How a string of bad choices made the 16th largest bank in the USA defunct overnight.
Inquiries about the situation surrounding the Silicon Valley Bank (SVB) have become increasingly frequent in recent times. People have become curious about what exactly transpired, how US regulatory authorities responded to the situation, and what, if any, implications this has for the Federal Reserve’s interest rate trajectory, monetary policy, and, ultimately, global markets.
SVB: The Early Days
Silicon Valley Bank was founded in 1983 by Wells Fargo executive Bill Biggerstaff and Stanford University professor, Robert Medearis. It was established in the heart of Silicon Valley, a region known for its technological prowess and tech-savvy decision-making. SVB grew rapidly to become the sixteenth largest bank in the United States, catering for the financial needs of technology companies around the world. However, a series of ill-fated investment decisions led to its collapse, and on 10 March 2023, the bank failed phenomenally, marking the third-largest bank failure in United States history.
Banking is a game of confidence. While banks promise to give you the money you have deposited in your account, in actuality, no bank could ever pay back all its depositors at once. The SVB collapse started when many of its depositors asked to withdraw their money to transfer it elsewhere. This was problematic for SVB since it lent out too little. Fundamentally, banks take deposits and other liabilities and lend out a substantial portion of them to create loans and similar assets. Assets can also be in the form of bonds, but in SVB’s case, it took little part in the credit function and instead channelled most of its deposits into investments.
SVB had a considerable asset-liability mismatch (ALM). In layman’s terms, SVB had deposits which were short-term in nature, but the assets it was buying were long-duration securities. This is not an uncommon practice for most banks but in the case of SVB, its ALM was significantly more pronounced.
High Concentration Risk
The majority of deposits in SVB came from Venture Capital (VC) funded startups and crypto companies. While the accounts were separate, many of these companies were effectively controlled by only a handful of VC firms who felt that the bank was becoming risky. This meant SVB had concentrated most of its deposits from a few sources only, and when the sources told their investee companies to move their deposits elsewhere, the concentration risk became readily evident.
Large American banks such as Citigroup and JP Morgan are highly regulated to protect consumers, ensure the stability of the financial system, and prevent financial crime. But regulations are lighter for banks with assets less than USD 250 billion. SVB went to great lengths to keep its assets slightly below this threshold to avoid high regulation. The regulatory body’s reasoning behind lighter regulations for banks with low assets is that these banks are not systematically important enough to dedicate resources towards their monitoring. However, without a close inspection of the bank’s internal and external activities, the highlighted risks flew under the radar for a considerable time, and SVB kept getting voted as one of the best banks in the US. Once SVB failed, investigations revealed that for the last few months, the bank had been operating without a Chief Risk Officer.
The crisis that led to the fall of SVB had been building up for some time, but it worsened due to rising interest rates in the US. Currently, interest rates have gone up 4.5% in less than a year, from near-zero levels. SVB was impacted in two ways. First, SVB invested in securities, especially mortgage-backed securities (MBS) where prices fell as interest rates rose. The alternative would have been to lend more instead, which, considering the fact that the MBS market is not as liquid as the market for treasuries made it difficult for SVB to get out of its vulnerable position. Additionally, because the majority of SVB’s investments were relatively long-duration or long-tenure securities, their drop in prices was more than those of short-term securities.
Second, as money became more expensive due to inflation, it was difficult for depositor companies to have ‘liquidity events’. The term refers to fundraising activities of various kinds in Silicon Valley, such as venture capital funding, Initial Public Offering (IPO), and raising money via Special Purpose Acquisition Companies (SPAC).
Effectively, the rising interest rates dealt a 1-2 jab-cross to SVB when its asset book lost money and its deposit growth began to dry up. Traditional banks on the other hand have their loans or other credit reprised upwards, meaning their interest rates increase almost immediately. Deposit rates, on the other hand, increase very slowly. As a result, when interest rates rise, for traditional banks, margins go up in the beginning.
When it comes to risk management, neglect is the biggest threat. The signs were evident for a long time, and SVB could have managed things somewhat better. Even though the MBS market is not as liquid as that for treasuries, SVB could have raised money against the book had they scoped for problems in advance.
It would appear that the severity of the consequences will be minimised because of US regulators. Up till now, deposits less than USD 250,000 was insured under the Federal Deposit Insurance Corporation (FDIC). The FDIC has now removed that limit, meaning, all the depositors of SVB will get their money back in full.
A Moral Hazard
The fact that the SVB is being bailed out essentially sends out the message that bankers and major players in the financial industry can take undue risks. In case things go south, its impact will be on shareholders and unsecured bondholders, not the management who can get away with their compensation and bonuses intact.
What remains to be seen now is whether the US Federal Reserve Board changes its stance on rate hikes. The US market has moved very rapidly with two-year yields down 60 basis points (0.6 percentage points) in a single day. Several Wall Street firms are assuming the Federal Reserve Board will not increase rates further as the terminal rate (the rate at which hikes are ceased) has fallen by 0.6-0.7 percentage points. Regardless of how things unfold, this single SVB crisis has had a definite impact on the outlook for both bond and equity markets.