When a string of regional banks failed in the spring of 2023, investors and depositors feared the advent of another financial crisis, and many were left wondering how these banks found themselves in a situation that led to bank closures, fire-sale purchases, and millions of dollars in losses for some bondholders.
The crisis was painful for some, but also offered important lessons about investment management, marking securities to market, diversification and risk.
Managing money at a bank
Banks around the world make money by taking in deposits and keeping only a portion of those on hand for depositors to withdraw. They use the rest to make loans and generate profits, under a system known as fractional reserve banking. The interest rate banks get from borrowers on those loans is a key way for banks to make money through things like mortgages. This helps keep banking fees low while allowing banks to generate profits.
Risk factors for banking
There are several risks banks manage under this setup. For one thing, if too many people ask to take out too much money at the same time, they risk a bank run – or depositors panicking about accessing their funds when a large portion of them are being used for loans and other profit-generating activities.
Banks typically manage that risk by making sure they match their assets and liabilities, so that their assets (loans) and liabilities (deposits) have similar terms. That way, if depositors want to withdraw funds, they aren’t tied up in a long-term instrument that isn’t liquid and can’t easily be converted to cash at a reasonable price.
A second consideration for banks is interest rates. Rates impact the price of bonds, so that rising rates mean lower bond prices. If duration risk isn’t well managed, when depositors come calling, the bank could have to cash in a bond before its maturity date. If rates are higher than they were when the bond was issued, that means selling at a lower price.
“If you have assets that have a 10-year term, your investments on the other side should have a similar term. That way, if interest rates go down, your assets will go up and match your liabilities,” explained Heather Mason-Wood, President and Chief Strategy Officer at Canso Investment Counsel Ltd.
“When you mismatch and then there’s a change in interest rates, that’s when you get hurt.”
She points to Silicon Valley Bank, which was shut down by regulators after facing a run on deposits in March 2023.
“Their deposits were just regular deposits, which are very short term in nature. The capital on the other side should’ve been matched in terms of the length of term they were investing in, such as very short Treasury bonds,” she said. “It wasn’t.”
Another problem SVB faced was a lack of client diversity – once word of problems began to spread in the tech community, which was its primary customer base, everyone tried to withdraw at once.
Managing money as an investment professional
Concerns around diversification, interest rate risk and market exposure are also part of the risks investment managers must assess and address.
While banks make money by loaning out funds they gather through deposits, investment managers take clients’ money and invest them in securities, mutual funds, bonds, or other investment products to get a return on those investments. They charge a fee for this active management, which is how they make money themselves while also trying to make money for their clients. Investment professionals rely on market analysis, research, and connections, as well as indices, to obtain information about performance.
Risk factors for portfolio managers
While investment managers don’t seek to match assets and liabilities in the same way banks do, they do consider interest rate risk and diversification – and they also need to mark securities to market to know their exposure to interest rate risk.
Bonds, for instance, trade in the market, which means their prices change every day depending on interest rates, as well as issuer-specific factors.
“As a bond manager, you’re looking at your portfolio every day to ensure you know where things are at from a risk perspective, whether it’s credit risk or interest rate risk, and you’re actively managing where your positions are and where you are,” said Mason-Wood.
“It’s about marking to market, which means that you should know, every day, if you were to sell the investments you hold, what you could get. For banks, (that means whether) they have sufficient capital to meet any withdrawals that may arise.”
Another consideration is the risk the asset itself carries, or credit risk. Different financial assets carry different risks; and investors are usually paid a higher return for taking on more risk that the asset will lose value or the issuer will default.
Managing risk for banks and investment managers
While the inner workings of banks and investment management firms differ, including how they make money and manage risk, both must consider interest rate risk, the quality and liquidity of the assets they hold, as well as the importance of diversifying to be able to withstand a crisis.
For all market participants, it’s crucial to understand what risks are being taken and consider whether those fit within the overall financial situation or goals of the person or organization.
“If you’re trying to build capital, then you don’t want to take too much risk because you could end up losing anything that you already have,” said Mason-Wood.
“Once you’re in a comfortable financial position, maybe you are willing to take more risk with your investments. It’s really about understanding the risk in your portfolio, and that comes from speaking with an investment professional to help you work through that.”
Disclaimer: The views and information expressed in this publication are for informational purposes only. Information in this publication is not intended to constitute legal, tax, securities or investment advice and is made available on an “as is” basis. Information in this presentation is subject to change without notice and Canso Investment Counsel Ltd. does not assume any duty to update any information herein. Certain information in this publication has been derived or obtained from sources believed to be trustworthy and/or reliable. Canso Investment Counsel Ltd. does not assume responsibility for the accuracy, currency, reliability or correctness of any such information.
