A Layman’s Explanation of Silicon Valley Bank’s Failure

A Layman’s Explanation of Silicon Valley Bank’s Failure

March 16, 2023

By the time you’re reading this, you’ll have likely heard that the market has been in turmoil for these last few days as a result of contagion fears, with all of this kicked off by the sudden failure of Silicon Valley Bank.  You’re probably wondering: do we need to be concerned about similar failures in other major or regional banks and if so, what should we do about it?

What happened to Silicon Valley Bank and why?

Late Friday, Silicon Valley Bank (SVB) was shut down by regulators that cited the bank’s lack of liquidity and insolvency.  How did this bank become insolvent when they had over $200 billion in assets?  To understand, you need to know a little about how banks make money. 

Fundamentally, a bank makes money by taking in deposits and then loaning out the same funds for a little more than they are paying to depositors.  The resulting difference or “spread” is what the bank realizes as revenue and allows them to continue operating.

In order to reduce risk, banks seek to diversify their holdings through increasing the number of depositors they work with and also by offering loans to a wide array of community stakeholders.  They do this just as you would diversify your portfolio of stocks and bonds.

However, what was so unique about SVB was the type of clients they focused on.  You’ve heard of Silicon Valley as being one of the tech centers of the country and a bastion of start-up companies.  SVB marketed heavily to those start-ups as well as the venture capitalists that sought to fund them.  They were VERY successful in that marketing effort and saw their deposits swell by more than three times over the course of couple short years.  This isn’t particularly problematic on its face.  However, there were a few problems with their execution, not least of which was the lack of diversity of their clientele.  They were loaning money to the venture capitalists and the companies they were funding, and then they asked those same clients to maintain all their deposits with them as well.  This strategy actually concentrated their risk within a small subset of clients, which were risky to begin with.

As their deposits were swelling at such a significant clip, they found they were not able to loan out as much money as they should have. So they weren’t earning the spread, but their cash was ballooning and they had to do something with it.  Despite the expectation that interest rates were going to be rising, they chose to purchase long-term treasury bonds with their capital reserves.  These were expected to be held until they matured, at which point all of the bank’s principal investment would have been paid back to them.

As an aside, here’s a secret: Banks divide their capital reserves into assets that provide liquidity and assets that are intended to be held to maturity, like those long-term treasuries.  The secret is that if a bank classifies its investment as being intended to be held to maturity, they do not need to value those investments daily.  They are disregarded from reporting in some respect, which no doubt made their balance sheets look much cleaner.

Now, as interest rates had risen so significantly over the past 18 months, the actual value of those long-dated treasuries’ market value had fallen considerably.  Over the same period, as borrowing costs were rising for the start-ups that were the bank’s preferred client type, the start-ups needed to use the capital that was in their bank accounts to fund operations.  As a result, the level of withdrawals from the bank were rising to a level where the bank was forced to sell bonds that has not matured and thus locked in serious losses on those sales.  They would no longer have enough in assets to cover potential withdrawal requests.

Bank depositors began to get wind of this fact because the bank had to disclose that they were selling those securities to meet withdrawal requests.  This in turn saw more and more bank clients seeking to transfer their funds away.  The dominoes had begun falling.  Social Media piled on and venture capitalists started telling their clients to pull their funds from the bank.  If one depositor requests all their money back, it’s not a big deal.  If they all ask for their money back, you create a bank run.

Ultimately SVB failed due to a confluence of factors that seem to be somewhat unique: poor security selection amongst their capital reserves, a flawed marketing plan, an inability to loan out funds at more lucrative rates for the bank, etc… It was a perfect storm that resulted in the bank being shuttered.

Some might wonder, why weren’t regulators more focused on the way this bank was positioning itself.  The frank reality is that under the prior administration, banking rules were loosened for banks that maintain less than $250bil in deposits, which they were.  Up to that point, the rigorous stress testing that was required of banks in the aftermath of 2008 were required of all banks with more than $50bil in deposits.  Had that regulation been maintained, it’s a reasonable assumption that we would not have seen this level of mismanagement from Silicon Valley Bank.

What can you do if you’re concerned about your banking relationship? 

First and foremost, I’ll start by saying that the unique conditions around SVB are not persistently seen throughout the banking system at this time.  It is an outlier by all accounts based on the data we have available. 

That being said, you should be aware of the limitations on FDIC insurance and be prepared to shift funds if you exceed insurance limits.  FDIC insurance covers depositors for funds held at a bank when those funds are equal to or less than $250,000 per registration.  What does that mean?  It means that if you have an account with $300,000 in cash at the bank, then $50,000 of those funds would be exposed to loss if the bank failed.  Notice I mentioned the limit, “per registration.”  This means that you could take that extra $50,000 and put it into your spouse’s name and then ALL of the funds would be insured because you would have $250,000 in one person’s name and the surplus in the other so all deposits would be under $250,000 per registration.

It’s worth mentioning that credit unions have protections as well, but the FDIC doesn’t insure deposits at credit unions, they have their own insurance fund run by the National Credit Union Administration.  This is still considered to be insured by the federal government, just not the Federal Deposit insurance Corporation.  The same limits apply.

In the wake of this event, obviously we’re seeing the markets do what they do: act first and ask questions later and that’s why we’ve been seeing some pronounced volatility.  We urge our clients to be calm in moments like these.  Cooler heads prevail.

The market will digest this moment in time, but the disruption is certainly unnerving.  And while we should expect to see some additional market movements rooted in these matters, we are here if you would like to talk about the challenges or opportunities these circumstances may create.