Silicon Valley Bank (SVB), a well-known provider of financial services to start-ups and venture capital firms, failed due to a liquidity crisis that had widespread effects on the startup ecosystem. The story of SVB highlights the many inherent risks that banks face, including mismanaging the economic value of equity (EVE), failing to hedge interest rate risk, and experiencing a sudden outflow of deposits (funding risk). When a bank’s assets and liabilities are not properly aligned in terms of maturity or interest rate sensitivity, risks emerge, causing significant losses if interest rates change.
The failure to hedge interest rate risk leaves banks vulnerable to changes in the market, which can erode profitability. Funding risk emerges when a bank is unable to meet its obligations due to an unexpected outflow of funds, such as a run on deposits. In SVB’s case, these risks combined to create a perfect storm that threatened the bank’s survival.
SVB recently made strategic decisions to restructure its balance sheet, aiming to take advantage of potential higher short-term interest rates and protect net interest income (NII) and net interest margin (NIM), with the goal of maximizing profitability. NII is a crucial financial metric that banks use to evaluate their potential profitability, representing the difference between interest earned on assets (loans) and interest paid on liabilities (deposits) over a specific period, assuming the balance sheet remains unchanged. On the other hand, EVE provides a comprehensive perspective on the bank’s underlying value and how it responds to various market conditions, such as changes in interest rates.
The surfeit of capital and funding in recent years resulted in a situation where startups had excess funds to deposit but little inclination to borrow. By the end of March 2022, SVB boasted $198 billion in deposits, compared to $74 billion in June 2020. As banks generate revenue by earning a higher interest rate from borrowers than they pay depositors, SVB allocated the majority of its funds to bonds, primarily federal agency mortgage-backed securities to offset the imbalance caused by significant corporate deposits.
However, in 2022, as interest rates escalated steeply, and the bond market declined significantly, SVB’s bond portfolio suffered a massive blow. By the end of the year, the bank had a securities portfolio worth $117 billion, constituting a substantial portion of its $211 billion in total assets. As a result, SVB was compelled to liquidate a portion of its portfolio, which was readily available for sale, in order to obtain cash, incurring a loss of $1.8 billion. Regrettably, the loss had a direct impact on the bank’s capital ratio, necessitating the need for SVB to secure additional capital to maintain solvency.
Furthermore, SVB found itself in a “too big to fail” scenario, where its financial distress threatened to destabilize the entire financial system, similar to the situation faced by banks during the 2007–2008 global financial crisis (GFC). However, Silicon Valley Bank failed to raise additional capital or secure a government bailout similar to that of Lehman Brothers, which declared bankruptcy in 2008.
Despite dismissing the idea of a bailout, the government extended “the search for a buyer” support to the Silicon Valley Bank to ensure depositors have access to their funds. Furthermore, the collapse of SVB resulted in such an imminent contagion that regulators decided to dissolve Signature Bank, which had a customer base of risky cryptocurrency firms. This illustrates a typical practice in conventional finance, wherein regulators intervene to prevent a spillover effect.
It is worth noting that many banks experienced an asset-liability mismatch during the GFC because they funded long-term assets with short-term liabilities, leading to a funding shortfall when depositors withdrew their funds en masse. For instance, an old-fashioned bank run occurred at Northern Rock in the United Kingdom in September 2007 as customers lined up outside branches to withdraw their money. Northern Rock was also significantly dependent on non-retail funding like SVB.
Continuing the Silicon Valley Bank case, it is evident that Silicon Valley Bank’s exclusive focus on NII and NIM led to neglecting the broader issue of EVE risk, which exposed it to interest rate changes and underlying EVE risk. Moreover, SVB’s liquidity issues stemmed largely from its failure to hedge interest rate risk (despite its large portfolio of fixed-rate assets), which caused a decline in EVE and earnings as interest rates rose. Furthermore, the bank faced funding risk resulting from a reliance on volatile non-retail deposits, which is an internal management decision similar to the ones previously discussed.
Therefore, if the Federal Reserve’s oversight measures were not relaxed, SVB and Signature Bank would have been better equipped to handle financial shocks with stricter liquidity and capital requirements and regular stress tests. However, due to the absence of these requirements, SVB collapsed, leading to a traditional bank run and the subsequent collapse of Signature Bank.
Moreover, it would be inaccurate to entirely blame the cryptocurrency industry for the failure of a bank that coincidentally included some crypto companies in its portfolio. It’s also unjust to criticize the crypto industry when the underlying problem is that traditional banks (and their regulators) have done a poor job of evaluating and managing the risks involved in serving their clientele.
Banks must begin taking necessary precautions and following sound risk management procedures. They cannot merely rely on the Federal Deposit Insurance Corporation’s deposit insurance as a safety net. While cryptocurrencies may present particular risks, it is crucial to understand that they have not been the direct cause of any bank’s failure.
In conclusion, the collapse of Silicon Valley Bank highlights the inherent risks that banks face when their asset and liability structures are not aligned correctly. It also reinforces the importance of proper risk management procedures for banks and regulatory oversight to prevent excessive risk-taking. In the end, the failure of Silicon Valley Bank emphasizes that the traditional banking industry must update its practices to keep pace with the dynamic and rapidly evolving financial ecosystem.