Silicon Valley Bank: A crisis hiding in plain sight
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By Hemal Fraser-Rawal & Bryan McLoughlin
In 1983, the information technology industry was a small part of the overall economy and Silicon Valley was not yet the global powerhouse it is today for start-ups and venture capital. Silicon Valley Bank (“SVB”) capitalised on the nascent opportunity in banking early-stage startups and, over the next 40 years, grew in tandem with the secular rise of the technology industry. Until its failure on Friday 10 March 2023, it was the 16th largest bank in the United States and the pre-eminent banker of entrepreneurs and technology investors[1].
The collapse of SVB invites an examination of why it failed and what, if any, are the wider consequences for the lending ecosystem. There are three key conclusions reached in our analysis:
1. The root cause of failure is poor asset-liability management. The velocity and extent of losses on its investment portfolio outstripped its equity base, largely masked by SVB’s accounting treatment, necessitated a new rights issue of $2.25 billion to cover those losses.
2. A weak balance sheet, coupled with poor treasury management creates favourable conditions for a bank run. Credibility in SVB quickly eroded, following the communication of the rights issue, as markets negatively responded to the news. The share price declined 60% on Thursday and trading in the stock was subsequently suspended on Friday. Customers, motivated by self-preservation and low conviction in the durability of SVB, moved quickly to withdraw deposits. The ensuing bank run was unstoppable as customers withdrew some $42 billion of deposits on Thursday, estimated to represent one quarter of SVB’s deposit base, and regulators stepped in to place the bank under the Federal Deposit Insurance Corporation (“FDIC”).
3. The end of SVB is the beginning of a more fragmented financing ecosystem. SVB banked an estimated 50% of technology companies in North America and the UK[2]. A laser focus on the technology sector and customer-centric operating model was key to a successful banking franchise that out-manoeuvred larger traditional banks. The acquisition and assimilation of SVB UK into HSBC risks eroding these competitive advantages. The ensuing fragmentation of banking services will undoubtedly create favourable opportunities for lenders in better accessing investment opportunities with expansion stage UK technology businesses previously banked and financed by SVB.
How and why did Silicon Valley Bank fail?
Globally, venture capital investment increased 1.4x from $347.6 billion in 2018 to $493.5 billion in 2022[3]. The influx of capital into venture capital firms and their portfolio companies was a boon to SVB. Over the same period, deposits at SVB increased 3.5x from $49.3 billion to $173.1 billion[4,5].
Deposits received from customers are accounted for by banks as liabilities. The economic model for a bank such as SVB is to monetise the deposits into income generating assets such as loans or investments. The velocity of deposits received by SVB created challenges in pacing the transformation of deposits into income generating assets. There is a finite volume of lending opportunities SVB can execute without taking unwanted credit risk. This in turn necessitated a step-up in investment activity.
Every large bank has a dedicated asset-liability (or Treasury) management function with the mandate to protect both income and capital from the interest rate risk which arises from the repricing and duration of assets and liabilities. In 2021, at the tail end of an unprecedented era of low interest rates in the United States, SVB invested a sizable proportion of its assets, some $91 billion of $120 billion in investible securities into long dated (10Y) treasuries and mortgage-backed securities (“MBS”). SVB was exposed to long duration assets generating an average yield of 1.64%[6].
In 2022, central banks executed a programme of interest rate rises to dampen higher inflation as a result of unprecedented fiscal stimulus by policymakers in response to the Covid-19 pandemic. The era of cheap money was at an end.
In fixed income, irrespective of asset quality, there is an inverse relationship between rates and prices. The programme of interest rate rises by the Federal Reserve had a negative impact on the fair value of SVB’s investment portfolio. SVB had classified the $91.3 billion of securities as Held-to-Maturity (“HTM”) which allowed SVB to present the portfolio at amortised cost versus fair value.
The Securities and Exchange Commission (“SEC”) and FDIC requires every bank in the US to disclose the fair value of assets classified as HTM (i.e. the price paid in an orderly transaction between market participants on that date) and to report the “net unrealised gain or loss”. It is quickly becoming a leading indicator of a Bank’s health. Overlooked until recently, net unrealised losses on HTM securities have increased as fixed income assets decline in value in response to a programme of rising central bank rates.
Diligent readers of SVB’s 10-K published on 24 February 2023 would have been rewarded (on page 125) however as the fair value of the portfolio indicated unrealised losses of $15.1 billion as at the end of 2022[7].
The material impact of the unrealised losses on SVB’s solvency is clearly indicated in the chart below: the losses of $15.1B wipe out 94% of reported CET 1 equity. This was not sustainable in the long run.
SVB announced on 08 March 2023 its plan to address the treasury mismatch and better position assets to higher yielding short-term securities. A substantial sale of available for sale (“AFS”) securities worth $21.1 billion to reduce further losses, together with a concurrent rights issue of $2.25 billion, was suggested by management as a credible solution.
The markets disagreed with management’s assessment. The weakened financial position prompted closer examination of bank liquidity and its durability, especially previously overlooked niche and regional banking franchises similar to SVB (such as First Republic and Signature Bank) outside the designation as systematically important [8].
The share price of SVB dropped 60% on Thursday as contagion fuelled selloffs. The “net unrealised loss” factor is now recognised to be significant across the market.
The laser focus on the technology sector, once a strength, quickly became a weakness. The private equity and venture capital investors quickly moved to withdraw funds and instructed their portfolio companies to take similar action on Thursday 09 March. A bank run was underway, and the cascading effect of customer withdrawals was insurmountable for SVB.
In a single day, withdrawals worth $42 billion or one quarter of total deposits, created a liquidity crisis for SVB[9]. NASDAQ announced the suspension of trading in SVB shares on Friday 10 March and the FDIC assumed control of SVB as receiver on Friday 10 March.
The Aftermath
The immediate effect of FDIC control was the freeze on wire transfers by SVB customers. SVB had operations outside of the US. The second-order effect of SVB’s receivership was concern over the stability of local operations given the degree of support by the parent undertaking.
In the UK, the Bank of England subsequently concluded SVB UK, a separate ring fenced entity with deposits of $6.7 billion and a loan book of $8.1 billion, was dependent on its parent group for liquidity and would be placed into an insolvency procedure.
SVB customers scrambled to access liquidity given uncertainty over the timing of access to funds and quantum available given the distinction between insured and uninsured deposit holders. Policymakers in both the UK and US moved quickly to provide reassurance to a market with fragile confidence:
· On Sunday 12 March, the Federal Reserve announced it would enable FDIC to complete its resolution of SVB in a manner that fully protects all depositors. Given the contagion and spill over to Signature Bank, a small SME focused bank, the Federal Reserve clarified similar depositor support. SVB shareholders and bondholder are outside the scope of protection and at risk of loss in its resolution. SVB customers have access to their funds as normal starting 13 March 2023[10].
· On Monday 13 March, the Bank of England announced the sale of SVB UK to HSBC with immediate effect. The acquisition retains staff employed by SVB UK and provides a return to normal operations for customers[11]. No meaningful communication on the longer term intentions and strategy for SVB UK have been shared with the market by HSBC.
The future of SVB
The bank is successful today with a lot of the traits that other entrepreneurial-started companies are. I think the biggest one that we talked a lot about is focus and consistency, and I think those are two of the really important things. And we could have branched off and done a lot of different things…Robert Smith, Co-Founder of SVB [12]
The failure of SVB is not a reflection on the quality of the banking and lending activities as some misleading reports have suggested. The lack of evidence indicating credit losses or stress together with the size of SVB’s early stage technology firms (3% of the total loan portfolio and a fraction of the loans made to funds at 56% of the total loan portfolio) support our conclusion[13].
The demise, once again, is rooted in a poorly executed asset-liability management programme.
The market leadership of SVB as banker to emerging technology firms and their investors is uncertain going forward. The consistent customer-centric focus and entrepreneurial culture that allowed SVB to outmanoeuvre traditional banks is under threat. The SVB of yesterday shall not be the SVB of tomorrow regardless of the ultimate solution for SVB’s operations in the US.
The acquisition of SVB UK by HSBC is positive for SVB employees and shores up confidence in the emerging technology and investment ecosystem. The operations of SVB in the UK, however, are small in comparison to that of its acquirer HSBC: the SVB UK loan book is only 10% of HSBC UK’s commercial business loan book. The core business of SVB is not strategically important to revenues or earnings of HSBC at a group level. The inevitable assimilation of HSBC culture and processes risk eroding the competitive advantage long enjoyed by SVB in the UK.
This dissolution of SVB’s market position, as banker to 50% of start-ups in the US and UK, will give rise to a more fragmented banking sector. The concentration of banking relationships with one player was, in itself, a systematic risk to technology companies and investors. Going forward the lessons of risk management will manifest in companies embracing multiple banking relationships to avoid a single point of failure.
This fragmentation reinforces the compelling and sizable market opportunity for bank and non-bank lenders to finance high quality growth stage technology companies. Many European countries have dedicated SME banking programmes and, although these programmes are generic and lack the laser focus of SVB on the technology ecosystem and its investors, such banks are well placed to serve earlier stage start-ups. For growth and later stage companies, the opportunity is particularly attractive for non-bank lenders who, unencumbered by process and regulation, have the capacity and ability to execute quickly.
There are three elements supporting our conclusion:
- Access to funding remains a critical concern for European technology companies in 2023. The takeover of SVB UK by HSBC is not a panacea for the dislocation and volatility in markets. Those investors with domain expertise and a flexible investment strategy are well placed to take advantage of the shortage of capital.
- The opportunity set for a non-bank lender’s fund strategy immediately increases. Companies seek reliable long-term partners. The crisis of confidence at SVB has triggered a search for new partners at many firms to re-finance SVB loans in both the short term and in the medium-to-long term as SVB facilities approach a maturity or renewal point.
- The break-up of SVB reinforces the fragmentation of European banking and financing of emerging technology companies. The SVB franchise expanded to other European countries such as Germany (2018), Denmark (2019), and Sweden (2022). The lack of a dedicated pan-European player with the core market focus and (previously) vaunted reputation of SVB reinforces fragmentation in each European market that creates favourable conditions for specialist pan-geographic investors.
Stay tuned for more thoughts on this in the coming months.
Notes:
[1] Federal Reserve Statistical Release — Large Commercial Banks in the U.S
[2] SVB website as of 13 March 2023.
[3] KPMG VenturePulse
[4] SVB 10-Ks for financial years ended 31 December 2018 and 2022.
[5] Note deposits at SVB peaked in December 2021 at $189.2 billion. In the course of 2022, in response to lower levels of fundraising by investors and investment activity into start-ups, deposits decreased.
[6] The Financial Times — “Silicon Valley Bank: the spectacular unravelling of the tech industry’s banker”
[7] SVB 10-Ks for financial year ended 31 December 2022.
[8] Reports have emerged recently that banks such as SVB lobbied policymakers and regulators for lighter scrutiny and oversight than the larger systematic banks.
[9] Financial Times — “Uninsured Silicon Valley Bank depositors seek fire sale of assets”
[10] Federal Reserve, Joint Statement by Treasury, Federal Reserve, and FDIC, 12 March 2023
[11] Bank of England, Statement on Silicon Valley Bank, 13 March 2023
[12] Computer History Museum, Silicon Valley Bank Oral History Panel Robert “Bob” Medearis and Roger Smith, 11 November 2014.
[13] This is evidenced in the low levels of loan losses incurred as a percentage of total loans at year end (2022: 0.39%, 2021: 0.10%, 2020: 0.42%) and gross write-offs as a percentage of average total loans (2022: 0.15%, 2021: 0.25%, 2020: 0.28%) per SVB’s 10-K as at financial year ended 31 December 2022.
