In modern financial markets, trade occurs across international borders. It’s common for banks to hold both domestic and foreign securities, and contagion is less likely to remain isolated. Indicators to watch for are:
- Global Politics: Political unrest, war, and natural disasters destabilize economic conditions and disrupt trade.
- Financial Crisis: Economic downturns won’t guarantee contagion but may lead to tightening of the credit environment and volatility in the public market.
- Market Volatility: Surprising and significant swings in equity prices can trigger selloffs as panic takes hold and investors liquidate to prevent catastrophic loss.
Every investment reacts to distinct influences. Conduct thorough due diligence before making investment decisions regarding public companies. While idiosyncratic risks are irregular by nature, researching the company, industry, and related commodities will inform you of the greatest outlying risks to monitor.
Mitigating Risk Through Non-Correlated Investments
If an existing or potential investment seems subject to greater volatility, portfolio diversification with non-correlated assets can stabilize your risk-adjusted rates of return. This approach creates a more resilient balance with investments that are secured by tangible assets and are less affected by the swings we see in traditional financial markets.
Alternative investments, such as real estate investment trusts, mortgage funds, and hard money financing, can enhance portfolio diversification, offer regular returns, and reduce loss from market shocks. As you evaluate each investment, be aware of liquidity and any terms that impact the access to your capital when necessary.
Strengthening Your Investment Portfolio
The successive failures of Silicon Valley Bank and First Republic Bank underscore the need for diligent risk management by investors to sustain banking stress in the future.
Strengthen your position by identifying the nature of risk to each investment and diversifying your portfolio with non-correlated investments. Explore Socotra’s Guide to Building a Resilient Portfolio to learn more about how hard money financing can protect your investments from market volatility.