Silicon Valley Bank Fails: What Happened, What’s Next?

The trading week ended with a thud, as Silicon Valley Bank (SVB), which catered to tech startups and the venture capital firms that financed those start-ups, was taken over by the Federal Deposit Insurance Corporation (FDIC). It was the second-largest bank failure on record and understandably, many are worried that when the 16th largest U.S. bank fails, that we are headed back to the land of the 2008 financial crisis. While this is serious and has significant consequences for those involved, it does not appear to pose a risk to the broader banking system.

So far, it does not look like the shuttering of SVB is akin to the collapse and contagion associated with Lehman Brothers and Washington Mutual (the record holder of the largest collapse in U.S. banking history). To understand why it is not the canary in the coal mine, we need to look more closely at what happened to SVB and what happens next.

How did SVB get so big, so fast? As its name implies, Silicon Valley Bank, which was formed in 1983, focused on the tech sector, and specifically on new companies that were formed (start-ups) and the venture-capital firms that helped to finance their growth. As the tech sector boomed on the back of low interest rates and abundant funding, these companies prospered and were able to deposit a lot of money at SVB. This trend was supercharged during the pandemic, as deposits at SVB nearly doubled in 2021 to just under $190 billion.

What did the bank do with its deposits? SVB Financial, the parent of SVB, did what many banks do: it kept what it thought was an adequate amount of cash on hand to meet any withdrawal demands from its depositors. Then with a bunch of extra cash sloshing around, it purchased U.S. Treasuries. These investments are considered rock-solid and safe, with the main risk being that if you need the money before the bond matures, you would be subject to price fluctuations as interest rate changes impact the value of bonds.

SVB had the unlucky timing of buying a lot of government bonds before the Fed began its rate-hike campaign a year ago. As interest rates increased, the value of the bonds on SVB’s balance sheet began to shrink. The “paper loss” on these bonds would not be a problem, as long as SVB depositors did not ask for big chunks of their money back. But the rise in rates and decline in the bond portfolio’s value coincided with the tech industry’s fall from pandemic grace.

How does a slow leak become a deluge? As tech and start-up companies came under pressure over the past 18 months, they needed to withdraw their deposits at SVB to finance their operations. To meet those depositor demands, SVB burned through the cash on hand and had to sell their government bonds to free up money. On March 8, the bank sold $21 billion worth of bonds at a loss of about $1.8 billion after tax and also announced that it was trying to raise more money to bolster its balance sheet. Here’s the problem: When a bank looks like its foundation is shaky, it can create a frenzy among depositors who quickly try to access their funds. This classic bank run resulted in SVB running out of money and forcing the FDIC to step in and take over.

What about other banks? Worries about SVB led depositors and investors to question the stability of other, similar small to medium-sized niche banks that provided funding to high growth sectors like tech and crypto. That’s why shares of First Republic, Signature Bank and PacWest were clobbered last week. The biggest banks (Global Systemically Important Banks) initially took some hits to their stock prices, but stabilized by the end of the week. The reason is that the run on SVB is a reaction to their banking model, not a run on the broader banking system.

It is important to note that after the financial crisis of 2008, the government stepped up the requirements for large institutions, which forces them to keep more cash on hand than small-midsize banks. Additionally, large banks have a more diversified customer and funding base, which can shield them from such shocks. Treasury Secretary Janet Yellen expressed full confidence in banking regulators to manage SVB and underscored that “the banking system remains resilient, and regulators have effective tools to address this type of event.”

What’s next for SVB depositors? Depositors who had less than $250,000 were always safe, but those above the FDIC limit were at risk. On Sunday evening, the Federal Reserve announced two measures intended to diffuse the situation. (1) ALL depositors at SVB and NY-based Signature Bank (which failed on Sunday) would have access to their money as of Monday March 13th, even those accounts above the $250,000 FDIC limit. (2) The Fed will make funds (via loans) available to those banks that come under similar liquidity pressure. The Fed underscored that no losses associated with the resolution of Silicon Valley Bank will be borne by the taxpayer. 

Lessons (so far) from SVB

--Know Where Your Deposits Are. Every banking consumer should keep their money at FDIC insured institutions and individual account balances under $250,000. Doing so, affords peace of mind and deposit insurance protection against the failure of a bank. (See FDIC website for more information).

--Reaching for Higher Interest Rates Involves More Risk. Flush with cash amid a low interest rate environment, SVB decided to buy longer dated bonds, which rewarded them with higher interest rates, but subjected them to steep losses if interest rates were to rise. By doing so, they forgot a core investing concept, which is when you reach for higher yield, you increase your risk.

Maybe bank management was caught off guard by their depositors need for cash, but this is a company that touts its “know-how and experience... across the innovation economy,” which means that perhaps it should have known that its customers have been bleeding cash for the better part of a year. If that was the case, the bank would have been better served by keeping more money in cash or in short-term bonds.

--ZIRP HURTS. For years, the Federal Reserve maintained a Zero Percent Interest Rate Policy (“ZIRP”). When rates remain low for long periods of time, it encourages growth, but also can lead to outsized risk taking. Now that the Fed has reversed course and is hiking interest rates to beat back inflation, there are unintended consequences, like a bank being forced to sell its “safe” bonds at a loss to meet its obligations.

--Watered-Down Regulation Can Bite Back. SVB was one of the small to mid-sized banks that lobbied the government to ease the post-financial crisis banking regulations. In 2018, those efforts bore fruit, as the Trump Administration reduced regulations and oversight for banks with assets less than $250 billion. Perhaps with more oversight and higher capital and liquidity requirements, SVB may have avoided this disastrous outcome.