The biggest US bank failure since the Great Financial Crisis of 2008 just happened last week. The bank is Silicon Valley Bank (SVB). SVB is among the top 20 largest banks in the US, with assets valued at over $200 billion. SVB just collapsed, and the regulator has taken over the bank. FDIC insures deposits up to $250,000; thus, those with balances up to that amount should not have any issues. Unfortunately, most SVB depositors have a lot more with SVB. Thanks to the prompt action by the regulators, all depositors ended up being made whole. A new lending facility is also introduced to provide liquidity to distressed banks. Wait a minute, a new facility? Are we injecting liquidity into the market?
What Caused Silicon Valley Bank to fail?
Silicon Valley Bank is popular among venture capital firms and technology startups. A significant percentage of them have a banking relationship with the SVB. During the 2019-2021 tech boom, SVB bank deposits increased three-fold. VC firms and venture-backed startups parked their cash there.
Risk Management Failure
SVB had to lend out these incoming deposits to earn interest so that they could pay back some interest to the depositors. As they could not lend them all, they lent a big chunk of them to the US government, the most creditworthy of them all. They parked a significant portion into MBS and US Treasuries with long maturity of 3 years to 30 years.
Here comes the SVB risk management failure: they invested depositors’ liquid money into long-dated bonds and securities, some even up to 30 years. What’s worse was that the interest rate of those bonds and securities was low. Knowing their illiquid investment profile, they still had no hedge against the interest rate movement. What a spectacular failure in risk management here.
As the Fed hiked interest rates last year, the value of their bonds dropped. Remember, bond value has an inverse relationship with its yield. This is fine as long as the bonds are held to maturity, where the principal will be returned.
The Fed Pivot and Tech Bust
As the Fed raised the interest rates, liquidity in the market became more scarce. Easy money was over. New deposits were slowing down. Many unprofitable tech startups kept withdrawing money to fund their operational expenses. There was also competition from the higher-yielding US Treasuries. Why would depositors keep the funds with SVB when they could get a higher yield from the latest US Treasuries?
The Collapse
Because they needed to keep serving the withdrawal requests, they started to have liquidity issues.
Here’s the deal with our banking system: when you deposit $100 into your bank, you technically have access to that $100 all day. However, behind the scenes, the bank does not always have 100% of all depositors’ money available. They lend out your money to earn interest so that they can pay back a portion of it to you. This is called fractional reserve banking. Only a fraction of the deposits (at least 10%) must always be available. The assumption is that not all depositors want to withdraw their money at the same time.
Remember, many of SVB’s assets were in long-dated bonds and securities. To shore up liquidity, they sold some of their holdings before maturity, triggering a massive loss. They sold $21 billion of their assets with $1.8 billion in losses. Eugh, that’s more than their previous year’s profit. They planned to raise capital by selling their shares to plug this massive loss.
This was a red flag. The market panicked, and the share price tanked 60% in one day. After dropping so much in the past year, along with the latest drop, SVB’s equity value was only ~$6B. They still had more bonds to sell if they needed more liquidity and would incur even more losses. With the low equity value, the market panicked because SVB might be insolvent should further liquidity issues arise.
As panic ensued, there was a bank run on SVB. Things escalated fast. You don’t want to be the last person to withdraw when there is a bank run. When a bank run starts, the process is fast, and collapse is inevitable. SVB CEO tried to calm the market to ensure their money was safe. Well, that’s again another red flag.
As the bank run worsened, SVB tried to raise capital and looked for buyers unsuccessfully. Hours later, the regulator officially took over SVB.
What is the Impact of Silicon Valley Bank Collapse?
FDIC insures deposits up to $250,000 per depositor. So all is well then? Well, unfortunately, not for Silicon Valley Bank depositors. Unlike the other regional banks, SVB primarily served businesses in the Silicon Valley area. Their customer base was concentrated. 97.3% of the SVB customers have deposits exceeding the insured amount. Ouch…
Tech Ecosystem
Many tech venture firms and startups had a banking relationship with Silicon Valley Bank. They parked their cash with SVB. Most of their money was locked because it exceeded the insured amount. There was a worry that they won’t be able to fulfill payroll obligations to their employees. There could be a wave of layoffs and bankruptcies among the tech sectors. Realistically, their money will likely not be lost, and most will be recoverable. But, with the uncertain timeline, it is as good as a death sentence to early-stage startups. Tech innovation could have been postponed for many years.
Other Industries
Is this contained just within the Silicon Valley technology venture firms and startups? Not really. Some companies have self-reported their exposure to SVB: Circle ($3.3 billion), Roku ($487 million), Bill.com ($670 million), BlockFi ($227 million), Roblox ($150 million), Sunrun ($80 million), Ginkgo Bio ($74 million), Ambarella ($17 million), LendingClub ($21 million), Payoneer ($20 million), Oncorus ($10 million), Eiger ($8 million), Sangamo Therapeutics ($34 million), Protagonist therapeutics ($13 million), and more. They would have faced short-term operational issues if their deposits were locked.
Crypto Contagion
Circle, the issuer of USDC stablecoin, was one of the depositors in SVB. Unfortunately for them, $3.3 billion of their $40 billion reserve was locked. That represented about 8% of its total reserves. USDC stablecoin, which is always supposed to be equal to $1 at all times, de-pegged immediately after the news. It reached as low as $0.88 before slowly recovering the peg.
Other stablecoins also de-pegged, as many have USDC as their collateral backing. Some of the de-pegging events were more of the market overreaction, but this highlights the systemic risk of the SVB collapse.
Contagion to Other Regional Banks
There have been rumors that other regional banks may also have unhealthy balance sheets and are vulnerable to a bank run. People were fearful as they had not seen such a bank failure at this scale in a long time. These regional banks are not ‘too big to fail’; thus, relying on the federal government to bail them out is a rather big ask. People have no strong incentive to hold their money in these regional banks. Why not just use the ‘too big to fail’ banks? Better safe than sorry, right?
The Resolution
Late Sunday, 12 March 2023, the Treasury, Federal Reserve, and FDIC released a joint statement to address the situation.
- All Silicon Valley Bank depositors will be made whole and can access their money immediately the next business day.
- Another systemic bank, Signature Bank, was closed down, and all its depositors will be made whole.
- Senior management was removed. Shareholders and unsecured debtholders are not protected.
- A new facility to provide additional funding to banks to help assure they can meet the needs of all their depositors.
This decisive action by the regulators provides a sigh of relief to the market. At least for now, a crisis of confidence in the banking system seems to be averted. The market is cheering for this resolution.
Is Fed Pivoting?
New facility to provide liquidity to distressed banks? That sounds like we are injecting more liquidity again into the system. This Bank Term Funding Program (BTFP) allows banks to borrow money for the short term by pledging high-quality assets. Therefore, the banks can use their underwater US Treasuries and MBS as collateral to borrow at full par value. So yes, there is short-term capital injection. But this is different from the typical Quantitative Easing we used to know when the government prints a massive amount of money. The amount here is limited to the losses of the banks’ current assets.
But aren’t we supposed to be reducing liquidity in the market? Though on the way down, inflation is still raging. Inflation usually correlates with the circulating money supply; thus, as the money supply goes up and down, so does inflation. Now that we start to add liquidity, inflation may become even more sticky. Is this a wise decision?
The Fed had some choices here. They can choose to shut down SVB, liquidate its assets, and return whatever is recovered to the depositors, a haircut but not a total loss. But they didn’t do that. They do not want any contagion to spread and for people to lose confidence in the US banking system. More bank runs, layoffs, and bankruptcies are not preferable. So they decided to make all deposits whole through the FDIC scheme and the Fed’s new lending facility. By guaranteeing that the banks will be able to meet their liquidity needs, people won’t need to withdraw their deposits, thus averting a bank run. Fiuhhh, everyone who queued in their local banks can go home and enjoy their week now.
As for the liquidity injection through their new lending facility, the starting amount is relatively minimal at $25B. But this can quickly expand if more banks require assistance. Some banks will tap this new facility, but the extent remains unclear. From the Fed’s point of view, this new facility allows them to maintain its current policy for a while until they want to shift its monetary policy officially or until something bigger breaks.
Regardless, the action from the Fed underscores their willingness to accommodate the financial system should something breaks. Even though it may create inflationary pressure, the Fed is committed to its action. Now that things started breaking, the Fed may become more cautious with their policy decision going forward. This can be the turning point, or as we call it, the Fed’s soft pivot. As a result, the market has priced a 25bps rate hike this March, down from the previous 50bps rate hike expectation. The market even priced rate cuts towards the end of this year.
