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.
The Anatomy of a Bank: How Do Banks Actually Work?
At the foundation of any banking system, there exists a crucial relationship between banks, customers, and the economy. Banks serve as intermediaries, moving money from those who have excess—savers—to those who need it—borrowers—while also generating profits through various financial operations. To understand how a bank works, it’s important to grasp the two main functions of a bank: accepting deposits and lending money.
Deposits: Where Your Money Goes
When you deposit money into your account, you are essentially lending your funds to the bank for safekeeping. However, unlike a savings box where your cash would remain untouched, the bank uses this money for other purposes, notably lending. In traditional banking, when you deposit $100 into your savings account, the bank doesn’t hold that money in a vault, waiting for you to return. Instead, the bank lends out a portion of that money to individuals or businesses that require loans—this is a core part of how banks make money.
For example, if you deposited $100, the bank might keep $20 in reserve for safety, and lend the remaining $80 to a customer who is purchasing a car. The borrower then repays the loan, plus interest, to the bank. The bank’s ability to lend and earn from interest payments is how they generate profit.
Loans: Banks as Lenders and Investors
The money the bank lends out is where the system begins to show its complexity. When you lend money to someone, the expectation is that the borrower will repay the principal amount with interest. This interest is the primary way banks make money. However, lending isn’t the only way banks can use your deposited funds. Many banks also invest in various financial instruments like government bonds, corporate bonds, and stocks, hoping to earn a return. The ultimate goal is to make these investments grow, creating returns that exceed the interest they pay to depositors.
Banks aren’t merely storing your money—they’re actively using it to fuel economic growth, by financing home mortgages, business investments, and personal loans, among others. In addition, these loans and investments are what the bank considers assets. To keep their business model afloat, banks need a balance: sufficient deposits to cover their loans and investments, and the ability to turn those loans into income-generating products.
Fractional Reserve Banking: A System That Enables Growth
The model that banks primarily operate under is called fractional reserve banking. This term refers to the practice where banks only keep a small portion of their deposits on hand, while the rest is loaned out or invested. The amount they must keep is determined by a reserve requirement set by the central bank, which is typically between 3-10% of the total deposits.
For instance, if you deposit $100, the bank might only be required to keep $10 in reserve and can lend out the remaining $90. The idea is that not all depositors will withdraw their funds at the same time, and the bank can use this money to lend and invest, generating a profit.
This system has been crucial for stimulating the economy, as it allows banks to create more money than they actually have in reserves. By lending out money that they don’t technically have in hand, banks enable individuals and businesses to access credit, which they can then use to spend or invest. The economy thrives when there’s a steady flow of money circulating through the system, and fractional reserve banking has been the catalyst for such liquidity.
However, this system is not without risks. If a large number of depositors suddenly request their funds back, the bank may not have enough cash on hand to meet these demands, as most of the funds are tied up in loans or investments. This phenomenon is what triggers a bank run, and as we will see in the case of SVB, it can lead to disastrous consequences.
The Fragility of Fractional Reserve Banking in an Economic Downturn
While fractional reserve banking has facilitated economic growth by allowing for the creation of money and the expansion of credit, it is also a system that relies heavily on a stable and predictable economic environment. In periods of economic stability, when consumers and businesses are confident and money is circulating freely, fractional reserve banking works relatively smoothly. However, when external shocks hit the economy, such as a recession, a financial crisis, or geopolitical instability, the fragility of the system becomes evident.
The Role of Interest Rates in Economic Stability
Central banks, such as the Federal Reserve in the U.S., play a crucial role in managing economic stability through the adjustment of interest rates. Interest rates are essentially the cost of borrowing money, and they have a profound impact on consumer and business behavior. When interest rates are low, borrowing becomes cheaper, which encourages spending and investment. This leads to economic growth, as businesses invest in new projects and consumers increase their consumption.
Conversely, when the central bank raises interest rates to curb inflation or prevent an overheating economy, borrowing becomes more expensive. As loans become costlier, consumer spending and business investment tend to slow down. This is particularly problematic for banks, as it impacts their lending activity and the value of their investments.
As interest rates rise, the value of bonds (which banks often hold as assets) typically falls. This inverse relationship between interest rates and bond values means that if banks have invested heavily in long-term bonds with low yields, they stand to lose a significant amount of money if the central bank raises rates. For instance, a bond with a fixed 1.5% yield becomes less attractive when new bonds are issued offering higher yields, such as 3%. To sell their bonds on the market, banks would have to lower their prices to make them more appealing to buyers, leading to capital losses.
The Impact of Rising Interest Rates on Banks
In an environment of rising interest rates, banks can face substantial losses on their bond portfolios. For example, when interest rates increase rapidly, as they did with the Federal Reserve’s rate hikes in 2022, the value of long-term, lower-yielding bonds decreases significantly. These losses are not just theoretical; they are real, and they can significantly reduce the bank’s capital reserves.
For banks like SVB, which held a large portion of its assets in long-term treasury bonds with yields lower than current market rates, the rapid increase in interest rates created a major problem. These losses were initially hidden from the public because SVB had classified its securities as “held to maturity.” This accounting practice allowed the bank to avoid marking its bonds to market value, which could have revealed the true extent of the damage. However, once it became clear that SVB was losing money on its investments, the bank found itself in a precarious situation, exacerbated by a bank run that drained its cash reserves.
In summary, while fractional reserve banking is a powerful tool for economic growth, it is highly vulnerable to changes in interest rates and external economic shocks. When interest rates rise, the value of a bank’s long-term investments falls, creating substantial losses. This highlights the fragility of the banking system, especially when banks are heavily invested in long-term, low-yield assets, and are unable to quickly liquidate these investments in times of crisis.
The Dangers of Asset Maturity Mismatch
The concept of asset maturity mismatch is critical to understanding why banks, especially in the case of Silicon Valley Bank (SVB), can face catastrophic consequences. Essentially, it refers to the situation where a bank’s assets—typically loans, bonds, or other investments—have a longer duration or maturity than the liabilities, which in this case are the deposits made by customers that can be withdrawn at any time. This mismatch creates an imbalance, as the bank relies on its long-term investments to generate income, but is expected to pay back depositors on demand or within a short-term period.
The Role of Long-Term Investments
To better understand the risk associated with asset maturity mismatch, let’s look deeper into the kinds of investments banks typically make. Many banks invest heavily in government bonds, corporate bonds, and other securities that offer relatively safe, albeit often lower, returns. These bonds have a fixed maturity period, meaning the bank will only receive the full repayment of the principal once the bond matures—often many years after it was initially purchased.
However, banks also make loans—especially mortgage loans or business loans—which also carry long-term repayment schedules. In normal circumstances, this isn’t a significant issue, as the bank expects to make a return on these long-term investments while having enough liquidity to cover deposit withdrawals. But the real problem arises when a sudden demand for withdrawals exceeds the available liquidity—often triggered by panic, a financial crisis, or a decrease in the value of the bank’s assets.
For example, if a bank invests in long-term bonds and holds them for years, it locks up a substantial portion of its capital, which isn’t immediately available for withdrawal. But customers, who may have deposited money only recently or are facing urgent financial needs, can demand withdrawals at any time. When a significant portion of deposits is tied up in long-term assets, the bank can find itself in trouble during a period of mass withdrawal requests.
Liquidity Crisis and Forced Sales
In the case of SVB, the bank had made significant investments in long-term government securities and bonds, many of which were low-yield and thus offered limited immediate returns. When interest rates began to rise rapidly in 2022, the value of these bonds fell. SVB found itself in a position where its assets were becoming increasingly less valuable in the current market, while its liabilities (the deposits it owed to customers) remained the same.
As depositors began withdrawing their funds at an accelerated pace—triggered by rumors and growing concerns about the bank’s stability—SVB had no choice but to liquidate these long-term securities at a loss in order to raise cash quickly. This forced sale of assets at a loss only exacerbated the situation, as the bank was not able to cover the withdrawals without significantly reducing its capital reserves. The mismatch between the maturity of its assets and its liabilities ultimately led to a liquidity crisis, which further fueled panic among depositors and triggered a full-fledged bank run.
This situation is a clear illustration of how asset maturity mismatch can create a dangerous cycle. When a bank is forced to sell long-term assets prematurely in order to meet short-term obligations, it does so at a loss. This erodes the bank’s capital base and can lead to a cascade of problems. Depositors, seeing that the bank is struggling to meet its obligations, may then rush to withdraw their funds, which leads to even greater liquidity problems, further exacerbating the crisis.
Managing Asset Maturity Mismatch
Banks are aware of this risk, and there are several strategies they can use to manage the mismatch between assets and liabilities. The most obvious method is through diversification of assets—spreading investments across different maturities, industries, and risk levels. By doing this, banks can create a portfolio that includes both short-term and long-term investments, allowing for some flexibility in times of financial strain.
In addition, banks can hedge their positions by using financial instruments like derivatives to protect against interest rate fluctuations. These hedges can help mitigate losses on long-term bonds when interest rates rise rapidly. However, not all banks adopt such risk-averse strategies, and some, like SVB, may decide to forgo hedging in favor of making higher returns on long-term investments. When these strategies fail, as in the case of SVB, the consequences can be severe.
In conclusion, asset maturity mismatch is a fundamental risk that banks face, especially when they invest heavily in long-term assets. This mismatch becomes a critical vulnerability when a bank’s customers demand immediate access to their funds, forcing the institution to sell assets at a loss. To prevent such crises, banks must carefully balance the duration of their assets with the liquidity needs of their depositors, while also considering external factors like rising interest rates.
The Trigger: The Bank Run
A bank run occurs when a large number of customers withdraw their deposits simultaneously, fearing that the bank will not be able to meet its financial obligations. This mass withdrawal is typically triggered by rumors, a loss of confidence, or evidence that the bank is in financial trouble. In the case of Silicon Valley Bank (SVB), the bank run was the result of a series of events, culminating in panic and the eventual collapse of the institution.
The Dynamics of a Bank Run
The mechanics of a bank run are relatively straightforward but highly destructive. When depositors begin to worry that a bank may not have enough funds to cover its obligations, they rush to withdraw their money. This initial wave of withdrawals often stems from business clients or institutional investors, who are more likely to be aware of any underlying financial instability. As word spreads, panic can set in, prompting other depositors to follow suit and pull out their funds as well.
In normal banking conditions, not all customers will demand their money at once. Banks are designed to handle regular, small withdrawals—most depositors don’t need to access their full balance on any given day. However, when a large portion of the bank’s customer base demands their funds simultaneously, the situation becomes untenable. The bank can’t immediately liquidate its long-term investments to cover the withdrawals, and as a result, it becomes unable to fulfill its obligations.
SVB was particularly vulnerable to a bank run due to its client base of venture capital firms, tech startups, and high-net-worth individuals. These clients tend to have large, concentrated deposits, and they are highly sensitive to signs of financial instability. When rumors began circulating that SVB was in trouble, the bank’s institutional clients moved quickly to withdraw their funds, knowing that the longer they waited, the less likely they would be to recover their full deposits.
The Events Leading Up to the SVB Bank Run
SVB’s bank run was triggered by a combination of internal and external factors. The first issue was the decline in the tech sector and the overall slowdown in the startup ecosystem. Many of SVB’s clients were heavily invested in the tech industry, and when the market started to shrink, these businesses needed to draw down on their cash reserves. At the same time, the Federal Reserve had begun raising interest rates to combat inflation, which led to a drop in the value of SVB’s long-term bond holdings.
In response to these mounting losses, SVB attempted to stabilize its position by selling a portion of its bond portfolio at a loss and announced plans to raise capital by issuing new shares. However, this move only deepened concerns among its investors and customers. The decision to sell assets at a loss sent a signal that the bank was struggling to meet its obligations, which further fueled fears about its solvency.
Rumors quickly spread throughout the venture capital community, and key investors began advising their portfolio companies to withdraw their funds from SVB. The fear of a systemic crisis, reminiscent of the 2008 financial collapse, set in. As a result, within just 48 hours, the bank saw an astronomical $42 billion in withdrawals—roughly 25% of its total deposits. This massive outflow of funds created a liquidity crisis that the bank could not recover from.
The Consequences of a Bank Run
As the bank run accelerated, SVB found itself in a race against time to find liquidity. The bank was forced to sell more assets at a loss to cover the withdrawals, further eroding its capital base. At this point, the situation became untenable, and the bank’s stock price plummeted, causing further panic among investors. By the time the California regulators intervened and closed the bank, it was clear that SVB was no longer viable.
The consequences of the bank run were severe, not only for SVB but also for the broader financial system. When a major institution like SVB collapses, it sends shockwaves through the entire economy, particularly in sectors that rely on the stability of the banking system to function. In this case, the tech and venture capital sectors were hit hardest, as SVB was a key player in providing financial services to these industries.
In the aftermath, the federal government and the FDIC intervened to protect depositors, but the damage to the banking system’s reputation was already done. The SVB collapse reinforced the inherent fragility of the banking system, where even seemingly stable institutions can be brought down by a sudden loss of depositor confidence.
In summary, the trigger for a bank run is a loss of trust in the bank’s ability to meet its obligations. In the case of SVB, a combination of poor investment decisions, rising interest rates, and a loss of confidence among its key clients led to a massive withdrawal of funds. The bank run that followed ultimately caused the collapse of the institution, serving as a stark reminder of how fragile the banking system can be when depositors panic.
The Aftermath: Bailout and Implications
The collapse of Silicon Valley Bank (SVB) was not just a moment of financial crisis for the bank, but a turning point that brought systemic risks in the banking sector into stark focus. In the immediate aftermath of the bank’s failure, federal regulators were forced to step in with an emergency response. The consequences of SVB’s collapse reached far beyond the bank itself, affecting not only the tech industry and its clients but the broader financial system. The government’s intervention revealed some uncomfortable truths about the fragility of the modern banking system and how much protection depositors and institutions really have in times of crisis.
The Federal Response: A Quick Bailout
Upon the collapse of SVB, the U.S. Treasury Department, the Federal Reserve, and the Federal Deposit Insurance Corporation (FDIC) moved swiftly to reassure the public and stabilize the situation. The FDIC, which typically insures deposits up to $250,000, made a significant move by assuring all depositors at SVB that they would have access to their full deposits, even those exceeding the FDIC-insured limit. This included venture capital firms, large corporations, and startups that had deposited far more than $250,000 in SVB.
The quick government intervention helped prevent immediate chaos, ensuring that depositors could retrieve their funds and avoid a broader panic across the financial sector. By guaranteeing that no depositor would lose money, the government’s response aimed to contain the fallout and keep confidence in the banking system intact. In essence, it was a form of a bailout, albeit one that focused on ensuring public trust in the system rather than directly bailing out the failing bank itself. SVB’s assets were seized, and the FDIC moved to manage the liquidation process.
The Implications for Shareholders and Debtholders
While the depositors were protected, shareholders and certain unsecured debt holders were not as fortunate. They faced significant losses as their investments became worthless following the bank’s closure. The fact that the government stepped in to protect depositors but did not provide the same protection for shareholders or unsecured creditors highlighted a significant divide in how different stakeholders are treated in a banking crisis.
This divide is crucial because it signals a distinction between the interests of the public (depositors) and those of private investors. For the general public, the safety of their money is paramount, and the government’s intervention ensured that trust in the system was not completely eroded. However, for investors who had chosen to take on the risk of owning shares in SVB or providing unsecured loans, their losses were inevitable. This distinction between the protection of depositors and the risk borne by investors is a hallmark of how modern banking systems operate: the public sector shields depositors, while private investors absorb the brunt of losses.
The removal of senior management also carried significant weight. The dismissal of key executives served as a clear message: the collapse of SVB was not just the result of external factors, but of poor management decisions, which contributed directly to the bank’s downfall. The bank’s leadership was blamed for failing to mitigate risks associated with rising interest rates and mismanaging the liquidity crisis. Their removal was seen as a necessary step to restore trust in the system and prevent further reputational damage.
The Larger Debate Over Bank Bailouts
The bailout of SVB, while aimed at stabilizing the immediate situation, reignited the ongoing debate over the role of government intervention in the banking sector. While protecting depositors may have been necessary to prevent a broader economic collapse, the moral hazard of bailing out financial institutions that take on excessive risk is a complex issue. Critics argue that by stepping in to protect SVB’s depositors, the government effectively shields banks from the consequences of their own risky behavior.
In many ways, the bailout mirrored the response to the 2007-2008 financial crisis, where government intervention was necessary to prevent a total collapse of the global financial system. However, the 2008 bailout involved far more systemic institutions, including some of the largest banks in the world, leading to widespread public criticism and concerns about the fairness of using taxpayer money to prop up private companies.
In the case of SVB, the question remains: should the government have allowed the bank to fail, letting market forces correct the imbalance, or was this intervention necessary to protect the broader economy? Proponents of the bailout argue that SVB’s failure could have triggered a cascade of failures among other banks and financial institutions, leading to a much more serious crisis. Critics, however, contend that the government’s intervention merely prolongs the inevitable and fails to address the fundamental flaws in the banking system that allowed SVB to take on such risky investments in the first place.
Long-Term Implications: Trust in the Banking System
The SVB crisis and its aftermath have serious long-term implications for the banking sector. While the immediate crisis was averted, the event has raised significant concerns about the stability of other banks with similar vulnerabilities. Smaller and mid-sized banks, particularly those heavily exposed to interest rate risks or concentrated in particular industries like technology, are now under increased scrutiny.
The SVB collapse has also highlighted the dangers of over-reliance on government bailouts to protect the banking system. If a significant enough financial institution fails in the future, the public might question whether the government should continue to step in and protect depositors at all costs. For taxpayers, the implicit guarantee of bailout funds raises ethical and economic concerns: how much are we willing to let banks take on risk, knowing that the government may step in to pick up the pieces?
In the long run, the SVB failure may lead to regulatory changes designed to better monitor and manage the risks posed by banks, especially those that are more susceptible to rapid liquidity crises. The government may implement stricter rules surrounding risk management, capital adequacy, and asset management to prevent another collapse from happening. Furthermore, there may be a broader push toward greater transparency in how banks manage their investments and handle liquidity.
What Can We Learn from the SVB Collapse?
The collapse of SVB provides valuable lessons for individuals, businesses, and financial institutions alike. It underscores the importance of understanding the inherent risks in the banking system and how those risks can have far-reaching consequences when financial institutions take on too much exposure in risky assets. For depositors, the SVB collapse serves as a reminder that no bank is truly “too big to fail,” and that government protection may not always be a guarantee in the event of systemic collapse.
One of the key takeaways from the SVB situation is the need for diversification, not just for individual investors, but for financial institutions as well. SVB’s concentrated exposure to the tech sector and its reliance on long-term bonds in a rising interest rate environment proved disastrous. Banks must be more proactive in managing their asset-liability mismatches and more cautious about the risks associated with long-term investments.
Moreover, for those who entrust their funds to financial institutions, there is an increasing need to critically assess the stability of the institutions they rely on, especially in times of uncertainty. While deposit insurance offers some protection, it is crucial to understand the systemic risks that exist within the broader financial system. A bank’s balance sheet should not be taken for granted; transparency and accountability in banking practices are essential for building trust in the financial system.
Finally, the SVB crisis should serve as a reminder of the importance of sound governance. Poor risk management, lack of foresight in the face of rising interest rates, and a failure to heed early warning signs were critical factors in the bank’s downfall. Financial institutions must prioritize strong risk management practices, foster transparent leadership, and be more vigilant in assessing their exposure to macroeconomic shifts in order to avoid similar failures in the future.
In conclusion, the aftermath of the SVB collapse serves as a cautionary tale about the fragility of the banking system and the potential consequences of unchecked risk-taking. While the government’s swift response may have prevented an immediate disaster, the long-term lessons from this crisis must lead to reforms that will strengthen the financial system and ensure that similar events are less likely to occur in the future.
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.