Why did Silicon Valley Bank fail and Why does it matter?

Ed Lander
The New Economics Forum
6 min readMar 14, 2023
Silicon Valley Bank (SVB) customers anxiously queue outside a SVB branch

Right now, in the wake of the Silicon Valley Bank (SVB) failure, financial markets are jittery. Firstly the failure of SVB came seemingly out of nowhere — at least to those who weren’t close to the bank in the final days of its operations. Secondly, there’s a whiff of the 2008 Financial Crisis about the failure that is leaving investors wondering which bank could be next to fail …

Before going into more detail on why Silicon Valley Bank failed, I’d like to look at a concept in investment banking — it’s called counter-party risk. This is the idea that if one bank fails, all other banks who hold assets at that bank can suddenly become at high risk of insolvency. In other words the required write-downs on their assets, due to a counter-party failure, can suddenly push their accounts into the red, and require an emergency sale of assets to recoup the losses. The problem is, in the middle of a financial crisis — with panic in the air — and with lots of institutions all trying to sell at the same time to bolster their balance sheets, conditions of a market spiral can develop, and even result in fire sales of particularly undesirable assets, which only exacerbates the problem.

During the 2008 Financial Crisis, many institutions failed, including investment banks, insurance brokers [1] and Government backed mortgage securitisation enterprises [2], all needing support and bailouts from the Federal government, or indirectly by the US Federal Reserve. It’s often said, however, that the failure of Wall Street investment bank Lehman Brothers was a pivotal moment in the development of the financial crisis that gripped the United States and the rest of the world. It was the domino effect of the failing institutions that brought financial markets to their knees in 2008 and almost ended the current monetary and economic paradigm.

As the aftermath of the 2008 Financial Crisis was so profound and drawn out, a number of financial reforms were developed and enacted to prevent anything similar happening again. These included, in the United States, the Dodd–Frank Wall Street Reform and Consumer Protection Act, which included wide ranging and comprehensive reforms of the US financial regulatory system and, crucially, gave the Federal Government and the US Federal Reserve powers to regulate the risky ‘derivatives’ market that effectively imploded during the 2008 Financial Crisis [1]. And globally, the Basel Accords were updated with Basel II revisions, and later Basel III revisions, which predominately set minimum capital requirements on banks to reduce the risk of bank runs during financial panics and of banks collapsing if they still occur.

So, in theory, thanks to these new financial reforms, the global financial system shouldn’t be as leveraged, or as prone to counter-party risk, than in the run up to the 2008 financial crisis. However, the reason for financial crises is often not just risky and unethical business practises, it is also lacklustre regulation. And the best regulations can be easily undermined by poor supervision and inadequate resourcing for regulatory bodies. Let’s also not forget that one of the main causes of the 2008 financial crisis was the lack of separation of commercial and investment banking systems, which allowed the huge losses at investment banks to put commercial banks, and their investment banking divisions, at risk, exposing ordinary retail customers and their savings to the huge investment division losses and requiring governments to step in to protect them. In fact it was actually legislation developed in response to the Great Depression of 1929–1939 that created this important separation [2], but which was later repealed by the Financial Services Modernization Act of 1999 after decades of lobbying by the financial services industry (commonly referred to as the repeal of the Glass–Steagall legislation).

As it’s clear to see, history shows that financial crises result in the development and implementation of strict financial regulations, but over time these regulations are inevitably watered down, increasing the risks of another financial crisis occurring …

So here we are — it’s 2023, and the financial community is proudly stating that the failure of SVB is not significant. They say that the so called ‘domino effect’ failures we saw in 2008 are unlikely to happen due to the improved regulation and supervision of the financial markets and investment banks since 2008. However financial markets are irrational and easily spooked. Sowing seeds of discontent, and letting fear of financial contagion spread unfettered, can itself create new panics and lead to further institutional failures as investors withdraw deposits from exposed banks and move their portfolios away from banking stocks and into other sectors. So it’s common to hear banking executives and central bank spokespeople talking down financial counter-party risks and any concerns about the stability of financial systems. And it was this public fake in 2008 that covered up a massive, systemic failure which allowed the ‘smart guys’ — who had insight into the crisis — to move their money out of sub-prime mortgage-backed securities before the collapse played out and caught out those who ended up purchasing these so called ‘junk bonds’ (typically pension funds and smaller investors). So can we trust our governments and the financial services industry to tell us the truth? Can we trust them to give us an unvarnished opinion of any growing problems in the financial systems in the wake of unprecedented interest rate hikes? Well, if history is a guide, then the answer is sadly no, we can’t — instead we should remain sceptical and exercise some caution and continue to be vigilant.

So, I appreciate that the first two parts of this article have largely been a history lesson about the 2008 Financial Crisis, however it’s a very useful example and one that is still very recent and quite prescient. It is also something I have particular insight of, having lived through it and learned a huge amount from the excellent exposé books that were published in its wake. But to answer the question posed in the title of this article — why did Silicon Valley Bank fail? Well, put simply, the executives responsible for investment decisions at SVB made some very poor decisions. In 2021, during the COVID-19 pandemic, where huge investment followed mass adoption of remote-working technology, SVB invested heavily in fixed-rate mortgage bonds with a very low yield — only 1.6% — and very long maturity cycle — over 10 years. Fast-forward a few years, and with inflation raging close to 10%, these investments quickly became a huge long term risk for the bank. Simultaneously, SVB customers were starting to struggle to refinance their loans at much higher interest rates. So as SVB customers started withdrawing deposits, SVB had to sell assets to free up the cash. And, with each sale of these fixed-rate mortgage bonds, SVB banked a loss. And, once news got out of their predicament, an old-fashioned bank run took place, where SVB customers tried to withdraw their cash before the bank was declared insolvent, and only hastened its demise …

So what now? Well, all investment banks, hedge funds and pension funds will be quickly trying to assess if they have any exposure to the SVB failure, and also if any of their trading partners and counterparties are also exposed. Any banks identified as ‘at risk’ will likely see clients moving their money and see their share prices fall in tandem. They could easily end up in a similar position to Silicon Valley Bank if their investment portfolio is similarly at high risk to inflation. And we have already started to see other banks failing. Admittedly small and niche banks — focused on cryptocurrency and the tech industry — however every bank failure increases the counter-party risk and the likelihood of a systemic crisis.

And, in tandem with action in businesses, central banks will likely be reassessing their current aggressive interest-rate hiking strategies — aimed at combatting unprecedented inflation — and trying to find a more nuanced approach to simultaneously tackling inflation whilst also preventing an economic recession and, crucially, not accidentally triggering a financial crisis that cannot be easily contained.

[1] The largest was American International Group, more commonly known as AIG

[2] Such as Fannie Mae and Freddie Mac. Or the Federal National Mortgage Association (FNMA) and the Federal Home Loan Mortgage Corporation (FHLMC) respectively

[3] It was layers and layers of dodgy sub-prime mortgage backed securities that got wrapped up into so called Collateralised Debt Obligations (CDOs) and sold all around the world that set the ticking financial time bomb for when the US sub-prime mortgage market imploded

[4] The Banking Act of 1935

--

--