Why the Silicon Valley Bank Collapsed and Why It Won’t be the Last in the Post-COVID Era
At the outset, the Silicon Valley Bank (SVB) operated just like any other bank. It would take deposits by paying a certain percentage of interest and lend that money to borrowers at a higher rate of interest. In SVB’s case, however, both the depositors and borrowers were mostly from the startup ecosystem.
The economic fallout caused by COVID-19 restrictions was and continues to be, one of great uncertainty. Starting in early 2020, in order to mitigate possible deflationary spirals caused by fear and restrictions, the Federal Reserve opted to implement, as it had in 2009, the two-pronged measure: a) lower interest rates to close to zero, and, b) quantitative easing. As a result, the Fed through the banking system pumped enormous amounts of money into the economy. The financial market was awash with liquidity.
Even as the US stock markets soared to new highs (e.g. Apple alone added about a $1 trillion dollar in market cap between March 2020 and Dec 2020), investors were looking at newer and riskier ventures to invest in. This resulted in startups, particularly startups in the technology space, from every corner being funded every which way. In fact these startups were almost being forced to take money which they could not put to use in the short term. Their burn rate was much lower than the funding they had secured. Even a couple of decades ago this was rare and extremely fortunate situation for struggling startups to be in!
The SVB attracted many customers from the startup world who brought with them the extra cash they had secured. However, even as the bank was doing well in attracting depositor money onboard, they were unable to find sufficient borrowers, both in number and size, to deploy all that cash and as a result had about $100 billion extra cash on the books. So in 2022, SVB’s managers decided to invest about $90 billion of that in long-term, 30-year US treasury bonds (LT bonds offer a higher return than short-term bonds). Why invest in long-term bonds which inherently carry higher risk to interest rate movements?
One can only guess that the SVB managers assumed that the current environment of “cheap money” will continue over the long term. A risky assumption, to be sure.
As US inflation hit a 40-year high, the Fed decided to recalibrate its monetary policy and depart from near zero rate. By the second half of 2022, most market analysts expected that a rate hike was coming and it was inevitable. From the SVB’s point of view the rate hikes impacted them in 3 major aspects:
- Startup Funding: It slowed down the startup funding to a trickle and perhaps even dried it up for many companies, which forced them to withdraw deposits made with the bank. To add to the problem, in the new environment the startups could not borrow at the higher rates.
- Strength of SVB’s Balance Sheet: What is worse, it negatively impacted SVB’s investments in the bond market. As rates rise, the money supply decreases and the bond prices fall. What was once a $90 billion investment in the US treasury bonds was now valued at roughly $75 billion (the fair value). SVB may have envisaged it as a hold-to-maturity investment (i.e. no loss), but it was forced to consider liquidating them given the prevailing environment.
- Inability to raise new equity: SVB announced on March 8th, that it sold $21 billion in securities at a loss of $1.8 billion, and would soon raise $2.25 billion in new equity. Given adverse market sentiments, this plan to raise new equity was shelved soon after.
SVBs key depositors, the startups, were facing a financial crunch in the new environment of higher rates and started withdrawing capital. In the early days of withdrawals, SVB had enough cash on hand to meet those demands smoothly. In the meantime, markets learnt that two other, smaller banks –the Signature Bank and Silvergate, were facing financial stress. Both Silvergate and Signature were seen to be SVB’s competitors.
The two bank’s liquidity troubles, along with the notional loss of $15 billion, spooked the customers of the SVB. This was a fundamental turning point in how the prominent VCs across the California state and beyond perceived SVB’s stability. Fearing total collapse, the VCs were the first to advise their portfolio companies to pull capital out of SVB. This bank run resulted in SVB selling some of its assets at a massive loss in the market –which only worsened the problem. Soon after, SVB had to close their doors and appeal for government intervention.
On March 10 2023, SVB was put under receivership.
What lies beyond credit risk: A Lesson
Ask a layperson, with no formal education in finance or economics, what the primary reason for a bank run is and they would probably answer: bad loans, or non-performing assets (NPAs). In other words, the bank lent money to borrowers who had little or no creditworthiness and suffered a loss when the borrowers failed to pay back (note: the word credit has roots in the Latin word credere, which means ‘to believe’). This is a fair answer coming from a regular person. However, as we see in case of Silicon Valley Bank there are other reasons for a bank run that go beyond credit risk.
While most bank employees across most levels starting from a loan officer to the CEO are trained to see credit risk aspect of most decisions, only the senior most management is entrusted with managing the liquidity risk and interest rate risk across the company.
- Interest Rate Risk: Interest rate risk is most pronounced when there is a rapid hike in the short term. As interest rates rise the value of previously issued debt, be it government or corporate, plunges as the money in the market competes for the higher yield debt. That is the prices of the old bonds, drop. A 2% increase would reduce the market price of a 30-year bond by about 33%. In SVB’s case it had over 50% of its investments fixed income securities, including the US government bonds. Interest rate movements in the market by itself is not a major problem if the fixed income securities are held to maturity, at which point the investor can collect the face value without realizing any loss. The notional loss would stay hidden on a public declaration and would fade away as the security’s maturity date draws closer. However, in a case where the bank is forced to sell its investment when the market value is lower than the face value, then it becomes an actual loss. Having to meet customer demand for deposit withdrawals, the SVB did exactly that.
- Liquidity Risk: this risk stems from a company’s ability to meet its obligations without incurring losses. SVB was able to meet its withdrawal demands with the available cash reserves. As its cash reserves started to dry up, SVB liquidated security investments at a stated loss of $1.8 billion, while simultaneously announcing measures to raise new equity to the tune of $2.25 billion. This only fanned the fear that SVB may not able to meet its obligations without a fresh infusion of equity capital.
SVB is unlikely to be the last bank to face a bank run in the era of post-COVID policies. Even before SVB’s trouble became the topic of mainstream newsroom discussions, market has been jittery about the position of Credit Suisse Group AG. Tracking the events around SVB, Credit Suisse’s credit default swaps (CDS) hit a record high on March 13th while its shares plunged in the European stock market. Market prices of CDSs spike in response to a perceived increase in debt risk. As on date, Credit Suisse is in negotiating with the Swiss central bank to borrow up to $54 billion to shore up its finances.
There are systemic risks that go beyond any one company. We can cover that in a different post.
Prof. Abhijith S
Assistant Professor – Analytics & Data Science