Silicon Valley Bank (SVB) was the 16th largest bank in the nation, with more than $175 billion in deposits at the time of collapse. SVB was the bank of choice for much of the tech world, with a core focus on banking venture capital firms and startups. In other words, it banked many new tech companies and the firms that funded those companies.
Their deposits grew at an astonishing rate, increasing from $60 billion at the end of the 1st quarter of 2020 to nearly $200 billion at the end of the 1st quarter of 2022. As we will see, this growth resulted in risk that the bank did not properly manage when the depositors needed to access their funds.
How Do Banks Manage Deposits?
Banks make money by taking in deposits and then lending them at an interest rate higher than what they are paying depositors – this is known as “net interest margin.” To accomplish this, they can’t simply put your money in their vault. Rather, banks take in your deposits, lend some of it out, and keep the rest as a reserve to meet the liquidity needs of depositors – known as “fraction reserve banking.”
How Are These Reserves Invested?
Most of these reserves are invested in less risky government bonds or mortgage-backed securities. It’s vital for the bank to make sure that customers have access to their money when they need it, or it risks creating a bank run to see who can get their money first.
SVB invested much of their reserves in long term bonds, which was their fatal mistake. The value or price of bonds moves inversely with interest rates. For example, in 2015 if I bought 10 Year Treasury Bonds at an interest rate of 1.5%, but today the Treasury is offering those same bonds at an interest rate of 3.0%, no one will want to buy mine at 1.5% when they are available for 3.0%. The only way to sell the bond is to sell it at a discount or loss. This can reduce the available bank reserves held for depositors.
Banks are supposed to hedge this interest rate risk with what is known as “interest rate swaps.” Why SVB did not do this is currently unknown, although we suspect they will soon be called to account.
How Do Banks Typically Fail?
Banks typically fail in two ways: bad loans or poor liquidity management. In 2008, the banking crisis was caused by poor loan quality, as subprime mortgage bonds began to default in unexpected numbers. The current bank failures have been tied to poor liquidity management. As the value of their bonds held as deposit reserves began to decrease, some banks were left short on cash.
As George Bailey learned in It’s A Wonderful Life, bank runs can happen fast.
What Happens When Banks Fail?
Typically, when a bank fails, the FDIC temporarily takes over the bank and either looks for a single buyer or sells off its assets in pieces to different banks. The shareholders are wiped out and the employees are laid off. When a bank has failed, its assets are sold at a discount, which typically means the depositors are at risk of taking a loss on deposits over the FDIC-insured limit of $250,000. In addition to taking a loss, the customers often won’t have access to their deposits for a period until the FDIC can find a buyer. This can create operational issues for companies beyond the net loss on their deposits.
What Happened to SVB?
As previously stated, SVB was the bank of choice for many tech startups. This resulted in an unusually concentrated depositor base for an industry that tends to be more volatile than the market at large. The recent economic slowdown has hit the tech industry the hardest, as many recent layoffs show. When business slows downs, businesses typically begin to draw on the deposits they have built up in order to maintain operations (see the SVB deposit growth from 2020 to 2022). When the SVB customers began to burn through their deposits, the bank had the tap the reserves they held for such occasions. But because these deposit reserves were held in long term government bonds that had lost a tremendous amount of value, the bank had to disclose this loss to investors. Panic set in, the bank run started, and SBV failed. This entire event took place over the span of a few days.
On March 10, 2023, the federal government took control of SVB and placed all its assets under the control of the Federal Deposit Insurance Corp. As a result, all employees were laid off and the shareholders were wiped out.
But there has been much controversy surrounding how the depositors were treated. FDIC Insurance guarantees that depositors can recoup at least $250,000 in the event of a bank failure. Unfortunately, the balances held by most SVB customers far exceeded the $250,000 insurance, with over 90% of their deposits begin uninsured. This created a dilemma for the FDIC. Do they make SVB play by the rules in place, which could result in a panic spreading throughout the country causing more bank runs, or should the government provide special treatment to a well-connected group by guaranteeing these customers immediate access to all their deposits. The government decided on the latter, which did seem to calm the panic and most likely prevented more bank runs.
It should be noted that Signature and Silvergate Bank were also recently placed under the control of the FDIC, but these banks were heavily concentrated in cryptocurrency, so we don’t think they are reflective of the broader market. Overseas, Credit Suisse’s liquidity has also generated concern, although this has been years in the making.
Was it the right decision? There are so many variables at play that it’s hard to have conviction here. Sometimes the right decision can be made for the wrong reasons, and vice versa. This certainly creates some perverse long-term incentives to engage in similar behavior, but a national bank run could result in catastrophic consequences for the economy. There are many competing interests to consider.
Is My Bank In Trouble?
The current bank failures have been not reflective of the general banking landscape, with a concentrated deposit base operating in very volatile industries. But in any event, it appears that the FDIC backstopping the deposits have calmed the panic surrounding the contagion of a bank run. It’s also worth noting that unlike 2008, where the bank failures were the result of a systemic deterioration of assets, the current bank runs have been the result of poor liquidity management of certain banks. Although credit quality appears to be stable at the moment, we believe it is prudent to continue monitoring bank loan losses, specifically that related to commercial real estate held by small to mid-sized banks.
This has created a real predicament, placing the Federal Reserve between a rock (inflation) and a hard place (recession). While the Fed needs to continue raising interest rates to fight inflation, the increasing interest rates is what caused the liquidity crunch in banks. The Fed met on March 22nd and announced a 0.25% increase in rates.
One predictable outcome, outside of the Fed’s interest rate policy, is the internal and external pressure that will be on banks to maintain sufficient liquidity to meet depositor demand. Banks typically can accomplish this through either increasing deposits or tightening loan standards, in addition to making sure their reserves are properly hedged. As loan quality tightens, fewer loans will be made. There will certainly be fewer new business loans made. In addition, existing business will often seek working capital loans from banks to help maintain operations or facilitate expansions, which will also become harder to obtain. We expect this will finally begin to start nudging the persistently low unemployment higher, and may finally lead to the anticipated recission, which previously wasn’t declared due to the low unemployment numbers.
The silver lining may be how this impacts future rate hikes from the Fed. The primary way the Fed has been fighting inflation through rate hikes is the hope that higher rates would lead to higher unemployment, which ultimately reduces economic demand and alleviates some of the price pressure that has been fueling inflation. The tightening loan standards may accomplish the unemployment increases that the Fed’s rate hiking cycle struggled with.