The Silicon Valley Bank collapsed on Friday, 10th March 2023 and it sent shockwaves through the financial world. But it wasn’t just us; most tech startups in Silicon Valley and over 2500 Venture Capital firms also held their funds with the 16th largest bank in the United States.
We’re talking about the Silicon Valley Bank Run, the second-largest bank failure in United States history. If you think your money is resting safely in your bank account, think again. After reading this article, you will never look at banks the same way again.
Let’s unravel the mystery of what happened to Silicon Valley Bank and understand the intricacies of how banks actually work.
Understanding the Basics of Banking
To fully comprehend the unfolding drama of Silicon Valley Bank’s collapse, it’s crucial to first grasp the fundamental workings of the banking system. Banks, in their simplest form, are financial institutions designed to facilitate the flow of money within an economy. They serve as intermediaries between those who wish to save and invest their money and those in need of funds to finance various ventures.
When you deposit your hard-earned money into a bank account, you’re essentially entrusting the bank to safeguard and manage those funds. However, banks are not merely custodians of your money; they are profit-driven entities. They utilize the funds you deposit to make loans to individuals, businesses, or even governments. In essence, your deposit becomes the source of capital that the bank deploys to generate revenue.
Consider a scenario where you deposit $100 into your bank account. The bank, operating within a framework established by government regulations, is required to maintain a certain portion of that deposit as a reserve. Let’s assume a reserve requirement of 10%. This means the bank must set aside $10 in reserve, leaving $90 available for lending or investment. This concept forms the basis of fractional reserve banking.
Fractional Reserve Banking
Fractional reserve banking is the system that allows banks to create money essentially “out of thin air.” As long as they maintain enough reserves to satisfy the required percentage set by the government, they can lend out a significant portion of the deposited funds. In our example, the bank has $90 available for lending, and it can charge interest on those loans, which is the primary way banks generate profits.
The loans made by the bank are recorded as assets on their balance sheet, but here’s where it gets interesting: these loans are not represented by actual physical cash. Instead, they are mere entries in the bank’s accounting system, essentially digital numbers on a screen. This process highlights the magic of modern banking—money is created and circulated based on trust in the system.
Consider a broader perspective, where multiple depositors entrust their funds to the bank. Each of them believes their money is safely stored within the bank’s vaults. Yet, the bank has leveraged these deposits to provide loans to borrowers in need of capital, each paying interest on the borrowed funds. It’s a delicate balancing act of trust, with depositors relying on the bank’s ability to meet their withdrawal requests while simultaneously deploying their money for profit.
The Link to Inflation and Rate Hikes
In this equilibrium, the system operates efficiently under normal economic conditions. However, it becomes susceptible to external shocks, such as wars, pandemics, or supply chain disruptions, which can disrupt the economy’s production of goods and services. One of the key challenges during such times is inflation—a sustained increase in the general price level of goods and services.
Inflation can erode the value of money over time, causing concern for central banks, whose primary mandate is to maintain economic stability. To curb inflation, central banks often resort to a tool called monetary policy. A crucial component of monetary policy is adjusting interest rates.
When inflation becomes a concern, central banks may opt to raise interest rates to cool down the economy. Higher interest rates make borrowing more expensive, prompting individuals and businesses to reduce spending. This can help mitigate inflationary pressures and prevent the economy from overheating.
Interest Rates and Bond Values
To understand the implications of interest rate changes on banking, it’s vital to grasp the intricate relationship between interest rates and bond values. Interest rates are essentially the percentage at which lenders charge borrowers for the use of their money. For example, if you borrow $100 at an interest rate of 5%, you will eventually need to repay $105.
Now, consider bonds—financial instruments that governments and corporations issue to raise capital. Bonds are essentially loans made by investors to these entities in exchange for regular interest payments and the return of the bond’s face value upon maturity. Bond values, or prices, fluctuate based on market conditions.
Imagine you own a bond with a fixed interest rate of 5%. If interest rates in the broader economy rise to 6%, newly issued bonds will offer a more attractive 6% return. As a result, your 5% bond becomes less appealing to potential buyers. To make it more attractive, you’d have to lower its price in the market. This inverse relationship between interest rates and bond values is a fundamental principle of fixed-income investing.
Conversely, when interest rates fall to, say, 4%, your 5% bond suddenly becomes more appealing because it offers a higher return than the newly issued 4% bonds. In this scenario, you could sell your bond for a higher price because buyers are willing to pay more for the higher return on investment.
Asset Maturity Mismatch
Now, let’s delve into the concept of asset maturity mismatch, a critical aspect that played a pivotal role in Silicon Valley Bank’s downfall. Banks often find themselves navigating a delicate balancing act between their assets and liabilities.
When banks accept deposits from customers, they often promise the flexibility of withdrawing these funds on demand or within a short period. In essence, they’ve committed to repaying their depositors in the short term. However, to generate returns and profits, banks deploy these funds by investing in various assets, such as loans, bonds, and other financial instruments.
Herein lies the potential issue: if a bank invests a significant portion of its depositors’ funds in long-term assets, it may not be able to liquidate these investments quickly in the event of a sudden surge in withdrawal requests. This misalignment between the maturity of assets (long-term) and the maturity of liabilities (short-term) creates an asset maturity mismatch.
In practical terms, a bank may have promised its depositors immediate access to their funds, but it has invested a substantial portion of those funds in assets that cannot be readily converted into cash. This situation can lead to a liquidity crisis, where the bank finds itself with insufficient cash to meet the sudden and simultaneous withdrawal demands of its depositors.
The Anatomy of a Bank Run
A bank run is a financial phenomenon that occurs when a substantial number of customers, fueled by fear or mistrust, decide to withdraw their deposits from a bank simultaneously. Bank runs typically arise from concerns about the bank’s financial stability. In the early stages of a bank run, customers often act out of panic and a desire to protect their assets, unaware that their actions could trigger a crisis.
The consequences of a bank run can be severe. As customers rush to withdraw their funds, the bank must sell its assets, sometimes at a loss, to meet the demand for cash. This process can erode the bank’s capital, making it even more vulnerable to further withdrawals. As fear and uncertainty escalate, a bank run can snowball, with more customers rushing to withdraw their funds, exacerbating the bank’s financial woes.
Silicon Valley Bank’s Collapse
With a solid understanding of the core concepts of banking, we can now explore how Silicon Valley Bank (SVB) found itself at the epicenter of a financial storm. SVB’s situation offers a stark illustration of the complexities and vulnerabilities that can surface in a fractional reserve banking system.
SVB’s Position Before the Storm
As the COVID-19 pandemic wreaked havoc across the globe, SVB found itself in a unique position. The bank was well-positioned to attract substantial cash deposits for its customers. These funds flowed in from a variety of sources, including Paycheck Protection Program (PPP) loans, a pandemic relief program for businesses, equity investments in venture capital (VC) firms, and general cash deposits.
Like any financial institution, SVB sought to maximize its returns on these deposits. In an environment where front-end yields offered meager returns of around 25 basis points (bps), the bank’s management sought opportunities to enhance its profits. This led them to explore longer-dated bonds, which offered slightly higher yields, hovering just above 1%.
In the early stages, it appeared as if SVB was playing a lucrative game, securing deposits and investing them in assets that promised a bit more return. However, as the year 2021 came to a close, ominous signs began to emerge. The once-booming tech sector, in which many of SVB’s clients were deeply entrenched, started to exhibit signs of a bubble.
The Tech Bubble Bursts
In the world of investments, bubbles form when the prices of assets, such as stocks or real estate, surge to unsustainable levels, driven by speculation and excessive optimism. At some point, the bubble bursts, often leading to sharp declines in asset values.
For SVB, which had invested significantly in the tech sector, the bursting of the tech bubble was a major cause for concern. As the tech sector began to falter, the pace of deposit growth at the bank slowed significantly. This slowdown can be seen in a telling graph that highlights the abrupt change in SVB’s fortunes.
The Federal Reserve’s Rate Hike
As SVB grappled with the fallout from the tech sector’s downturn, the Federal Reserve (the Fed) announced a series of rate hikes in early March 2022. This marked a significant shift in the interest rate environment, which had a direct impact on the bank’s investments.
SVB was now faced with the stark reality that its investments, particularly its bond portfolio, were yielding an average of 1.79%. However, the current 10-year Treasury yield had surged to approximately 3.9%. This was a clear indication that SVB’s investments were now underwater, as the returns on its assets couldn’t keep pace with the rising interest rates.
Critical Decisions and the Triggering of a Bank Run
Facing the challenge of mounting losses on its investments, SVB’s management was left with a critical decision—should they hedge their bets against further interest rate hikes or designate the securities in question as “held to maturity”? The latter option offered a lifeline in the short term, as it meant that mark-to-market losses would not flow through the bank’s income statement.
However, this decision also meant that SVB was effectively committing to playing the long-term game, trusting that the Fed would not implement any further rate hikes. Unfortunately, the Fed had already signaled its intent to continue raising interest rates, making SVB’s bet a risky one.
The Unraveling and Panic
As interest rates continued to rise and SVB’s investments suffered, rumors of the bank’s financial troubles began to spread like wildfire among its clients. Fearing the worst, people started quietly withdrawing their funds. On a Wednesday, SVB made an official announcement, revealing that it had sold a significant number of securities at a loss to return funds to its clients. Additionally, the bank announced plans to sell $2.25 billion in shares to bolster its balance sheet.
The announcement sent shockwaves through Silicon Valley and the broader financial community. Venture capital firms, some of SVB’s key clients, reportedly advised companies to withdraw their money from the bank. What followed was nothing short of a financial maelstrom—a staggering $42 billion in deposits flowed out of SVB in just two days, roughly equivalent to 25% of its total deposits. This level of withdrawals was simply unsustainable.
The Domino Effect and Regulatory Intervention
As SVB’s stock plummeted on Thursday morning, it began to drag down the shares of other banks with it. Investors were gripped by a sense of déjà vu, reminiscent of the 2007-2008 financial crisis. By Friday morning, trading in SVB shares was halted, and any efforts to swiftly raise capital or find a buyer had been abandoned.
Recognizing the gravity of the situation, California regulators intervened, effectively shutting down the bank and placing it in receivership under the Federal Deposit Insurance Corporation (FDIC). It was a dramatic and unprecedented move that reflected the severity of SVB’s predicament.
The Aftermath and Government Intervention
The fallout from SVB’s collapse led to a swift and coordinated response from various government agencies. On a Sunday, the Department of the Treasury, the Federal Reserve, and the FDIC issued a joint statement, announcing that they were taking decisive action to protect the U.S. economy by bolstering public confidence in the banking system.
In essence, this statement signified a bailout for SVB and other banks facing similar challenges. It assured customers that they would be able to withdraw their funds come Monday. While this intervention may have been seen as a positive development, it laid bare a darker truth—we are all at the mercy of institutional organizations, and they were the ones who had set this financial rollercoaster in motion.
Conclusion:
In the end, the saga of Silicon Valley Bank’s collapse serves as a sobering reminder of the intricacies and vulnerabilities within the banking system. It highlights the interconnectedness of the financial world and the fragility that can result from a web of complex financial instruments and decisions.
As individuals, our trust in the government and banks ultimately rests with us. Being well-informed and understanding how the current banking and economic system works is not just a matter of curiosity; it’s essential for those who seek to preserve their wealth and protect themselves against systemic risks, especially in these uncertain times.
In closing, the story of Silicon Valley Bank is a testament to the fragility and complexity of modern banking. It underscores the importance of vigilance, informed decision-making, and a deeper understanding of the financial mechanisms that shape our world.