Anatomy of a Collapse: The Fall of Silicon Valley Bank

The week ending on March 17, 2023, the tech industry witnessed two major events that sent shockwaves throughout the industry. Firstly, Open AI's GPT-4 made its debut with remarkable new features, generating significant interest among people. On the other hand, the industry was left reeling from the collapse of Silicon Valley Bank (SVB), which has now become the second-largest bank failure in US history. This unexpected turn of events has created a sense of widespread shock and uncertainty within the tech industry.

For the past forty years, Silicon Valley Bank has been one of the largest banks in the United States that caters to a specific market niche. Unlike traditional neighborhood banks, SVB is known for its strong focus on serving the innovation economy, which includes the technology, life science, healthcare, private equity, and venture capital industries. Due to its focus on these sectors, SVB plays a crucial role in supporting the growth and success of tech startups throughout the United States.

In order for tech startups to expand their operations, they require funding or capital, which is typically obtained through investment from venture capital firms and angel investors. These investors provide funding to startups in exchange for equity stakes in the company. Since these transactions involve the transfer of money, they are facilitated through a bank. Once startups receive their funding, they often deposit the funds into a bank account to continue their business operations. This is where Silicon Valley Bank comes into play, as it serves as the bank of choice for a large number of businesses and startups that operate in the technology and venture capital industries. As a result, the majority of Silicon Valley Bank's customers hold business accounts with the bank with deposits exceeding the federal government's insured amount of $250,000.

To many of us, the 1016 movie The Big Short directed by Adam McKey holds a very special place and is like a prophecy. The film dramatically depicts the events leading up to the fall of Lehman Brothers in 2008. At the end of the movie, the character Mark Baum, played by Steve Carell, bemoans our inability to learn from our mistakes. He predicts that in a few years, everyone will forget everything and the world will continue to operate in the same way. When I asked a friend about the collapse of Silicon Valley Bank, he echoed Baum's cynical sentiment, suggesting that he never believed the US banking system had truly changed after the 2008 Subprime crisis. While I share his concerns about the US banking system, the incidents involving SVB and Signature Bank (the third-largest bank failure in US history) have their own unique aspects that warrant further exploration.

What do banks do with the funds deposited by their customers?

Banks do not keep the entire amount of money deposited with them idle in their vaults. Instead, they retain a portion of it as liquid cash to cater to daily withdrawal requirements and invest the remaining amount. Therefore, when we deposit money in a bank, only a fraction of it is held as cash reserves, while the rest is utilized for investment purposes. This is called Fractional Reserve Banking.

Imagine you deposit $10,000 into your bank account. The bank will hold a portion of that money, let's say 10%, as liquid cash and invest or lend out the remaining amount. In this case, the bank will keep $1,000 as cash and lend out $9,000 to someone who wants to borrow it. The bank will earn interest on that loan, which it can use to cover its expenses and pay you interest on your deposit. Now, the person who borrowed the $9,000 may deposit it into another bank, possibly even the same bank, which will keep 10% of that deposit as cash and lend out the remaining $8,100. This process of lending and depositing repeats throughout the economy as long as there is money left to be lent or invested after taking into account the fractional reserve percentage.

The above table shows that in mere 10 iterations, your initial deposit of $10,000 creates a market deposit of over $60,000, a six-fold increase in value.

Fractional Reserve Banking plays a critical role in sustaining modern economies, with "more" being the keyword for growth. The system enables banks to generate money by issuing loans, as they can create new loans by utilizing a portion of the deposits they have received. This aligns with the principle of producing more to buy more, where an increase in consumer spending leads to higher income for producers, which, in turn, fuels further consumer spending.

It is worth noting that the Fractional Reserve Banking system rests on two fundamental assumptions, which serve as its pillars. Firstly, banks assume that not all depositors will withdraw their funds simultaneously, and therefore they only need to retain a fraction of the total deposits as reserves to fulfill any potential withdrawal requests. Secondly, the system relies on the assumption that the economy will remain stable, and borrowers will be capable of repaying their loans. If either one of these pillars collapses, it could destabilize the entire system.

Commercial banks invest depositors' money in a variety of ways, depending on their business strategies and the types of services they offer. Some common ways that commercial banks invest depositors' money include:

• Loans: Banks lend money to individuals and businesses, earning interest on the loans they provide. Banks may offer different types of loans, including personal loans, mortgages, and business loans.

• Securities: Banks may also invest in various types of securities, such as stocks, bonds, and government securities. These investments generate income for the bank in the form of interest or dividends.

• Real estate: Some banks may invest in real estate, either by owning properties or providing financing for real estate projects. Banks can earn income through rental income or capital gains on property sales.

• Other financial instruments: Commercial banks may invest in other financial instruments such as mutual funds, exchange-traded funds (ETFs), and derivatives.

It's important to note that banks are required to follow regulatory guidelines to ensure the safety and soundness of their investments. They must also maintain sufficient reserves to meet depositor demands and protect against unexpected losses.

How did SVB invest the money deposited by its customers?

In response to the economic impact of the COVID-19 pandemic, the US government implemented measures such as the purchase of Treasury securities and mortgage-backed securities to increase the liquidity of the financial system. As a result of these actions, SVB experienced a significant increase in deposits from venture capital firms and start-ups. The bank invested over $80 billion of its deposits in highly secured government mortgage-backed securities (MBS) mostly maturing in over 10 years of time, which had an average yield of 1.56%. One of the benefits of investing in long-term bonds is to secure higher interest rates compared to government bonds with shorter maturity span. Investing in long-term government securities with fixed interest rates can provide a stable source of income for investors who are looking for a relatively low-risk investment option.

Long-term government securities with fixed interest rates, also known as government bonds or treasury bonds, are debt instruments issued by a government to borrow money from investors for a fixed period. These bonds typically have a maturity of 10 years or more and offer a fixed interest rate, which is paid to investors periodically until the bond reaches maturity. The interest rate offered on these bonds is usually lower than the interest rate on other types of bonds, but they are considered to be less risky because they are backed by the government. However, there is always the possibility that interest rates may rise during the life of the bond, which can lead to a decrease in the bond's value.

What challenges did SVB face amid the post-COVID high inflation?

This is precisely what happened with SVB. The Federal Reserve's injection of excess liquidity into the market resulted in consumers having a surplus of cash. As per the economic principle of "too much money chasing fewer goods and services," this led to a surge in inflation in the US economy. This decrease in the value of money reduces the purchasing power of citizens, leading to a dampened public sentiment, which is something that politicians try to avoid. Therefore, the Fed opted to increase interest rates to put the brakes on inflation.

Since the reopening of the economy in 2021 after COVID-19 lockdowns, the US and other countries have experienced significant inflation levels not seen in recent history. Some experts attribute this rise in inflation to a pandemic-driven shift in consumer spending habits, where people moved from spending on services to goods. This shift happened at the same time as disruptions to supply chains and labor markets, which are also believed to have contributed to the inflationary pressures.

Data source: Consumer Price Index - U.S. BUREAU OF LABOR STATISTICS and US COVID Mortality Statistic - Our World in Data

The above chart shows that the Consumer Price Index (CPI) in blue, which is a key metric to gauge the retail price of a basket of goods and services and thus inflation rates in the United States, has been increasing rapidly since April 2021.

Central banks around the world primarily use interest rates as a tool to manage inflation. By adjusting interest rates, they can decrease or increase the amount of cash flowing into the economy. When interest rates are high, people tend to invest more in banks to earn higher returns, which reduces the amount of money available in the market. This decrease in liquidity leads to lower demand for goods and services, resulting in lower prices. Conversely, when the central bank wants to stimulate consumer spending, it can lower interest rates, which increases the amount of money available in the market, leading to higher demand for goods and services and subsequently higher prices.

Data Source: Federal Open Market Commission Website

To tackle the steep rise in inflation, which almost reached 9% by March 22, the US government opted to raise the interest rates. Over the course of seven meetings, they increased the interest rate by 450 basis points. This move had a negative impact on SVB's fixed-interest bond portfolio, which was invested in when interest rates were low. Consequently, the value of these bonds dropped significantly due to the sharp increase in the Fed interest rate.

How do banks manage the risk of their investments?

Investments inherently involve risk, whether they are in government or corporate bonds, the stock market, or commodities like gold and silver. In any investment, there is always the possibility that the asset's value may decrease due to unforeseen circumstances. For example, borrowers may fail to repay loans, or the price of purchased assets, like shares or commodities, may decline below the purchase rate, leading to a loss in investment value. This holds true for commercial banks as well, as they also face risks associated with their investments.

Let's understand this with an example -

Suppose you have invested $10,000 in a fixed deposit with an annual interest rate of 5% for a period of 5 years. Using the below formula of Future Value, your investment would be worth approximately $12,763 after 5 years.

Future Value = Present Value x (1 + Interest Rate) ^ Number of Years

However, there will always be some rate of inflation in the economy. Given a hypothetical current inflation rate of 2%, the value of your investment after adjusting for inflation would be approximately $11,593.

Future Value (inflation-adjusted) = Present Value x (1 + Interest Rate - Inflation Rate) ^ Number of Years

Although your investment has gained $1,170, it's important to note that the current inflation rate may increase in the future, potentially eroding the gains you anticipated and leaving you worse off.

The above table shows how the gradual increase in inflation rate erodes the investment value of fixed deposits over 5 years to the point where the investor is left with a loss of ~$500 at the end of the maturity period.

It's difficult to avoid these risks entirely, but they can be minimized by diversifying the investment portfolio into multiple asset classes that aren't impacted by a single event uniformly. As the saying goes, it's unwise to keep all of one's apples in one bucket. For example, investors can simultaneously invest in precious metals like gold or silver, which are often considered safe-haven assets during times of economic uncertainty. Investing in these assets can provide a level of protection against inflation and currency devaluation.

What is hedging and how does it help banks and other investors in mitigating investment risks?

Hedging is a strategy that investors use to reduce the risks associated with their investments. It involves taking an offsetting position in a related security or asset to protect against potential losses. The goal of hedging is to minimize the impact of adverse price movements and preserve the value of the investment portfolio.

In the previous example, incorporating precious metals as an investment alongside fixed deposits can be viewed as a hedging strategy to reduce risk. If the economy experiences inflation in the future, and the inflation rates increase significantly year on year, the investment in precious metals can potentially increase in value. This means that any losses incurred in the value of fixed deposits due to high inflation can be offset by the profits made in the precious metal investment. In simpler terms, the gains made in the precious metal investment can compensate for the losses incurred in the value of fixed deposits.

Hedging can be an effective way to manage risk, but it also involves additional costs and complexity. Depending on the strategy used, hedging can reduce potential profits if the underlying asset performs well. Moreover, there is always the risk that the hedging strategy will not work as intended, and losses may still occur.

Overall, hedging is an essential tool for banks and other investors who want to manage their risks and protect their portfolios against adverse market movements. It allows them to focus on their long-term investment goals while minimizing the impact of short-term price fluctuations.

The Real Problem: Systemic failure or strategic naivety?

At the end of 2022, the bank's year-end financial report showed that it had nearly no interest rate hedges on its large bond portfolio. The bank had terminated or allowed the expiration of hedges on over $14 billion of securities throughout the year. Interest rate hedges typically involve using swaps, which is a financial instrument that allows an investor to convert fixed-rate bonds or loans into floating-rate by paying a third party. For banks like SVB, interest rate hedges can be important since many of their investments are in fixed-income bonds such as Treasuries or mortgages. When interest rates rise, the value of fixed-income bonds falls, which happened to SVB.

In April 2021, the CFO of SVB informed analysts that the bank had put hedges on $10 billion of available-for-sale securities and that the bank would continue to do more to protect against further rate movement. However, by mid-2022, the bank changed its strategy and announced to investors that it was focusing on managing down-rate sensitivity, which meant that it was protecting itself if rates were to fall again.

Available-for-sale securities refer to financial assets that a company holds for investment purposes but not for trading or long-term holding. These securities may include stocks, bonds, or other financial instruments that a company can sell at any time to generate cash or profit.

In the case of a bank, available-for-sale securities can be used to hedge their portfolio in long-term fixed-interest rate government bonds. Banks are required to maintain a certain level of capital as a buffer against potential losses, and investing in available-for-sale securities can help banks achieve this goal.

Specifically, the bank can purchase available-for-sale securities that are expected to perform well if interest rates rise, which can offset any potential losses on the long-term fixed interest rate government bonds if interest rates rise. This strategy is the ideal hedge strategy for banks which helps to mitigate the risk of losses due to fluctuations in interest rates.

Throughout 2022, the bank decreased its hedges to the point where only $563 million of its $26 billion in available-for-sale securities had interest rate hedges at year-end, down from $15.3 billion a year earlier. The bank did not report any swaps on its other $91 billion bucket of bonds, which are held-to-maturity securities. Due to the rising interest rates on its available-for-sale bonds, the bank reported losses of over $2.4 billion last year.

Silicon Valley Bank's collapse on March 10th, despite having $212 billion of assets, was swift and shocking. The bank's risky move of investing heavily in long-term bonds without hedging its bets on interest rates staying low backfired, causing the bank to become insolvent. A class action lawsuit has been filed in federal court in San Jose, California, that alleges that the CEO Greg Becker and CFO Daniel Beck concealed from investors the potential impact of high-interest rates on the business of the bank. Meanwhile, a California lawmaker has been investigating the actions of Greg Becker, the CEO of SVB, in the weeks leading up to the bank's collapse. According to SEC filings, Becker sold SVB shares worth $3.6 million on Feb. 27, which has raised concerns and is being looked into. Although shareholders were wiped out, and bondholders faced significant losses, it can be argued that it was not a failure of the financial system, but rather a bad business decision that led to the collapse of SVB.

However, the United States banking regulators have regulations that require commercial banks to maintain appropriate risk management and hedging practices. These regulations are designed to ensure that banks manage their investment portfolios prudently and minimize risk to the financial system.

How do the banking regulators ensure oversight and vigilance across the banking sector regarding risk management?

The primary regulatory agencies responsible for overseeing commercial banks in the United States are the Federal Reserve System, the Federal Deposit Insurance Corporation (FDIC), and the Office of the Comptroller of the Currency (OCC). These agencies have established rules and guidelines that require banks to maintain appropriate hedging practices, as part of their overall risk management framework.

For example, the Federal Reserve System has established guidelines for managing interest rate risk, which require banks to use a variety of tools, including hedging strategies, to manage their exposure to changes in interest rates. Similarly, the OCC has issued guidance on managing credit risk, which includes recommendations for using credit derivatives and other hedging strategies to manage credit risk exposure.

In addition to these guidelines, banking regulators also conduct regular examinations of commercial banks to assess their risk management and hedging practices. During these examinations, regulators may review the bank's hedging strategies and risk management systems to ensure that they comply with regulatory requirements and are consistent with industry best practices.

Overall, the regulations and oversight provided by the United States banking regulators are intended to ensure that commercial banks maintain appropriate hedging practices and manage their investment portfolios prudently, in order to minimize risk to the financial system.

Why didn't US bank regulators see it coming?

According to experts, the lack of oversight in the US financial sector may be attributed to the gradual relaxation of laws put in place after the 2008 crisis. Initially, the Dodd-Frank law of 2010 required banks with at least $50 billion in assets to adhere to strict capital, liquidity, and other requirements. However, in 2018, the law was modified with support from former President Donald Trump to only apply to banks with $250 billion in total assets, resulting in fewer banks being subject to these requirements. Furthermore, regulators are said to be less vigilant about banks with exposure to treasury-linked securities, which are perceived as safe. In addition, regulators are more lenient towards banks that have meaningful relationships with depositors who hold more than $250,000, the threshold for federally insured deposits.

The crisis that impacted SVB was not caused by any issues with the long-term solvency or stability of their investment portfolio. Rather, the problem stemmed from their anticipation of a potential further reduction in interest rates, leading them to clear their hedge position in the hopes of making a significant profit. However, with no offsetting bet to cover their position, their liquidity became vulnerable to short-term fluctuations in interest rates. When they tried to borrow money from the market to maintain their reserve ratio, news got out and caused panic among customers. Many of these customers had deposits that exceeded the $250,000 limit assured by the Fed, and as a result, they began to withdraw their funds.

The aftermath of the collapse exposed the flaws in America's banking system. Despite having enough assets to return depositors' money, it would have taken a long time, leaving many tech firms in a financial freeze. This situation led to potential lay-offs and bankruptcies across the tech sector, and regulators and the government feared that depositors were losing faith in other banks. Consequently, on March 12th, they declared SVB too big to fail and guaranteed all deposits. If the sale of its assets does not cover the cost of the depositor bail-out, a fund financed by all banks will have to contribute, penalizing the entire industry for the recklessness of one institution.

What headwinds are start-ups likely to face?

Several stakeholders in the industry have stated that although the bailout will minimize the immediate impact, there may be a dampening effect on the entire tech industry due to the shift in sentiment. Since the U.S. government is guaranteeing all deposits, the direct impact on Indian firms and the industry as a whole is expected to be modest. Start-ups may face difficulties in making U.S. payroll and investments for a short period of time, but those with less than $250,000 per account at SVB should not be greatly affected.

As per multiple media reports, approximately 21 Indian startups had received investments worth $1 billion from SVB. The bank's failure has led to several challenges for these startups, such as obstacles in conducting international wire transfers, limited communication from U.S. agencies, and restrictions on withdrawals. Officials from the Indian Finance Ministry have acknowledged that the collapse of SVB could have an impact on some Indian tech startups and IT firms. However, they are of the opinion that any potential negative effects are unlikely to spread rapidly to India and are not expected to pose significant systemic risks.