Silicon Valley Bank: Lessons Learned and Potential Implications
The past few days have been nothing short of general chaos in the financial services industry — not much better can be said for anything outside of it either. This past Friday, we saw the eventual collapse of the 16th largest bank in the United States and the largest collapse of a bank since the 2008 financial crisis: Silicon Valley Bank (SVB). As their stock plummeted -60% and their deposits ran dry, the market was halted and the news was predominantly widespread across every major network. The optimistic sentiment in the market quickly disappeared and every market reflected that same public fear. Nearly every text, every email, and every social media notification of mine was suggestive that this issue was more than significant — an energy that seems to be fairly representative of the situation at hand. A bank-run ensued and the public was left to investigate what exactly happened to get us to this point — and better yet, what complications could additionally be on the horizon.
I have spent the better portion of the weekend researching, listening, and trying to understand in detailed fashion what specifically caused SVB’s failure and what implications this could have on the future, especially as our central bank works to navigate a gloomy macroeconomic environment. However, I do not want this short-piece to simply regurgitate every article and tweet you have been reading on the causes of this crisis. Instead, I want this article to highlight the key points, the lessons learned, the eventual complications that could arise, and potentially some alarming updates to look into. I hope this serves as both interesting and provocative. Let’s dig in.
Summary
Silicon Valley bank was started in the 1980’s as a primary advocate for innovation in Silicon Valley that was ripe for growth and startup potential. A significant portion of the country’s startups banked with SVB, whether it be information technology, fintech, healthtech, e-commerce, or electronics. SVB remained particularly relevant in the venture capital industry, since they took investor funds alongside bank loans to aggressively invest in the hottest startups in the San Francisco area. This relationship has lasted decades and has only grown stronger with time. In the past few years, SVB’s liabilities (deposited funds) had grown exponentially, as low interest rates, endless liquidity, and a booming market fueled venture capital. Funds invested rapidly (and often foolishly) in these startups and SVB enjoyed the mutual benefits that came in lending/partnering with many venture funds and their portfolio companies.
However, as is done in the foundation of banking, SVB needed to invest those deposited funds to reap yields greater than the yields promised to depositors — such is the benefit of a fractional reserve banking system here in the U.S. However, with elevated deposit levels and huge amounts of capital at their disposal, SVB needed to invest in safe, established securities. The problem is that inflation and bond-yields were incredibly low back in 2020, at rates often <2%. In this case, most of these long-term assets were held at a rate of 1.66%. They decided to buy $91.324B of RMBS and CMBS “HTM” securities with a nearly 4-year duration. MBS, municipal securities, and other bonds are notably incredibly safe — as long as nothing drastic changes in the next four years, those assets will mature and continue to pay out to their depositors. And then…
Wouldn’t you know it? Inflation accelerates to 40-year highs, markets cool down, and private investment segments slow to a halt. Jerome Powell and The Federal Reserve hop into action and raise interest rates up at an incredibly quick level to a current 4.5%, compared to 0.0% in 2021. These rate hikes cause venture capital deal flow to slow and limit future funding across the board. Portfolio companies must start withdrawing more capital to stay afloat while venture capital slows on its promise in bringing future capital to SVB.
SVB at this point faces several challenges:
- The $91B MBS investment faces a liability mismatch since their current 1.66% rate is tiny compared to the now 5% rates being introduced into the market. The higher rates being introduced ultimately devalue the currently existing bonds since yield and price are inversely correlated ($15B unrealized losses in their “HTM” portfolio)
- The deposited funds are being depleted extremely quickly, as deal flow and investment slows
- Due to fundamental regulation, banks must keep 10% of deposited funds in the bank as liquid — this limit was being pressured as deposited funds were being emptied and they had little areas to invest
In order to meet deposit requirements, SVB decided to start liquidating their “available-for-sale” (AFS) bonds in their portfolio to ensure they could meet fund requirements. In doing so, they undertook significant losses ($2B) overtaking the current equity cushion of SVB ($12B). This may have covered the present liabilities, but it took them into negative cash territories.
Facing this decision, SVB decided to publicly notify customers of their practices in place and their conclusive decision to unwind long-term investment positions. This quickly scared depositors — they feared that their funds could be gone if they did not withdrawl cash urgently. This quickly caused a bank-run, in which funds are depleted at exponential rates and the bank is left eventually empty of liquid funds. This was undoubtedly made worse with venture firms contacting their portfolio companies to pull their money out — it was calculated that SVB was undergoing $4.2B in withdrawals per hour on Friday. At this point, the U.S. authorities and FDIC swooped in and seized the bank’s assets, market trades were halted, and the bank was presently empty of cash. The bank had failed.
Over the weekend, there was significant anxiety and worries about what could happen before Monday. Auctioning off SVB was not working, Janet Yellen promised no bail-out, and venture capital firms and their portfolio companies were left with no more than $250k in remaining capital. However, since then, the FDIC and regulators have “stepped-in” to fulfill depositor fund access and eliminate the possibility of a greater banking crisis. The question now is, what happens next?
In the following points below, I translate this commentary to original economic data.
- Paper Equity Cushion of $12B (5.6% of assets)
- Assets of $212B in large positions in MBS ($82B/83% residential) and Direct Loans ($74B/VC capital)
- Liabilities of $200B in deposits and internal debt (~11% of which was FDIC insured)
- “HTM” MBS Portfolio undertakes $15B in unrealized losses, overtaking $12B equity cushion
- SVB sells $21B of liquid “ATM” securities at 9% loss to cover losses ($2B)
- Paper Equity Cushion of $10B
- SVB notifies depositors of recent activity
- Bank run ensues, depleting SVB of $16B in hours, although $42B was attempted in being withdrawn
- FDIC ensures approximately $10B of that $200B
You can see all of this in the edited balance sheet below.
Lessons Learned
In the aftermath of SVB’s fallout, it is difficult to fully understand what are the implications of the current environment. However, I do think we can take a few lessons and learn from them going forward.
#1. Diversification is still priority
SVB failed to diversify its investments to weather a potential economic downturn. In doing so, they dug their own grave and took their deposited funds with them. Much can be said with the bank depositors as well — putting all of one’s capital in one institution in the promise of $250k coverage seems irrational.
#2. Mismanagement destroys organizations
SVB’s leadership failed to take action to avoid this organizational failure. Based on preceding evidence, it appears that leadership failed to do their job and did not hold parties accountable to their roles. It also does not help via public perception that senior leadership unloaded significant stock in the days leading up to SVB’s failure.
#3. Technological advancements and centralized funding sources only accelerate bank-runs
SVB dealt with deposits being withdrawn at $4.2B per hour at the peak of the bank-run — such rapid pace has never been recorded before on any other bank failure. Also, having one generalized bank customer (VC) leads to sudden and exhaustive withdrawals as all of the funding originated from a few key sources.
#4. Market sentiment remains influential and emotions have the final say
The market sentiment has flipped overnight and fear currently drives the market. Regional banks have been heavily depleted, finance stocks have been significantly lowered, and bonds have been getting significant interest. Much of the same environment was there beforehand, but the market now looks much different — much more fearful.
#5. Public figures and industry influencers continue to have significant sway in government intervention
This past weekend, we saw many key public figures interact online in the scope of promoting some action on the bank’s failure. Mark Cuban, Bill Ackman, and others rushed to online platforms to plead their perspective and to promote a response from government leaders. Whether or not that was the cause is largely debatable, but it did influence some of the public’s perception on the topic.
Complications
#1. The Federal Reserve’s ability to slow inflation and raise interest rates
With The Federal Reserve and FDIC getting involved in ensuring depositor funds, they complicate a current agenda to slow down high inflation and restore equilibrium to the economy. They will input more liquidity into the economy and will have to slow down or avoid raising interest rates at all in the coming months. The Federal Reserve was predicted to raise rates by 50 basis points this month; now, it is looking like there could be no raise altogether. Along with the SVB meltdown, public investors have been removing funds from regional banks and technology stocks and investing them into short-term treasury securities, which in their own effect have lowered yields.
#2. Mortgage and housing markets continue taking on water
With both preceding evidence and the current MBS situation, the mortgage and housing markets have been taken significant punishment the past few months. In the face of this news, it seems as if that trend is only going to continue worsening.
#3. Trust and confidence in the venture capital ecosystem
VC firms and their portfolio companies have weathered some difficult months this past year, but it now looks like the problems have only been exacerbated. The near-death experience that many fund managers and CEOs just felt will only enforce greater caution in the venture investment market. It will also be interesting to understand how they plan on adjusting to different banking expectations.
#4. Reliance and participation in the regional banking infrastructure
The failure of SVB will no doubt damage the regional banking infrastructure’s reputation. Banks that have largely been diversified, safe, and well-managed will undergo significant volatility due to the mismanagement of a competitor. Market volatility, yield changes, and FDIC action will also influence the role that regional banks play in the coming years. For the better sake of our economy, I hope that such institutions thrive in these scenarios — our economy needs the diversified banking system to create a more fair market.
#5. Widening wealth gap and further civil unrest
Lastly, I think this new banking crisis will only widen the currently deep wealth gap and provoke greater public backlash and unrest. It is deeply ironic that SVB caters to a wealthy, elite customer base with billions in capital and a recent boom (2020 and 2021) in their evaluation — by the government inserting themselves into the situation, the greater public will only see such action as a force to unfairly protect the wealthy from losing their money. Whether or not this is a fair assessment, I do think the public will push back on this involvement. This is best represented in the following expression: “privatize the profits and socialize the losses.”
Final Thoughts
In looking at the aftermath of SVB’s demise, we see the general consequences that come with short-sighted thinking. Poor leadership, an altogether lack of risk management, and a lack of public awareness were at the foundation of what caused their ultimate failure. Time will tell if such issues persist in other organizations and if the parties at fault will face corporate consequences. Either way, the future appears gloomy and the market has only grown more complex.
Even The Federal Reserve has $1.2T in unrealized losses on their current $8T asset portfolio — who knows what the next few months hold.
